More on Carried Interest

I received the following comment on my initial post on carried interest:

One way of framing the carried interest question is to find the policy that preserves
the favored tax treatment in the aggregate. If I hold an index fund, my dividends
are taxed at a 15% rate and my realized long-term capital gains are taxed at a
20% rate. Now suppose I hire you to pick my stock for me. However we tax you,
there should be a consistency so that the aggregate dividends and capital gains
are still taxed in a favored manner.

My way of thinking of this would be the following: Suppose a set of friends get together to buy stock. There are five of them and they each put up 20% of the capital. They do well, and decide that one of them who has been bringing the best advice to the group should become the "general partner" and do most of the work. For that, the other four agree to reduce their share of any portfolio gains from 20% to 18%, so that the fifth partner will get 28%.

Since the aggregate capital gains are still the same, the argument above would imply that the manager/GP in my example should get capital gains taxation on his 28% just like the other four "limited partners."

This is a nice analogy, and analogies are nice for framing the issues and perhaps particularly for thinking about horizontal equity issues (are folks in this situation being treated similarly to folks elsewhere doing essentially the same thing?).

But this argument does not trump, for l return to the issue of economic efficiency -- what activities do we want to favor from an "activity level" point of view? By giving our newly minted General Partner the ability to get capital gains treatment on his larger share of the pie, we are enabling division of labor in investment activities. If we made the GP pay ordinary tax rates on any larger share he was given by his partners, we would reduce the incentives the partners would have to take advantage of comparative advantage and specialization.

Do we want to encourage such division of labor? Well, that is the question -- do we want to encourage the supply of specialized labor into management of private equity and venture capital? Perhaps. Capital gains rates are low after all because we want to encourage long term investments over short term.