Why Carried Interest Tax Hike Deserves to Die in IRA and Otherwise

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The Inflation Reduction Act (referred to by critics such as Phil Kerpen as the Income Reduction Act) will likely be voted on in the Senate as soon as this weekend. It contains a lot of noxious provisions highlighted by my CEI colleagues and others.

Joel Zinberg, CEI’s Senior Fellow and health policy expert, states that the bill’s “drug price controls would decrease the number of innovative drugs developed, thereby diminishing Americans’ quality and length of life,” while its “insurance subsidies would expand federal spending without enacting any meaningful reform to a broken system.” CEI Senior Fellow and energy policy expert  Ben Lieberman writes that the bill’s “homeowner rebate provisions and other measures in the Inflation Reduction Act take regressive climate policy to a whole new level.”

Yet, as a result of the deal announced last night to garner the support of Sen. Kyrsten Sinema (D-AZ), it appears that at least one destructive provision will be dropped. It is a measure that would massively hike taxes on the “carried interest” in business partnerships.

The decades-old treatment of carried interest in the tax code as a capital gain instead of ordinary income is often characterized as a perk for high finance. Yet, as I have written, carried interest a key feature of “the structure of partnerships that are used by innovative businesses—from small firms to venture capital and angel investors — that take risks and make an outsized contribution to economic growth and job creation.”

From my previous writings:

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.

It’s good that common sense has appeared to prevail on this destructive measure, but there are still some terrible policy provisions in the misnamed Inflation Reduction Act. Hopefully, the common sense on this provision will be contagious, and enough members will see the folly of the bill’s other destructive parts.

CEI Research Associate Josh Rutzick contributed to this post.