Why We Tax–Moving Beyond Carried Interest

For the past few weeks (alright years), it feels like the debate on tax reform has centered around the “carried interest loophole” whereby private equity managers get their income taxed at a low rate. Based on the tax plans of Jeb Bush and Donald Trump, it appears the GOP is willing to remove the loophole as part of broader tax reform. Ultimately, removing the loophole is barely relevant, perhaps increasing revenue by $3-4 billion/year. Rarely has so much time been spent on an issue that matters so little. However, there are important policy lessons to be gleaned from the carried interest debate that actually have profound impacts on how and what we tax.

The Democrats have largely argued the point on “economic fairness” grounds, and republicans must be careful not to let the debate slip into this territoy because the fairness argument is misguided.

Let’s begin with the fundamental question: Why do nations tax? Nations tax to generate revenue that funds the government and associated social programs. Via these programs, the government (at the federal, state, and/or local level) provides national defense, education, welfare, economic and social security, etc. With the revenue, we can provide some comfort during retirement (ie Social Security and Medicare) or help those in hard times (ie unemployment insurance and food stamps), whatever that society deems fair and appropriate. The goal of taxation then is to provide the necessary amount of revenue while having the least impact on growth and the economy as in the end economic growth and not government provides the path for upward mobility and superior standards of living over time.

At the Federal level, we probably need to generate around 17.5-19.5% of GDP as tax revenue to provide services and run a roughly balanced budget. The challenge is finding the right mix of taxes that achieves this revenue run-rate while having the least negative spillover into the economy and capital allocation. By choosing not to tax X, we have to tax Y, so the economics savings of X better outweigh the costs of Y. It is at this level where the rationale for the carried interest loophole collapses. Was there really no better use for that $3 billion than exempting private equity managers from income tax rates? Almost certainly not. We are better off spending that $3 billion lowering taxes on the middle class who will spend their tax savings.

Economic fairness is a challenging, intangible concept, and typically, the side getting the benefit is the one who deems the action is fair, irrespective of reality. Fairness is a powerful political argument in the short-run that wreaks havoc in the long-run. Theoretically, what is fairer than a communist system where all join in the spoils equally? Yet in reality, such systems atrophy, breed corruption, cronyism, and collapse (see the Soviet Union). Economic fairness quickly erodes into an effort to help out connected industries and firms, unleveling the playing field. Focusing on making the tax system more efficient (ie maximizing revenue while minimizing economic distortions and mal-incentives) often yields the same results while promoting a balanced, growing economy that benefits all over time.

It is from this perch that republicans should argue tax and economic policy, and the potential for change is breathtaking with carried interest just a drop in bucket. Whenever a financial decision is made for tax rather than economic reasons, chances are that an inefficient tax policy is in place, and the shining example of this is the deduction of corporate interest expense, something the Bush and Trump plans actually start to address. Under current law, corporations cannot deduct dividend expense but can deduct interest expense, which makes debt artificially inexpensive.

Making something artificially cheap tends to lead to more of it, and debt is typically not something you want to incent the creation of. Leveraged systems have greater fixed charges and can be more vulnerable to shocks. A major reason why the tech bubble bursting only lead to modest recession while the Housing bubble nearly precipitated a global depression was the tech wreck was (primarily not exclusively) an equity issue whereas the housing crash was (again primarily not exclusively) a debt issue. Put simply, you cannot go bankrupt if you don’t owe anyone money. Equity losses are painful, but being unable to pay back debt can be devastating. Now, this is not to say the government should actively disincentivize debt, which can play a critical role in a capital structure and is a preferred asset class for many investors.

Rather, the government should neither incentivize debt nor equity over the other, instead letting the pure economics lead to the decision. Unfortunately, we have a system of financial arbitrage (a clear sign of an inefficient tax policy) whereby companies issue debt to repurchase stock because tax savings make interest expense less than the cost of the stock’s dividend. Similarly, private equity firms can sometimes can generate excellent returns, merely by issuing debt to take out equity and enjoy a sizable tax break. Now sometimes, these transactions make good economic sense, and as such, they would continue without the tax deduction. However, transactions that don’t make sense would not occur, and that capital would be free to be used in ways that are actually economically justified, which would be supportive of long term growth.

Removing interest deductibility on nonfinancial firms (financial firms like commercial banks need it to operate as they are in the maturity transformation business) would raise around $120 billion/year (about 40 carried interest loopholes!). To make up for this lost revenue, we have to maintain absurdly high marginal rates, and in the end, less indebted firms are subsidizing heavily indebted firms. It just so happens that these less indebted firms are often in technology, healthcare, and many start-ups, which are the primary engines of growth and innovation. The firms we need to invest for our economy to grow are the ones saddled paying for someone else’s subsidy.

By removing just this one deduction, we could bring headline corporate rates down to about 25-27% from 35%, making the US tax regime much more competitive immediately while giving our most innovative companies more after-tax profits (as they are no longer subsidizing heavily indebted firms) to invest in the future. Recognizing that some small business rely on bank loans to fund growth, we could continue to permit the deduction of interest expense on the first $25 million of debt without meaningfully impacting the amount of incremental revenue.

Now obviously any reform has to be phased in over about 5 years to allow companies who have built capital structures based on tax policies time to adjust and move to equity funding in a gradual fashion to avert a shock. In the end, moving on interest deductibility is the logical next step in the carried interest debate, and it actually will generate meaningful revenue with which to lower rates. Plus by no longer incentivizing debt over equity, we will build an economy more appropriately funded and insulated from potential shocks, which will be constructive for long term growth.

Carried interest and interest deductibility are just two examples of inefficient tax policies that lead to the misallocation of resources and unnecessarily drag on growth. Addressing these and other loopholes to bring down rates is the best path to counter the democrats’ politically motivated but doomed-to-fail “fairness” pitch as this conservative approach is the surest way to achieving economic growth and help the middle class regain the ground it has lost under the Obama Administration.