In a recent piece for the National Review, Kevin Williamson made the essential point that the “carried-interest loophole” isn’t “a loophole at all,” and he’s absolutely right.

As he points out, “The steps between making an investment and realizing a profit are many and complex and difficult. And not every deal works out in the end. Sometimes, they – this may shock you – lose money.” The risky nature of private equity investing, whereby the odds generate positive returns, is “one of the reasons that it enjoys tax advantages.”

The Risk of Investing

Carried interest is not income. Income is what we expect to earn; it’s a salary or a deal we have in place, often in contract form. And while work is penalized way too much by the tax code, there’s a big difference between what we earn in a paycheck versus “carried interest.” With the latter, we are only rewarded with actual income if a collection of investments bears fruit. There’s nothing certain about it, which explains why carried-interest income is taxed at the long-term capital gains rate of 23.8 percent, versus a top income tax rate of 43.4 percent.

If the investment succeeds, the returns will be impressive precisely because the odds of success are so slim.

 

Regarding the income tax rate, 43.4 percent is much too large a penalty to levy on top earners, on anyone for that matter, but particularly on those who make earn a lot of money because of their significant accomplishments. They’re the vital few whose accomplishments accrue for us all, as evidenced by the extraordinary economic impact of billionaires like Jeff Bezos, the late Steve Jobs, and Phil Knight. Their valuable work shouldn’t be so heavily penalized.

As for capital gains, there are no companies and no jobs without investment first. In that case, the cost of investing should be zero. Why would we penalize society’s benefactors who forego consumption in favor of investments that create opportunities and advancements that greatly enhance our living standards?

Meanwhile, “carried interest” is the income that an investment manager only earns after exceeding a predetermined (“hurdle rate”) return for investors in a partnership. This form of income is very uncertain because there is not a guarantee that the investment managers will exceed their hurdle. This is especially true in private equity partnerships.

Figure that private equity investors are frequently committing capital to companies that are on the proverbial deathbed, desperate for capital infusions that might revive them. Because they’re so ill, the odds of their revival are slim. If the investment succeeds, the returns will be impressive, but they’ll be impressive precisely because the odds of success are so slim.

Some private equity funds focus on developing small companies with an eye on growing them into big ones. Once again, the odds of success are extraordinarily slim. And just the same, the long odds of success mean that if investors commit the capital wisely, such that small becomes large, the eventual returns can be pretty grand. But this is the polar opposite of a sure thing.

Crucial growth capital is locked up in yesterday’s best ideas at the expense of tomorrow’s.