Tax Carried Interest at Ordinary Income Tax Rates

Carried interest is a form of compensation for investment managers at private equity firms and hedge funds. Many investment managers are often compensated according to a “two and twenty” arrangement: the investment managers are automatically paid 2 percent of all assets invested, and earn an additional 20 percent of whatever additional profits they help to bring in. This 20 percent fee is known as “carried interest.”

The proper tax treatment of carried interest is a subject of debate. Specifically, it is not always clear whether carried interest should be treated as labor income or capital income. Under current US law, carried interest is treated as capital gains income and is taxed at the same lower rates as long-term capital gains. Some observers argue that because carried interest is a form of compensation for managers’ talents and services, it is no different than any other form of labor income.

This option taxes carried interest as ordinary income for all taxpayers. This would increase marginal tax rates on income, reducing incentives to work and save, resulting in lower economic output. However, because carried interest is a relatively small portion of income, the overall macroeconomic effects would be small.

On a conventional basis, this option would decrease the primary deficit by $16.3 billion over the budget window. Long-run GDP and GNP would both be slightly lower. Incorporating changes in interest costs, the publicly held debt-to-GDP ratio would be largely unchanged from baseline, reaching 175.9 percent by 2056.

Taxing carried interest as ordinary income would primarily affect taxpayers within the top quintile, decreasing after-tax income for this group by less than 0.5 percent.