Friday Letter Obama's carry tax is a blunt instrument

Washington is once again – inevitably – focused on carry tax as a revenue raiser. Private equity professionals would have welcomed a more nuanced approach.

It wasn’t really a surprise when US President Barack Obama said earlier this week he planned to raise $18 billion in revenue by increasing the taxes on carried interest.

Currently taxed at a 15 percent capital gains rate, which goes up to 20 percent after 2012, carried interest has for years been on US policymakers’ radars. Many have argued, and put forth various related bills and proposals, that it ought to be considered ordinary income (which post-2012 will be taxed at a 39.6 percent rate for the top tax bracket). Other countries, too, have increased the tax on carry; in the UK, for example, capital gains tax rates shot up to 28 percent last year from 18 percent.

Despite repeated attempts, no proposed legislation changing the designation of carry tax in the US has managed to pass both chambers to date. But now Obama has made clear that what he feels are “tax breaks for millionaires and billionaires” won’t continue.

It’s a shame, however, that the spirit behind one of those prior Senate proposals – which would have taxed 75 percent of carry as ordinary income and the balance at the capital gains rate – seems to have fallen by the wayside. As we’ve pointed out in the past, the arguments for and against changing the tax designation for carry are complex because it does not fit neatly into either the capital gains category or the ordinary income category, no matter how much rhetorical force is put behind attempts to do so. Even if we’re not sure the 75/25 idea had the percentages right, it was an attempt to compromise and capture the multifaceted nature of how private equity funds share in the profit they generate.

It is also regrettable that higher taxes on carry may adversely impact some of the smaller, SME- and regionally-focused US fund managers. By definition they receive less fee-related income than the bigger groups, and a blanket increase on carry tax would hit the most important part of the compensation structure that keeps them truly aligned with their investors and devoted to their portfolio companies’ success. As one LP told us this week, taxing more aggressively what a professional at such a firm takes home will make attracting and retaining talent even more difficult than it already is for smaller funds. (Those smaller firms, it’s also worth noting, are the ones that are most frequently operating in distressed US regions Obama has flagged in his plan to boost job creation.)

In any event, and regardless of whether they agree with Obama’s ideas on fiscal policy, most US fund managers are by and large resigned to the idea of paying more taxes. As the chief executive of one large US fund manager noted recently: “In order to solve the problems we have in this country, everybody’s going to have to sacrifice something.”

But again, making this sacrifice would have been easier had the government tried to recognise some nuance, both in the nature of carried interest and among the various types of fund managers and their importance to the economy.