Lowman S. Henry is chairman and chief executive officer of the Lincoln Institute of Public Opinion Research, Inc., a nonprofit educational foundation based in Harrisburg, Pennsylvania. He serves as host of the Lincoln Radio Journal, a weekly public affairs radio program syndicated on 79 Pennsylvania radio stations, and is host of American Radio Journal heard on 134 radio stations nationwide.
Tax policy received scant attention in the presidential debates, but when it did, both candidates displayed a serious lack of understanding regarding at least one critical component of the tax code: carried interest. Although arcane in nature and unheard of by most, carried interest is a tax rule that fosters capital formation, encourages
investment and, ultimately, leads to job creation.
type of capital gain. Homeowners are familiar with the term “capital gain,” which, in that circumstance, refers to the increase in value of your home over time as you make improvements or rising market prices increase its sale price. If you sell your principle residence and make more than $500,000 in profit as a married couple, you must pay a capital gains tax. You pay the capital gains tax rate, not the ordinary income tax rate, on the transaction because you already have paid taxes on the income used to purchase the house.
Likewise, carried interest is a longterm capital gain that is earned by an investment partnership. In this case, the asset is not a house, but an investment portfolio that the partnership established and grew over time. When sold, the portfolio manager pays a lower capital gains tax rate on the fund’s profit, not the higher ordinary income tax rate.
The presidential candidates, unfortunately, decided to portray carried interest capital gains as a loophole granted to special interests. Both President-elect Donald Trump and Hillary Clinton wanted to raise this capital gains rate claiming it gives investment fund managers an unfair tax break. Fairness, however, is not what such an increase would
achieve. Rather, it would amount to double taxation.
The negative effects would be much worse than over-taxing a subset of taxpayers. The partnerships that are formed when an investor joins with a fund manager result in a structure that fosters informed investments that grow over time. This growth generates profits. When the profits are reinvested, that is called capital. Such capital is invested in businesses, so that they can grow, expand and create jobs.
Carried interest capital gain rules play a critical role in allowing capital to form. If you raise the carried interest capital gain tax rate, the government will take more in taxes—dramatically decreasing the amount of capital available for investment in the economy.
A significant portion of that capital available for investment is invested right here in Pennsylvania. According to the American Investment Council, private equity firms invested an estimated $24.49 billion in Pennsylvania-based companies in 2015. There are 143 private equity firms headquartered here. These companies support more than 185,103 workers at facilities both in Pennsylvania and in other states.
In other words, carried interest capital gains is not a tax device aimed at making Wall Street fund managers richer. Rather, it is appropriate taxation that makes more capital available for investment in the companies that are creating much-needed new jobs for Pennsylvanians and elsewhere.
Raising the current 23.8 percent carried interest rate to 33 percent as proposed by President-elect Trump (or almost 50 percent as previously suggested by Clinton) would result in only a modest increase in tax revenue flowing into the federal treasury. And we all know that any move to raise this rate would likely be coupled with other tax hikes on working families and small businesses.
Even if you set aside the unfairness of double taxing investors, raising the carried interest tax rate or eliminating that category of capital gain entirely would have the detrimental effect of reducing capital formation. That means dramatically fewer dollars available for companies to grow and create new jobs.
Carried interest is not a tax break for the wealthy; rather it is a way for investors to put their earnings to
work creating the new jobs needed as the nation struggles to recover from the Great Recession.