Taxing Carried Interest as Ordinary Income: Private Equity Fights Back, Using Public Pensions as “Human Shields”

April 3, 2025

FYI Week of April 4 2025

On February 6, after meeting with Republican lawmakers to discuss tax cuts, President Trump said that closing the carried interest “tax deduction loophole” was one of his priorities. On the same day, Democrats introduced bills in both the House and the Senate that would fully eliminate favorable taxation for carried interest. As expected, this has become a target of intense lobbying, with Axios recently reporting that the private equity (PE) industry – “as it braces for the fight of its life” — is launching “a 7-figure ad campaign to make its case for how it boosts the economy.” As part of this effort, and as one line of defense, the American Investment Council (AIC) is already arguing that more than 30 million public servants depend on private equity returns. However, this comes at a time when some in the press are increasingly arguing that the alleged abuses committed by PE firms in eroding health care and affordable housing would not be possible without the billions of dollars invested with them by public pension funds.

[The AIC, formerly the Private Equity Growth Capital Council, is an advocacy, and research organization based in Washington, D.C., that was created by a consortium of private equity firms to defend the private equity and growth capital investment industry.]

By way of background, carried interest is a share of profits from a private equity, venture capital, or hedge fund, paid as incentive compensation to the fund’s general partner (GP). It is considered a “performance fee,” based on the GP’s role as opposed to their investment in the fund, and as such, is intended to align the GP’s compensation with the fund’s returns.

Carried interest is the primary source of compensation for the GP, usually amounting to 20 percent of a fund’s returns, paid once the initial investment is returned to the limited partners (LPs). It is typically only paid if a fund achieves a specified minimum return. (Many GPs also charge a two percent annual management fee, separate and apart from carried interest.)

The controversy surrounding carried interest is due to the way in which it is taxed. That is, carried interest on investments held longer than three years is subject to a long-term capital gains tax with a top rate of 20 percent, as compared with a top rate of 37 percent for short-term gains and the wage income of salaried workers. (High income earners may also be subject to an additional 3.8 percent tax called the “net investment income tax” on both short- and long-term capital gains, making their top long -term capital gains rate 23.8 percent.)

This reflects a significant change in the taxation of carried interest that was made as part of the 2017 Tax Cuts and Jobs Act (TCJA). Specifically, the TCJA extended the holding period required for carried interest to qualify for long-term capital gains treatment from one year to three years. Trump had called for repeal of the treatment of carried interest as long-term capital gains during his 2016 Presidential campaign but then seemed to downplay the issue once in office.

Furthermore, while AIC president Drew Maloney insists the TCJA change “struck the right balance,” it did not affect many private equity firms, which tend to hold on to investments for well over three years, according to the Washington Examiner. The publication also reports that the change was included by former Treasury Secretary Steven Mnuchin — “who did not want to tax carried interest as ordinary income” — as a way “to allow Trump to claim victory.”

[The Washington Examiner is a conservative news magazine based in Washington, D.C., consisting of a website and a weekly printed magazine. Its content focuses almost exclusively on national politics from a conservative point of view.]

But now, Trump — and other critics of the current tax treatment of carried interest, including “liberal Democrats,” according to the Washington Examiner — maintain that the current tax treatment of carried interest amounts to a loophole “that benefits some of the richest people in the country.” For example, the publication points out that “the liberal group Americans for Financial Reform noted that four executives at the private equity firm KKR saved $26 million in taxes in 2020 alone via carried interest.” Investopedia also notes, “partners being paid via carried interest may be paying less taxes than regular employees while earning a higher salary.” The article goes on to say, “This creates inequality in taxation between general partners who earn more but pay less in taxes than regular employees who earn less and pay more in taxes.”

However, AIC and other supporters of the current treatment of carried interest are mounting a vigorous defense of the status quo. They essentially argue that raising taxes on carried interest would be arbitrary and deprive businesses of a source of investment. Raising taxes on carried interest would also limit investments facilitated by the industry, which accounts for millions of jobs through the companies it manages, so the argument goes.

For example, on March 24, a new report was released by AIC and Ernst & Young LLP (EY), arguing that private equity “continues to play a crucial role in building the U.S. economy, fostering business growth, creating jobs, and strengthening industries across the country.” The report provides new data on the national impact of private equity investments, as well as detailed statistics for all 50 states on jobs, wages and benefits, and GDP.

“Nationally, private equity directly employed 13.3 million workers, up from 12 million in 2022,” the report asserts, and employees at private equity-backed businesses also “earned an average of $85,000 in wages and benefits in 2024, a roughly 6 percent increase from 2022.” In total, the private equity sector “contributed $2 trillion to gross domestic product (GDP) in 2024 and now represents approximately 7 percent of total U.S. GDP,” according to the AIC/EY report.

The robust industry defense also invokes public employees’ retirement and how governmental pension plans benefit from PE – and how they would suffer if carried interest was stripped of its special tax treatment.

For example, AIC President & CEO Drew Maloney and AIC Chair of the Board Pam Hendrickson have said that private equity delivered the strongest returns for public pensions portfolios, and AIC stresses that “[m]ore than 30 million public servants depend on private equity returns.”

“We all know that pension funds are struggling to meet their obligations around the country,” they said, underscoring that “[y]ou’ve got firefighters and policemen, you have teachers … janitors, cafeteria workers, bus drivers,” all of whom “are dependent on these [PE] returns in order to have a comfortable retirement.” The fact that PE is “able to deliver year after year one of the best investment performances for private equity inside of a pension fund is really an amazing achievement,” they insist.

So, will Trump prevail in doing away with the treatment of carried interest as long-term capital gains? After all, as the Washington Examiner coverage stresses, taxing carried interest as if it were ordinary income “would bring in $13 billion over 10 years to the Treasury, according to an estimate from the Congressional Budget Office published in December 2024,” thus helping – albeit in a small way — to raise revenue to help cover the overall cost of extending the 2017 tax cuts.

Many Democrats, as noted earlier, are already on board with legislation of their own to revoke carried interest’s current tax treatment, introduced by Senator Tammy Baldwin (D-WI) and, in the House, by Congresswoman Marie Gluesenkamp Perez (D-WA) and Congressman Don Beyer (D-VA). The legislation was introduced on the same day that Trump announced his intentions to support raising taxes on carried interest. After all, “[m]any on the Left see hedge funds and private equity firms as exploitative to begin with and favor measures to rein them in or raise their taxes,” the Washington Examiner argues.

But what about Republicans? After all, they have generally opposed Democratic efforts to raise taxes on carried interest over the past decades. “But it is conceivable that Trump could sway congressional Republicans to include carried interest reform in the sweeping tax overhaul they are pursuing as one of a number of measures to raise revenues to offset tax cuts elsewhere,” the Washington Examiner suggests.

However, the conservative publication also notes that key GOP senators, especially Majority Leader John Thune (R-SD) and Finance Committee Chairman Mike Crapo (R-ID) “have historically opposed efforts to tax private equity.” So, it is by no means a “done deal” that change will happen.

What does appear to be increasingly certain is that public pensions will be included in the debate by the AIC, which is already using governmental systems as “human shields,” arguing that changing carried interest treatment will be harmful to public employees’ retirement.

Not only does this involve public plans in a contentious debate not of our choosing – for example, NCTR has no position on the tax treatment of carried interest – it also will inevitably serve to underscore the involvement of public pensions in funding PE, which is increasingly attracting critical attention.

For example, “Public pensions fuel private equity damage” is the title of a recent editorial in the Toledo Blade, which references a bipartisan staff report by the U.S. Senate Budget Committee on the findings of their investigation into the ways in which PE investment in health care have negative consequences for patients and providers.

As the “NCTR FYI” for the week of January 30, 2025 – entitled “Connecting the Dots: Public Pensions and PE’s Impact on Health, Housing” — explains, PE investment strategies are facing growing regulatory, financial, and headline risks. Given that some argue the rise of PE over the past two decades has been fueled in significant part by public pension plans — who are now, collectively, the largest investors in PE funds —the Toledo Blade editorial’s title demonstrates that the media and others are increasingly “connecting the dots.”

Making it appear that public pension plans are now strongly supporting the current tax treatment of carried interest – and the inequities that many Democrats, and now even Donald Trump, criticize — will not be helpful in dispelling the perceived negative consequences of this association.

Public pension plans’ increased investment in alternatives such as PE is an important way in which to diversify portfolios and enhance returns. Losing sight of this by drawing attention to problematic consequences in certain sectors such as healthcare, or inequities in tax treatment, makes justifying these investments difficult.