There is a strong consensus among presidential candidates and the general public that our tax code is too complex and in need of reform. As a business owner, I agree. However, I also believe we should not abandon policy that drives growth and innovation in our economy for political expediency.
The tax treatment of carried interest is a timely case in point. This long-standing tax law is again being singled out as a political target. And yet empirical evidence shows that tax laws that incentivize long-term investments serve as economic engines. While many politicians have long supported the current law, which taxes carried interest as a long-term capital gain, several candidates for president are misrepresenting what carried interest is in an effort to score cheap political points by calling for its tax treatment to be changed.
Carried interest is not a tax loophole. Despite some critics’ best efforts to mislabel carried interest as a “loophole,” it is anything but. For more than 100 years our tax code has consistently recognized that carried interest is capital gains income. The law appropriately recognizes that carried interest is a share of profits from a capital asset – e.g. an operating business – owned for years, and bears with it the risk that the company will not generate a profit. Changing the tax treatment of carried interest would deprive certain partnerships of the same long-term capital gains treatment available to other kinds of businesses that make long-term investments.
Long-term investing comes with risk. Unlike a salary, if an investment fails, no carried interest profit is realized. Moreover, in certain cases, prior carried interest can be “clawed back” if subsequent investments do not earn profits. That is, partners actually have to return carried interest income if their investment fund does not achieve the return target rate set by investors in partnership agreements. Have you ever heard of an employee having to return a portion of their ordinary income in this way? Neither have I.
Private equity partners, real estate partners, and venture capitalists already pay ordinary income tax. Like everyone else, partners in real estate, venture capital, and private equity funds pay federal ordinary income tax rates of up to 39.6 percent on their salaries and bonuses. Further, they also pay applicable state taxes. And like everyone else, they pay long-term capital gains rates on profits they make for the sale of capital assets they have held for more than a year, such as companies and buildings they own and improve.
Our tax system appropriately treats those who invest expertise to grow a business the same as those who invest money. In a partnership, some individuals have money to invest and some offer contributions of expertise and ability to tackle the hard work of creating or growing a business. We do not - and should not - place a higher value on one group over the other. In the United States, there are more than 27 million partners invested in over three million partnerships – a number that grows almost every year. To tax comparable partnerships and partners differently would create a discriminatory policy that punishes certain types of partnerships and partners while favoring others.
Long-term investment is an economic driver. Last year alone, private equity drove over $480 billion into the U.S. economy and is responsible for saving jobs, turning around companies, and helping companies grow. I’ve experienced private equity at work firsthand. I ran my former company, the U.S.-based manufacturer AxleTech, under a three-year partnership with the private equity firm The Carlyle Group. During this time, we tripled AxleTech’s level of capital spending on new machinery and facility expansion, resulting in a doubling of worldwide production. We also nearly doubled employment from 450 employees to about 900, including 300 unionized employees between 2005 and 2008. Now I’m an operating executive at the The Carlyle Group and I witness private equity success stories all across the United States.
By and large, lawmakers recognize the importance of long-term investment and incentives for those willing to provide financial or so-called sweat equity in a partnership. This is a policy that we should embrace. It allows those who invest their heart, soul, and expertise in an enterprise to be rewarded for taking the risk of creating something they believe in.
Petrovich is an operating executive at The Carlyle Group, a private equity firm. Prior to Carlyle, she was CEO of Axle Tech International, culminating in the December 2008 sale of Axle Tech to General Dynamics.