In American tax law, there is a provision that allows a specific category of financial professionals — private equity fund managers, venture capitalists, and hedge fund managers — to pay taxes on a significant portion of their compensation at the long-term capital gains rate of 20 percent, rather than the ordinary income rate that can reach 37 percent. The provision is called the carried interest rule, and it has been called a loophole by politicians on both sides of the aisle, including three consecutive presidents, for more than twenty years.
It is still there.
What Carried Interest Actually Is
When a private equity fund raises capital from investors and generates returns, the fund managers take a share of those profits — typically 20 percent — as their compensation for managing the fund. This share is called the "carried interest" or just the "carry."
Under current law, this compensation is treated as a capital gain rather than ordinary income, provided the underlying investments were held for at least three years. This is the disputed part. Critics argue that the carry is straightforwardly a fee for services — compensation — and should be taxed as such. Defenders argue that because the managers' compensation is tied directly to investment performance, it shares the economic character of a capital gain.
Who Benefits
The carried interest provision benefits a relatively small number of individuals, but those individuals are among the highest earners in the American economy. Managing partners at large private equity firms routinely earn hundreds of millions of dollars in carried interest in good years. At that income level, the difference between a 20 percent and 37 percent rate on even a portion of earnings can amount to tens of millions of dollars per individual per year.
The private equity industry manages trillions of dollars in assets. It owns a significant share of American businesses across virtually every sector. And it is one of the most consistent and organized political donors in Washington, with contributions that span both parties.
Why It Keeps Surviving
The political history of carried interest reform is a case study in the gap between stated intention and legislative reality. The provision came under sustained attack in 2007, when it was included in a House-passed bill that died in the Senate. It came up again in 2010, 2012, 2017, and 2021. In 2022, the Inflation Reduction Act included a modification — extending the holding period required from one year to three — but did not eliminate the preferential treatment.
"Every time it comes up, the same things happen. Both sides denounce it. A bill passes one chamber. Then it disappears."
The persistence of the provision reflects several overlapping dynamics. The private equity industry employs sophisticated lobbyists and makes substantial campaign contributions. Some of the fund managers who benefit most are also significant donors to Democratic campaigns, complicating the party's ability to make this a clean partisan issue. And the revenue at stake — significant in absolute terms, but modest relative to overall federal receipts — has repeatedly made it a secondary priority when other legislative battles dominated the agenda.
The Counterarguments
Defenders of the provision make several arguments worth engaging with seriously. They contend that private equity managers take genuine investment risk — they do not receive their carry unless the fund performs — which distinguishes them from employees who receive wages regardless of outcomes. They argue that taxing the carry as ordinary income would reduce incentives for the kind of long-term investment that private equity represents. And they note that the three-year holding period requirement already disqualifies short-term trading strategies from the preferential treatment.
Tax economists are genuinely divided on some of these questions, though the dominant view in academic literature is that the risk-based argument is overstated — managers' base salaries, management fees, and fund structures protect them from most of the downside risk that would typically justify capital gains treatment.
The Path Forward
The carried interest debate will almost certainly resurface in any comprehensive tax legislation in the coming years, particularly given that several major provisions of the 2017 Tax Cuts and Jobs Act are set to expire. Whether it closes depends less on the merits of the arguments — those have been relitigated exhaustively — and more on whether the political environment in a given Congress makes it advantageous for leadership in both chambers to bring it to a floor vote simultaneously.
That has not happened in twenty years. It may happen in the next two. Left on Red will track legislative developments on this and related tax provisions as part of our ongoing coverage of wealth and taxation policy.