Carried interest is actually a bit more complicated. Members of private partnerships are typically compensated along a 2/20 model: they earn a management fee equal to 2% of the size of their fund, and receive a performance fee of 20% of any profits. The 2% management fee is taxed at the ordinary income rate -- i.e., 35% -- but the 20% of profits are taxed at the capital gains rate of 15%, despite the fact that fund managers ordinarily do not risk much of their own capital. There's a final wrinkle. Managers must hold on to a position for a year to qualify for the long-term capitals gain rate of 15%; if they do not, profits are taxed as ordinary income.
Megan McArdle considers these facts and lays out her strongest counter-argument for maintaining the carried interest exemption:
The arguments for the carried interest are farily compelling: without it, the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets. This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture?Short answer: because the returns on these "untried ventures" are the most lucrative in our society. It's difficult to imagine someone choosing not to work at a private equity fund because carried interest was eliminated, given that it would be nearly impossible to find an equally well-paying job (none of which would enjoy tax subsidies either). Indeed, McArdle herself reaches the same conclusion -- albeit, rather tentatively.
But this is less a hypothetical question than an empirical one. Consider the case of high-frequency trading (HFT) hedge funds. As previously mentioned, a fund must hold a position for one year to qualify for the 15% capital gains rate. Venture capital, private equity and real estate trusts make multi-year investments, so this does not affect them. But many hedge funds, particularly the automated HFT crowd, hold very short-term positions. Consequently, those hedge funds have their entire income taxed at the ordinary rate. This has not seemed to much affect their staffing. Indeed, if there have been stories about HFT hedge funds having trouble hiring due to prospective employees worrying about their tax statuses, I have certainly missed them.
The proliferation of HFT funds the past few years shows that the marginal supply of hedge funders is relatively inelastic to the carried interest loophole, due to the inability to substitute a higher-paying job. Pretending otherwise is simply searching for a justification for an unjustifiable policy.