Carried Interest Tax Hike: Negatives for Entrepreneurship and Small Business

By SBE Council at 20 February, 2025, 4:32 pm

by Raymond J. Keating –

Given the negative connotations of the phrase “tax loophole,” when is a “tax loophole” not a “tax loophole” at all? Quite simply, when the so-called “tax loophole” actually makes sense from a tax policy and economic perspective. (Yes, most of the tax code ignores economic common sense, but that’s a larger debate for another day.)

Our focus here is on the tax treatment of “carried interest,” and the implications for entrepreneurship, small business and innovation-driving investment if the top tax rate on carried interest were to increase by 71 percent, as advocated by assorted Democrats in Congress and encouraged by President Trump.

For example, earlier this month, 13 Senate Democrats announced the “Carried Interest Fairness Act,” which would increase taxes on carried interest investment from 23.8 percent up to 40.8 percent. An accompanying press release, of course, declared that the bill would “eliminate a tax loophole that benefits wealthy money managers on Wall Street.” That’s followed by a collection of inaccuracies and non sequiturs about this levy and taxes in general.

Indeed, as is typical with an assortment of efforts to raise taxes, a combination of class warfare politics and a pursuit of higher taxes to continue to fuel unsustainable levels of federal government spending and debt, means the taxation of carried interest as capital gains is labeled as a “tax loophole,” “tax giveaway” or “tax break” for the wealthy.

On and off for nearly a decade-and-a-half, the political push has persisted to tax carried interest as ordinary income. In reality, though, such a tax increase, if imposed, would fly in the face of sound tax policy.

What is Carried Interest?

It must be understood that carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. For decades, partnership tax law has recognized that carried interest – or ownership, profits-based returns for investment partnerships – is different from ordinary income, that is, from wages and salaries.

Indeed, carried interest is subject to all of the risks and uncertainties of ownership, directly tied to the enterprise value and returns. Therefore, for more than six decades, carried interest has been properly treated as capital gains for tax purposes.

And, in reality, private equity partners are not money managers, but instead are investors in firms, and active in the management process that spurs the firm on to increased profits, or, if the wrong decisions are made, to losses and perhaps failure. The risks are clear and substantial, as is the case with the ownership and operation of any business.

As John Berlau of the Competitive Enterprise Institute has explained: “In all types of partnerships – from hedge funds to venture capital to small businesses – the partners are taxed on a business’ earnings at individual tax rates, instead of the business being taxed at corporate rates and then doubly taxed on any dividends it pays out. In many partnerships, some partners get bigger stakes in the company because of the services they perform, in addition to the capital they have contributed. This is called the ‘carried interest.’ The individual with the carried interest is taxed at the rates of ordinary income for his or her salary and for much of the business’ activities. But these partners pay the individual capital gains rate when the other partners receive capital gains for sales of such assets as stock and real estate.”

Keep in mind, as noted by John Rutledge in a Wall Street Journal piece from 2010 which still remains relevant today, that the returns on private equity, venture capital and real estate investment partnerships are made up mainly of long-term capital gains. Since much of the returns for hedge funds are short term, they are taxed as ordinary income anyway. This effort to stop carried interest from being treated as long-term capital gains negatively affects long-term investment.

Unfortunately, the 2017 tax relief measure, which largely offered positives for the economy, did include extending the long-term holding period for carried interest as it related to the capital gains tax from one year to three years.

Rutledge drove home the ills of this tax increase on carried interest for entrepreneurial ventures and investment:

“The resulting drop in after-tax returns for all investors will reduce capital committed to long-term investments in partnerships of all sorts. This means less capital formation, less construction activity, less manufacturing activity for capital goods makers and their suppliers, fewer start-ups, fewer jobs, lower productivity growth, and lower wages. The direction of these changes is not in question. The only question is how much less of these things we are going to get…  Venture capital (like other investment partnerships) competes for pension fund money based upon after-tax returns. The drop in after-tax return caused by the carried interest tax hike means less money steered their way, and so promising biotech, software or clean-tech ventures may not get funded.”

In a 2021 study, John Manuel Barrios of the Yale School of Management and Yael V. Hochberg of Rice University – Jesse H. Jones Graduate School of Business, and each with the National Bureau of Economic Research, found:

“Our analysis suggests that changing the taxation regime for carried interest from taxation at (long-term) capital gains rates to ordinary income rates would significantly reduce the attractiveness of forming a new fund for the vast majority of funds in U.S. states other than CA, MA and NY. These funds are predominantly smaller, earlier stage funds, and represent a significant proportion of available VC funding sources outside of the traditional Big 3 VC states. Given the importance of VC funding for U.S. innovation, our findings may serve to inform and aid policymakers in their current deliberations as they consider, design, and implement potential new tax laws that will affect the VC industry.”

Many Losers: Increasing Tax Rates on Carried Interest

It must be pointed out that increasing tax rates on carried interest will undermine U.S. competitiveness, as investing in the U.S. becomes less appealing, especially compared to major competitors that do not tax carried interest at the higher tax rates that usually apply to ordinary income. This works against the President’s goal of making the American economy great again, and the most competitive in the world.

Taxes cannot be raised without negative consequences, nor can the ill effects of tax increases be limited to the individuals or groups that happen to be the targets of politicians.

Increasing taxes on investment will negatively impact business startups and growth, and will inflict broad damages on incomes and jobs for workers, on entrepreneurship, on competitiveness, and on economic growth. Putting aside the political rhetoric, that’s the harsh economic reality if taxes are increased on carried interest.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. He is the author of “The Weekly Economist” book series, and 10 Points from Walt Disney on Entrepreneurship.