You & I start a company. I provide $100,000 in seed money but little actual work/time. You provide no seed money but a lot of work & time. We agree to split ownership of the company 50/50.

5 years go by.

We sell the company for $1,000,000. You get $500,000, I get $500,000.

Should I get to pay a lower tax rate than you?

FWIW, the common rebuttal scenario goes like this:

You and I earn $200k in wages, and each pay $100k in taxes. You spend your remaining $100k on a boat. I invest my $100k, and 5 years later it's worth $200k. Suppose that $100k gain is taxed like ordinary income at 50%. After taxes I have $150k, which I also spend on a boat.

Without taxes, you would have had $200k to consume in year 0, but you actually got $100k; your effective tax rate is 50%. Without taxes, I would have had $400k to consume in year 5, but I actually got $150k; my effective tax rate is 62.5%.

Who should pay the higher tax rate? The person who consumes their wage income immediately, or the one who defers consumption? For them to be equal, the capital gains tax rate has to be 0%.

My comment was providing a defense of preferential tax treatment for carried interest.

You provided an argument for a 0% tax rate on capital gains.

I'm not sure how your comment is a rebuttal to mine? Perhaps you responded to the wrong comment by accident?

Your example seems to have nothing to do with carried interest. There's a single investor; no investment manager. The question around carried interest is whether certain types of income earned by investment managers should be classified as labor or capital income, whereas you have one person with labor income and one person with capital income, and are asking who should be taxed more heavily.

In my comment "I" am the investor and "you" are the investment manager.

I'm sorry if that was unclear.

No, you have risked nothing but your time. Since you have no investment at risk you should not get preferential tax treatment meant to encourage you to do so.

(I think you might have inverted the "I" and "you" in my scenario making your comment a bit confusing. But I think I understand the point you were intending to make.)

Why is the risking of money deserving of special tax treatment but not the risking of time?

I personally don't think it is but that is the logic used to justify the capital gains tax.

No. You shouldn't. The person doing the actual work should be paying it as tax on labor, and the person who put up the funds should be paying it as capital gains. And obviously, capital gains should be taxed at a rate greater than labor.

That is a fine point of view, but perhaps outside the scope of the topic under discussion.

The parent poster is saying that carried interest should be capital gains taxable to avoid having it in the higher bracket, as it would be if it were taxed as wages. Thus, the idea that it is wages but that should be cheaper than capital gains answers the issue.

Uh, what?

You want to make it more expensive to increase productivity? (Because that’s what capital does - it gets invested to increase profits).

The logical path you’re going down would replace road builders with people with spoons to move dirt around and file down rocks with spoons to put them in the ground to walk on.

Seriously, if you consider the logical conclusion of your argument, we end up in madness.

That's nonsense. The gains of investing in a work crew still make money for capital. They still get their income. The increase in productivity is its own reward - the road gets built faster or with less labor, you're able to out-bid your competition. It makes more sense to extract money from the people who contributed money than from people who contributed labor.

Nonsense?

#1 You’ve just discouraged capital investment.

#2 you’ve just agreed with my initial statement that there is a reason carried interest is taxed the way it is. If you tax capital more than labor, then by definition, carried interest is fine, because the people who pay it ARE THE PEOPLE DOING THE LABOR!!

Seriously, I realize that this is an emotional topic for many people, but you have to think through the second order effects. The first effect is pretty simple, but in this case the second order impacts have all sorts of ramifications.

I’m fine with people having their opinion and feeling that something is right or wrong - that’s healthy. What’s not healthy is having an opinion that is either self-contradicting, or made out of frustration.

Think through the scond order effects. Harry’s gave a great exam-let that showed just one simple version. There are tons more.

Carried interest is a misapplication of the idea of labor. Of course it's fine that they're taxed less than people who put up only money - but I disagree with the entire idea of capital taxation being less.

Capital investment is discouraged, but it's not as if it's going to stop due to this discouragement. What are people going to do with their money, NOT invest it? Found their own companies instead? Acquire capital assets and lease them? It's not as if you can work _instead_ of capital gains, cap gains income is passive.

Capital gains taxes in the US have been higher in the past, and at several points, were higher than wage taxes are now. Things worked out fine.

Cap gains are absolutely NOT passive.

I build a company. Work my fingers to the bone for years, and take a significantly reduced salary compared to my market value. Later I sell it for a billion dollars.

That is taxed as long term capital gains. Are you saying that’s passive? Sure, you buying a few shares of Ford is passive, but tons of capital gains like in my example are not.

Also, you comment “that came out fine” is rather flippant. When you dominate the world after a world war, pretty much everything is going to go your way, whether you tax income at insane rates or make black people drink from separate fountains. Both occurred in the same time period. If you use you’re argument that “things worked out fine”, why not also keep that around? I think the reason is we’ve managed to see that correlation doesn’t drive our decisions there. And they shouldn’t in taxation either.

Then let hedge fund managers organize their funds as equity purchases from their investors. To use your analogy, if managers were deserving of 20% of the profits, then structure it as investors own 80% and managers own 20%.

Of course, that would make many hedge funds a lot less attractive for many investors. Hedge fund managers want to have their cake and eat it too.

That is (more or less) what hedge fund managers do.

I know they are organized as partnerships, but the managers don't really have any equity rights to the committed capital, only the profits. But I guess that's really no different than an investor with preference rights in a startup.

In any case, thanks very much for your explanations, really helped me think about the issue in a different way.

Happy to help out!

In any case, as I stated elsewhere(1), I'm actually not sure what I believe on this topic. I can really see it both ways.

1. https://news.ycombinator.com/item?id=17276214

This analogy doesn't work; carried interest isn't granted because of any sort of ownership stake.

That is not correct. Hedge funds and VC funds are generally organized as partnerships. The General Partners (GPs) are just as much owners as the Limited Partners (LPs).

I think harryh ‘s comment states everything I could but much more succinctly, so I’ll just second his statement.

:)