Since a certain Vermont senator announced his 2016 bid for the presidency, the myth that rich people don’t pay their “fair share” of taxes has been revived from left to right. Actually, the top 1% — frequently heckled by that same Vermont senator — pay nearly half of all federal income taxes. Nevertheless, political class warfare continues.
Most recently, the Trump administration announced its support for a long-time priority of the Democrats: raising taxes on “carried interest." The latter is a share of profits collected by investment managers as a “performance fee” on alternative investments such as private equity. Currently, carried interest is taxed at 20% like any other long term gains tax. The Trump administration has proposed taxing it as regular income, which would increase the rate to 37%.
This might seem little more than an annoyance for finance types. In truth, it threatens progress. The perception that high earners are the only ones benefiting from the set tax rate on carry is misguided. If lawmakers succeed in this tax hike, investors of all income brackets will pay for it.
To critics, such a view is an outrage — surely successful asset managers should pay for their exclusive access to this wealth! Nonetheless, operating on feel-good tax policy ultimately misses the law of unintended consequences. Raising taxes on carried interest will hinder effective management of sizable investments in real American industries, from artificial intelligence funds to grocery chains. Portfolio management thrives off rewarding merit, with those achieving the greatest returns receiving a share of the pie. This encourages hard work and creates a culture of excellence.
The "fairness" argument overlooks the critical role performance-based compensation plays in attracting talent to the financial sector. Carried interest is a reward to a fund manager based on how much they were able to grow an investment. It’s not an employer-paid income. High-performing investment managers aren't simply collecting a paycheck; they generate returns funding public pensions, supporting critical infrastructure projects, and driving innovation across multiple sectors. Taxing their earnings more heavily actually discourages the huge risks involved in putting wealth to work. Furthermore, taxes are a price. This one raises the cost of buying and improving companies.
Raising the cost of alternative investment would come with costs. Some estimates go as high as 5 million jobs lost in the next five years, and up to $3 billion in annual pension fund losses. While pushed as a David vs. Goliath, help-the-little-guy tax reform, taxing carried interest as ordinary income would chill investment activity by private equity firms, venture capital groups and real estate partnerships.
Despite populist politicians' false claims, these firms are responsible for supercharging entrepreneurship and promoting competition in the economy. They aren’t evil or bad for everyday Americans. These investments support the creation of new businesses, creating jobs and raising tax revenue.
In turn, investors — whether savvy bankers in Manhattan or typical earners with 401k plans — receive returns on their financial commitment. Those working day and night to strategically make these decisions shouldn’t face extra tax penalties.
Less investment means fewer startups, weaker pensions and slower innovation — but politicians still pretend Wall Street excess can fund their wish lists. In reality, taxing carried interest like wages won’t level the playing field. It’ll just knee cap the industries keeping the economy running.
