Carried Interest

On to Chapter 2 in my ongoing series on “Hidden Structures that Create and Maintain Gross Inequality”.

Today we’ll discuss something innocuously called “carried interest”. No, it’s not something regular people earn when they lend their money to a bank (you all do realize that’s what we do, right? When we deposit money at a bank, we are lending the bank our money for the privilege of earning bubkus while they turn your money into billionaire paydays for the likes of Jamie Dimon). And, no, it’s not something you physically “carry” at all.

Thought experiment: ask 1,000 people on the street what “carried interest” refers to. My educated guess is 999 will have no idea because it has no applicability to, like, 99.9% of U.S. citizens.

First, a bit of history. In the 1500s and 1600s, merchant ships were hired to carry goods from one place to another. In those times, ship captains would often be given a share — commonly around 20% — of the profits from the cargo they “carried” on behalf of investors. This share was their reward for transporting goods, bearing risks (storms, piracy, shipwreck), and delivering the cargo. Thus, the ship “carried” cargo and received an “interest” in profits for doing so. Et voila, the term “carried interest”.

So, the ship captains took actual risk and for their efforts, were rewarded with a share of the profits. This… actually makes sense. Incentives were aligned - if the captain protected and delivered the cargo owned by private investors, he would be well rewarded.

Eventually, this type of arrangement spread to other partnerships - mainly oil and gas and mining. From there, it was only a matter of time before the “masters of the universe” on Wall Street figured out how to grift off of it.

26 U. S. C. 1061 deals with this gift to Wall Street “titans”. It essentially says that income received by partnerships - hedge fund, private equity, venture capital, and real estate, among others - is taxed at lower long term capital gains rates if the partnership exists for more than three years.

But… remember, the rationale behind capital gains tax rates that are lower than ordinary tax rates is to encourage investors to risk their own money to grow business and the economy. It might have made sense to tax seafaring captains in the 16th and 17th centuries this way because they: a) were providing services, b) had “skin in the game”, and c) were taking on significant personal and financial risk.

That’s not what today’s financial “wizards” do. They generally use OPM - other people’s money - to invest with the sole goal of maximizing profits at the expense of others (private equity, anyone). They provide, in theory, “management expertise” with little - if any - capital risk to themselves. That’s a long way from having to fight off pirates and raging storms in order to earn one’s keep.

For example, entrepreneurs who risk their own capital and sweat equity in their start-up businesses don’t get the carried interest benefit. Neither do manual laborers who provide a service and literally risk their physical well-being. Much like “stepped-up basis” I wrote about yesterday, those with money make the rules, and the rules basically favor only those with money.

KEY QUESTION: Why should income “earned” by wealthy Wall Streeters using OPM be treated any differently than the income hard-working people receive for their labor? As with “stepped-up basis”, lower capital gains tax rate is, in theory, to incentivize people to risk their own money in productive investments for society. But using "other people’s money” entails, duh, no capital risk.

CONCLUSION: We are all paying higher taxes so Wall Streeters can avoid paying taxes because these self-proclaimed “Masters of the Universe” have the means and power to influence tax law. End of Story.