Is carried interest simply a tax break for the ultra rich?

Paul Solman
Business and Economics Correspondent
BY  
Social impact investing is taking off, says Pax World CEO Joseph Keefe, not simply because investors care about diversity and sustainability, but because companies focusing on those issues deliver strong long-term results. Photo by Flickr user Surat Lozowick.

While the top tax rate is almost 40 percent for all earned household income for those who make more than $450,000, the top tax rate on long-term capital gains is only 20 percent. Photo by Flickr user Surat Lozowick.

Editor’s Note: There is one thing that Bernie Sanders, Hillary Clinton, Jeb Bush and Donald Trump all agree on — their professed dislike of the “carried interest” loophole.

Carried interest is a money manager’s share of the profits made by investing clients’ money — typically, around 20 percent. If those profits were made on investments held for more than a year, they’d qualify for the long-term capital gains tax rate of 20 percent, instead of the earned income tax rate of nearly 40 percent.  This would apply to both the clients’ share of the profits, and the money manager’s “carried interest” share.

While some, like the Private Equity Growth Capital Council, argue that it’s an important driver of economic growth, Sanders, Clinton, Bush and Trump have all said they would seek to end the carried interest tax break.

And they aren’t the only ones. The group Patriotic Millionaires, headed by Morris Pearl, is pushing to end it, on the grounds that it is really just ordinary income.

Economics correspondent Paul Solman spoke with Morris Pearl about carried interest and his crusade against it. Tune in tonight to watch this week’s Making Sen$e report on the topic. The following transcript has been edited and condensed for clarity and length.

Kristen Doerer, Making Sen$e Editor


Paul Solman: What is carried interest?

Morris Pearl: The term originated from the practice of ship owners and ship captains getting a 20 percent commission on the things they carried. If you were going to operate a ship and drive it from, say, the New World back to Europe with some valuable cargo, you and the captain of the ship would keep an interest of 20 percent for whatever you carried. So it’s called the carried interest.

Today, it means that if you’re managing money for somebody, you might have an arrangement where you get a 20 percent fee based on the income that your client makes.

Paul Solman: So if you’re managing money for me, and my portfolio goes up by a million dollars, you get $200,000?

Morris Pearl: Right. If I’m managing money for you, we would sign an agreement where you would get 4/5 of the profits, and I would get 1/5 of the profit for doing the management work. So yes, if your portfolio went up by a million dollars, I would get $200,000. But furthermore, if that million dollars happen to be a long-term capital gain, you would get the benefit of the long-term capital gains rate, but so would I as your partner.

Paul Solman: If my portfolio is held for a year and a day, I’m a long-term capital gain recipient. And you are too, because you get 20 percent of my profit.

Morris Pearl: And the partnership agreement specifies that the manager would get 20 percent of the profits of all the people who are investors in the arrangement, even though the manager didn’t invest the money.

Paul Solman: Is the capital gains tax break a good idea? After all, the point is to encourage investment, which makes the economy grow and makes everyone better off.

Morris Pearl: Well, to an extent, it’s a good idea. But I think that it is way too low in comparison to the taxes that ordinary working people pay. I don’t think it is right that wealthy people, who simply collect income from their investments, pay tax at a much lower rate than people who actually work for a living. The wealthy should pay tax a higher rate than the working class people, not a lower rate.

Paul Solman: Why?

“I don’t see why I should pay taxes at a lower rate than other people, because I happen to have the good fortune of being wealthy enough to live off my investments instead of having to work.”

Morris Pearl: I think the wealthy have more ability to give back to their country that helped make them wealthy. I have a lot of money not because God’s countenance shined upon me, but because I could build a business based on all the things that the government provided. I went to public schools. I went to a public university. All those things came from the taxes paid by people who came before me. I don’t see why I should pay taxes at a lower rate than other people, because I happen to have the good fortune of being wealthy enough to live off my investments instead of having to work.

Morris Pearl: I have worked hard in my life, but there are plenty of people who worked far harder than I have at actual backbreaking jobs, whether it’s driving buses, taking care of the sick people in the hospitals or rescuing people from fires. They pay tax at a much higher rate than I do.

Paul Solman: But you make more than those people, because you add more to the economy, and in the end, that makes everybody a little better off.

Morris Pearl: Well, look, Paul, it’s simply not true. The wealthy people have their money, and they become wealthier when they get more money. It’s the less wealthy people, the working class, the middle class; they spend money when they make more money. So giving a tax break for the wealthy does nothing or very little to help the economy grow. Giving a tax break to working-class people or middle-class people does a lot to help the economy grow. If you run a business, and you’re depending on people coming to your business to buy things from you, the thing you want most is for your customers to get a raise, so they can afford to buy more from you.


Update: This editor’s note has been updated. The original description of the carried interest loophole was incomplete. 

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