Now is Not the Time to Increase Taxes on Critical Investments

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Increasing taxes on investment is always a bad idea. Increasing taxes on investment during an economic crisis is economic malpractice. And yet, Reps. Bill Pascrell Jr., D-N.J.; Andy Levin, D-Mich.; and Katie Porter, D-Calif., have a new bill that does just that. Their proposal would increase taxes on investments that support businesses and jobs all across in America at a time when investments are needed more than ever.

The Carried Interest Fairness Act of 2021 is simply the regurgitation of a misleading talking point that has been around for more than a decade: Hedge fund billionaires are gaming the system to screw the little guy. To rectify this, the bill’s authors want to close “one of the most egregious loopholes in the federal tax code”—which they call the “carried interest loophole.”

Like most things in tax policy, this overheated rhetoric dramatically overstates and oversimplifies the issue. Closing the carried interest “loophole” would in effect increase taxes on investment managers, real estate developers, and other investment partnerships at a time Americans need these resources to rebuild our economy.

The bill would tax the very incentives that help investors best direct resources to support the most promising businesses and entrepreneurs as they recover from the economic hardships caused by COVID-19. 

Carried interest ultimately boils down to how the tax code defines labor income as opposed to investment income. The U.S. tax system taxes income from saving and investment twice: once when you earn it as wages, and a second time on any investment growth. This system of double taxation makes the type of investments necessary to support economic growth, job creation, and wage gains more expensive.

Our tax code’s built-in bias against saving for the future is partially mitigated by having a lower tax rate on capital gains and dividends. The top rate on investment earnings is 20% in contrast to the top income tax rate of 37%. This is a pro-growth feature of our tax code, not a loophole.

Whether or not you think carried interest is different than a traditional capital gain ultimately comes down to what you think the difference is between wage and investment income—a blurry line that is only necessary in our poorly structured income tax regime.

Many investment managers are compensated with both a traditional wage and some incentive-based compensation based on the profits from their investments. The portion of the investment earnings shared with the manager is known as “carried interest” and helps make sure the person investing your money is incentivized to manage it as best she can.

Since this carried interest comes from investment earnings, it makes sense to tax it like all other investment income, since it was likely already taxed as wages when the money was initially earned. This lower rate to diminish double taxation is what some refer to as the carried interest “loophole.”

In a report from 2007, Stuart Butler, then-economic policy director of The Heritage Foundation, described how new taxes on investment “would not only threaten the economy generally[,] but would also jeopardize a particularly important and crucial part of the entrepreneurial economy: capital-intensive firms that take the risk of investing in and restructuring underperforming enterprises and putting them onto a sound footing.”

Ending more egregious tax preferences, which actually do provide unfair benefits to a select few investors, like the exclusion of interest on state and local bonds or the corporate subsidy for low-income housing, would represent constructive reforms to the tax code. These would also meet the goal of raising taxes on high-income taxpayers. The new revenue should be used to lower tax rates for everyone.

If proponents of treating carried interest as wages were serious about designing a fair system, labor costs associated with management services should be deductible to the investment partners, lowering their taxable income. Proposals to tax carried interest usually ignore this crucial wage deduction, choosing only to focus on raising revenue.

By one account, if wage deductions were allowed, the proposal “would likely be a slight decline in total tax revenues.”

Haphazardly imposed new taxes on carried interest from critical investments is a bad idea that will harm the economy without raising much revenue.

New ways to raise taxes on investment income always come at the expense of all of us. Especially in a time of economic crisis, American workers rely on the support of continued investment for a future that will bring with it higher wages and greater economic opportunity.

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