Carried Interest

To a tax lawyer or lobbyist, the phrase "carried interest" has a fairly clear meaning: it is the share of the profits of a partnership kept by the general partners by virtue of their performance of managerial services.

Of course, a general partner with managerial responsibilities may also put some of his own "skin in the game," and earn a share of profit on the same basis as does any limited partner ... i.e. any investor. But the issue of "carried interest" involves specifically the portion of his compensation that is designated as a share of profit yet that is earned as a reward for services.

And the issue is this: how is that income to be taxed? Is it a capital gain or is it ordinary income?

Traditionally, carried interest has been taxed at the capital gains rate, which is a considerable tax break for some very wealthy people. This break came about, so far as I can tell, through historic accident, and has been maintained in place for the obvious reasons of cronyism and dealmaking.

There isn't any good resource-allocation justification for this. Back in July 2007 an Associate Professor of Law at the University of Colorado at Boulder, Victor Fleischer, put it this way: "[W]e 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." Yet they do agree on this -- "carried interest obviously represents a return on labor, not capital." Further, tax profs tend to believe in a broader base and lower taxes, which also inclines them to oppose a special exemption from ordinary taxation for this particular sort of [managerial] labor.

Personally, I'm against the taxation of income as such, whether the income is from labor or capital. But that does not mean that I'm going to support unwarranted carve-outs from an income tax on behalf of the privileged so long as an income tax is in place.

A lot is going wrong in the world today. A lot of what is going wrong, involves policies of the U.S. government concerning matters of taxation and finance. But this one thing is going right. The capital tax treatment of carried interest seems about to be dumped onto the publishers' slush pile of history.