Finance

Carried Interest: Why Mitt Romney's Tax Rate Is 15 Percent

As you know by now, Mitt Romney's tax rate is somewhere near 15 percent — well below the 35 percent income tax rate for the highest earners.

Romney hasn't released the details yet, but the NYT reported last month that, as part of his retirement agreement with Bain Capital, Romney "has probably qualified for a lower tax rate than ordinary income under a tax provision favorable to hedge fund and private equity managers."

That tax provision applies to something called "carried interest." We discussed carried interest, and the controversy surrounding it, a while back. Here's a lightly edited excerpt from that post.

Carried interest became a political issue a few years back, when a tax-law prof named Victor Fleischer wrote an academic paper arguing that "this quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate."

Many private-equity managers are paid under a structure popularly known as "two and twenty": They get a paid a fee that's two percent of the assets under management, and they also get to keep 20 percent of the profits from their funds. That 20 percent is carried interest.

Here's a wildly oversimplified example. Imagine that investors — pension plans, endowments, whatever — put $100 million into a private-equity fund. The fund turns a profit of $15 million. The people who run the fund would get $2 million as a management fee, plus $3 million as a share of the profits.

The $2 million is taxed as income; the $3 million is taxed at the (much lower) capital gains rate.

David Weisbach, a tax prof at the University of Chicago, argues that this is appropriate.

If the private equity guys borrowed the money, invested it, and made a profit, everyone would agree that the profits should be taxed as capital gains — that's what the capital gains tax is for, Weisbach told me this week.

In private-equity funds, the investors' money is structured as equity, rather than debt. But that shouldn't make a difference for how the profits are taxed. "A fundamental economic idea is the type of financing should not affect the taxation," he said. (For more, see this Weisbach paper, which was funded by a private-equity industry group.)

Fleischer comes at it from a different angle: Basically, he argues, carried interest is what private-equity managers are paid for doing their job. So it's income, and should be taxed as income. The only reason it's not, he argues, is because the relevant part of the tax code is out of date.

"The tax rules were written in 1954, and we didn't even have significant private equity funds back then," he told me this week. "Now we've got billions of dollars flowing through."

So how does this apply to Romney, given that he's no longer working as a private-equity manager? Back to that NYT story from last month:

In what would be the final deal of his private equity career, he negotiated a retirement agreement with his former partners that has paid him a share of Bain's profits ever since ...

... since Mr. Romney's payouts from Bain have come partly from the firm's share of profits on its customers' investments, that income probably qualifies for the 15 percent tax rate reserved for capital gains, rather than the 35 percent that wealthy taxpayers pay on ordinary income.

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