Option 10:
Tax Carried Interest at Ordinary Income Tax Rates
Topline Estimates
Source: Tax Foundation General Equilibrium Model.
Carried interest is a form of compensation for investment managers at private equity firms and hedge funds. Many investment managers are often compensated according to a “two and twenty” arrangement: the investment managers are automatically paid 2 percent of all assets invested, and earn an additional 20 percent of whatever additional profits they help to bring in. This 20 percent fee is known as “carried interest.”
The proper tax treatment of carried interest is a subject of debate. Specifically, it is not always clear whether carried interest should be treated as labor income or capital income. Under current US law, carried interest is treated as capital gains income and is taxed at the same lower rates as long-term capital gains. Some observers argue that because carried interest is a form of compensation for managers’ talents and services, it is no different than any other form of labor income.
This option taxes carried interest as ordinary income for all taxpayers. This would increase marginal tax rates on income, reducing incentives to work and save, resulting in lower economic output. However, because carried interest is a relatively small portion of income, the overall macroeconomic effects would be small.
On a conventional basis, this option would decrease the primary deficit by $16.3 billion over the budget window. Long-run GDP and GNP would both be slightly lower. Incorporating changes in interest costs, the publicly held debt-to-GDP ratio would be largely unchanged from baseline, reaching 175.9 percent by 2056.
Taxing carried interest as ordinary income would primarily affect taxpayers within the top quintile, decreasing after-tax income for this group by less than 0.5 percent.
Modeled Results
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About the Authors
Erica York is Vice President of Federal Tax Policy with Tax Foundation’s Center for Federal Tax Policy. Her analysis has been featured in The Wall Street Journal, The Washington Post, Politico, and other national and international media outlets.
Garrett Watson is Director of Policy Analysis at the Tax Foundation, where he conducts research on federal and state tax policy. His work has been featured in The Washington Post, The Atlantic, Politico, the Associated Press and other major outlets.
Dr. Huaqun Li is Senior Economist, Director of Modeling Projects at the Tax Foundation. She focuses on developing and maintaining the Foundation’s Taxes and Growth Model, which models the budgetary and economic effects of changes to federal tax policy.
Dr. William McBride is the Chief Economist & Stephen J. Entin Fellow in Economics at the Tax Foundation, where he oversees major research projects primarily related to reforming the federal tax code, advancing sound tax policy, and improving the federal government’s fiscal outlook.
Alex Durante is a Senior Economist at the Tax Foundation, working on federal tax policy and model development. Alex worked as a research assistant at the Federal Reserve Board and served as a staff economist on the Council of Economic Advisers.
Alex Muresianu is a Senior Policy Analyst at the Tax Foundation, focused on federal tax policy. Previously working on the federal team as an intern in the summer of 2018 and as a research assistant in summer 2020. He attended Tufts University, graduating with a degree in economics and minors in finance and political science.
Peter Van Ness
Peter Van Ness is a Research Software Developer at the Tax Foundation working on federal tax policy and model development. Peter previously worked as a research assistant at another think tank and as a data analyst at a consulting firm.
Aleksei Shilov
Aleksei Shilov is a Research Software developer at the Tax Foundation working on economic model development and federal tax policy. Aleksei joined the Tax Foundation as an intern in January 2025. He holds a B.S. in computer science and a minor in economics from Northeastern University and is currently based in Boston, MA.
Daniel Bunn is President and CEO of the Tax Foundation. Daniel has been with the organization since 2018 and, prior to becoming President, successfully built its Center for Global Tax Policy, expanding the Tax Foundation’s reach and impact around the world. Prior to joining the Tax Foundation, Daniel worked in the United States Senate at the Joint Economic Committee.