It’s really hard to defend the carried interest exemption (the one that allows private equity and venture capital partners to pay tax on their share of fund profits at capital gains rather than ordinary income rates). You have to give Greg Mankiw a hand: he sure gave it a good shot in the Times this weekend.
Mankiw’s general point makes a lot of sense. He argues that it’s sometimes hard to distinguish returns from labor and returns from investment, using five examples of people who buy a house for $800,000 and later sell it for $1,000,000. For example:
“Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.”
In this case, although some of Carl’s profit is due to his labor, all of it gets treated as capital gains by the tax code. In a perfect theoretical tax world, you would divide Carl into two people, the investor and the carpenter, and the investor would pay the carpenter some amount for his labor; the carpenter would pay ordinary income tax on that amount (and the investor would deduct it from his taxable profits). But that’s not how we do things.
The key example, for Mankiw, is the next one:
“Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.”
In this case, Dan pays capital gains tax on his $100,000 in profits because he’s part of an investment partnership—even though the thing he contributed to the partnership is labor, not capital. Private equity partners, Mankiw argues, are just like Dan: they enter into a partnership with investors, in which the private equity guys contribute expertise and effort and the investors contribute cash. Hence they should pay capital gains on their share of the profits (usually 20 percent).
But there are two big problems with this argument, one of which Mankiw essentially points out. Mankiw recognizes that Carl is contributing labor, even though the tax code pretends he is just contributing capital. If the basic principle is that the capital gains rate should be reserved for profits from investment activity, not labor activity, it’s clear that Carl should pay ordinary income tax on some of his profits; it’s just as clear that Dan should pay ordinary income tax on all of his profits.* (That’s also the logical result if you think, as many supply-siders do, that the point of lower capital gains rates is to encourage savings; Dan in particular didn’t save any money.)
In other words, Mankiw’s own examples make it look like Dan is benefiting from a dubious loophole. Then he argues that since private equity partners are doing the same thing Dan is, they should benefit from the same dubious loophole. That’s not much of a defense.
The other problem is that private equity partners are not actually like Dan the carpenter. If Dan and Ms. Moneybags are in a true 50-50 partnership, then Dan is on the hook for half of their losses, as well. The great thing about 2 and 20, for private equity partners, is that they get a cut of the profits but they don’t absorb a share of the losses. This means that the 20 is more like a performance bonus than like a partnership share. So if the 20 is in a gray area, as Mankiw argues, it is even closer to ordinary income than Dan’s partnership share—which, as Mankiw shows (although he doesn’t quite come out and say it, for obvious reasons), should be treated as ordinary income.
Still, I don’t think you can do a better job than Mankiw does trying to defend the carried interest loophole. Which just shows how indefensible it is.
* The same argument can be made about most stock-based compensation, including stock owned by company founders. If Mark Zuckerberg ever sells any of his bajillion dollars’ worth of Facebook stock, he will pay capital gains tax—even though he earned that stock by contributing expertise and labor to the company, not investing his savings in it. As a onetime company founder, I used to think that I was entitled to capital gains tax rates because I bought my shares on day one (for a pittance). But from a substantive perspective, it’s clear that mainly what I contributed to the company was labor, not investment. In the end, this is all an argument (though not necessarily a conclusive one) against a distinction between ordinary income and capital gains in the first place.
This post originally appeared at The Baseline Scenario and is posted with permission.