The UK chancellor Rachel Reeves rowed back last year from getting rid of the so-called carried interest loophole whereby the profits of private equity and hedge fund managers are taxed at a lower rate, closer to that of capital gains, than the higher rates of income tax.
Despite Labour’s election pledge to impose the top 45% tax rate on private equity bosses, Reeves instead offered a compromise: increasing capital gains tax on carried interest from 28% to 32% in a move, she said, would raise revenue without risking the country’s competitive edge.
Stateside, meanwhile, Donald Trump has vowed to get rid of the “carry” loophole. When Joe Biden tried to increase taxation on alternatives during his term of office, he was stopped by a Democrat senator. Ironically, if taxation on private equity is increased in the US, it is now more likely that it will be at the hands of the Republicans, traditionally the party of finance and low taxation.
Carried interest has been the subject of significant tax policy debate on both sides of the Atlantic.
It is currently taxed as a capital gain rather than ordinary income in many jurisdictions, leading to accusations that PE executives enjoy an unfair tax advantage.
Critics argue for reform to increase tax fairness, while proponents contend that the current system incentivises investment and economic growth.
One of the strongest arguments for taxing carried interest as ordinary income is fairness. Private equity managers earn carried interest as part of their compensation, similar to salaries and bonuses in other industries.
However, unlike most employees, their income is taxed at a lower capital gains rate (often around 20%) rather than the standard income tax rate (which usually exceeds 40% in most countries). Reform advocates argue that this creates an inequitable system where high earners pay disproportionately lower taxes compared to other professionals.
Opponents argue that the current taxation of carried interest represents a loophole that allows wealthy fund managers to avoid paying their fair share. While capital gains taxation is intended to encourage long-term investment, carried interest functions more like a performance-based fee than a true investment return. Since fund managers rarely invest their own capital to earn carried interest, treating it as capital gains is seen as an inappropriate tax benefit.
Private equity managers are among the highest earners in the financial sector, while their effective tax rate is often lower than that of middle-class workers. Reforming the taxation of carried interest is seen as a step toward addressing wealth inequality by ensuring that high-income individuals contribute proportionally to tax revenues.
Supporters of the current tax treatment argue that carried interest is designed to align fund managers’ interests with those of their investors by rewarding long-term performance. Taxing carried interest as ordinary income could reduce incentives for long-term investments and lead to short-term, riskier financial strategies.
Private equity plays a significant role in funding startups, restructuring struggling companies, and driving economic growth. If carried interest is taxed at a higher rate, private equity firms may become less willing to take risks on new ventures, potentially leading to reduced investment in innovation and job creation.
Proponents of the existing system argue that carried interest is not guaranteed income but a return on risk, similar to how entrepreneurs are rewarded when they successfully build a business. Since private equity managers earn carried interest only when funds perform well, taxing it as capital gains recognizes the inherent risks involved.
The debate over carried interest taxation is complex, with compelling arguments on both sides. While reform proponents emphasize fairness, closing loopholes, and raising revenue, opponents warn of economic consequences, reduced investment, and global competitiveness concerns. Any change to the taxation of carried interest must balance these competing interests to ensure a fair yet growth-oriented financial system.
This opinion piece was first published in the March / April issue of Funds Europe.
