July 31, 2007
The Academic Consensus on Carried Interest
Posted by Victor Fleischer

The Senate Finance Committee held another hearing on Carried Interest today; you can read the written testimony here. 

While the political issue is very much up in the air in DC, even among some Democrats, it's safe to say that there is an academic consensus among tax profs on the issue:  the status quo is problematic, and it should be addressed.   Three academics testified to that effect today - Joe Bankman (Stanford), Charles Kingson (Penn), and Darryl Jones (Stetson).  I'd previously testified at a committee roundtable, and Mark Gergen (Texas) testified at an earlier hearing.

We may not all agree on exactly what to do about the tax issue -- (1) tax the grant of a profits interest at ordinary income rates, (2) tax the returns at ordinary income rates at the back end, or (3) a hybrid approach (like my Cost of Capital or loan approach), or (4) even repealing the capital gains preference altogether.  Some of us would apply the changes to all partnerships, others would limit it to smaller partnerships.  But as more tax academics weigh in, it's clear that there's a consensus that this is an issue worthy of legislative action.  There's myself, Mark Gergen (Texas), Joe Bankman (Stanford), Dan Shaviro (NYU), Lily Batchelder (NYU), Noel Cunningham (NYU), Darryl Jones (Stetson), Alan Auerbach (Berkeley), Chris Sanchirico (Penn), and many others -- everyone agrees that there's a case for reform.  And this isn't a bunch of lightweights; nor is it a group that generally believes in higher taxes, or more redistribution. We tend to believe in a broader base and lower rates, and that's one way of viewing carried interest reform.  There are really few academic voices in dissent; the most prominent voice in dissent had his research sponsored by the Private Equity Council, so I'm not sure he counts on this issue.

What's remarkable about all this is that we tax profs are not a group that agrees on much -- there's division in the tax academy about income tax vs. consumption tax, corporate tax vs. full integration, territorial vs. worldwide taxation, whether to have an estate tax. 

One way to see why a consensus has emerged on this issue is to consider what happens to carried interest in a consumption tax world.  Consumption tax advocates tend to believe that not taxing capital income is the best way to grow the economy, as it encourages saving over consumption.  Now imagine a capital gains rate of zero, i.e. no tax on investment income.  In that world, private equity fund managers would pay no tax at all on their carry, since it qualifies as investment income.  (The fund managers get to exchange services for an investment in their own fund using pre-tax dollars -- and pay no tax on the back end, either.)  That can't be the right result -- carried interest obviously represents a return on labor, not capital.  So even if you have an underlying belief that encouraging investment is the best system for economic growth, we need to deal with the carried interest issue.  And it's this kind of thinking that explains why, in addition to the likes of the New York Times and Washington Post, you also have the Economist and Financial Times in favor of carried interest reform.

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