The Medieval Geniuses Who Invented Carried Interest and the Modern Barbarians Who Want to Tax It

It’s no secret that both Donald Trump and Hillary Clinton fail to understand that taxation is theft. Neither was even willing to retain the few laudable provisions that exist in the tax code. Instead, they used class warfare to condemn what is commonly referred to as “carried interest.”

Carried interest allows the investment manager of a fund or partnership to be compensated with the profits of the funds. The proceeds are taxed as capital gains rather than income.

Despite the heated rhetoric, the provision of law is based on a historical parallel that dates back to the Middle Ages. A look back into history shows how carried interest was created and why it is a vital component of a thriving society.

Merchants Fuel Long-Distance Trade

Once Venice's government was comprised of people who knew how to make money and create jobs, there was a dramatic increase in financial and legal innovation.Think back to Venice, Italy in the year 1036. Due to the geographic location and numerous beneficial alliances, Venice began to grow wealthy as an international center of trade. Up to that point, the Venetian head of state, or Doge, had absolute power and was always selected from one of the three wealthiest families. But as the wealthy merchant class grew, so did their power, and by 1036 the first merchant was elected as Doge.

As the wealthy merchant class gained power, Venice’s trade greatly expanded, creating enormous opportunity for its citizens. However, after a series of political crises and a deadly plague in 1172, the Doge Vital II Michele was assassinated, leaving a void in the government. A new constitution was created by the merchant class that changed the city remarkably. Dogal powers were drastically reduced and the Great Council, or parliament, was created. But now, instead of the nobility controlling the city, the Great Council was made up of a group of families that had built their wealth on trade, not inheritance.

Now that the government was comprised of people that knew how to make money and create jobs, there was a dramatic increase in financial and legal innovation.

As the National Bureau of Economic Research stated:

By the early fourteenth century, financial innovations included: the appearance of limited liability joint stock companies; thick markets for debt (especially bills of exchange); secondary markets for a wide variety of debt, equity, and mortgage instruments; bankruptcy laws that distinguished illiquidity from insolvency; double-entry accounting methods; business education (including the use of algebra for currency conversions); deposit banking; and a reliable medium of exchange (the Venetian ducat). All these innovations can be related directly back to the demands of long-distance trade.

Long-distance trade had the potential for enormous profit, but it carried a substantial risk. An enterprising young man could more than double his money if he could fill a ship with goods to trade with Constantinople and the Eastern Mediterranean. However, raising the capital to buy the original goods and hire a ship was beyond the reach of someone trying to get a start in the merchant trade. Additionally, there were pirates, bad weather, and shipwrecks to consider. Any of these factors could affect the profitability of the trip.

Enter Carried Interest

This is where the idea of carried interest enters the story. Start-up merchants needed investors, and investors needed some incentive to finance the merchants. For the investor, there was the risk of their investment literally sailing out of the harbor never to be seen again. The Venetian government solved this problem by creating one of the first examples of a joint stock company, the “colleganza.” The colleganza was a contract between the investor and the merchant willing to do the travel. The investor put up the money to buy the goods and hire the ship, and the merchant made the trip to sell the goods and then buy new foreign goods that could then be brought back and sold to Venetians. Profits were then split between the merchant and investor according to the agreements in the contract.

This arrangement limited the liability for both parties. For the first time, poorer merchants had a chance to improve their lot in life by taking on the inherent risks of travel. This shared liability and carried interest agreement opened the doors to a greater number of Venetians participating in trade and wealth-building. Without the colleganza, Venice would have never grown so successfully, and its people would have been stuck in a class system with no opportunity for economic mobility. No longer was wealth reserved for those lucky few born into it. Instead, wealth was available to anyone willing to work for it.

We Must Retain the Carried Interest Provision

Eliminating the carried interest provision is a turn in the wrong direction.Back to modern day: there are those in the government that want to cripple start-up businesses looking to grow their company. Businesses rely on investors to get started or jump to the next level of success. Just like the merchants of Venice, American businesses would stagnate without investors willing to take a risk. And investing in start-up businesses is risky as there is no guarantee that the money invested will ever return a profit. For over 100 years in America, the risk for investors has been offset by the lower tax rate for capital gains and carried interest.

Some people in the government think that carried interest should be taxed as regular income, but that just doesn’t make sense. Just like the Venetian investors who watched their money sail away, sometimes for years, before returning, today’s investors often must wait years to see a profit or possibly even suffer a loss. A lower capital gains tax rate serves as a great incentive to take that risk.

Eliminating the carried interest provision is a turn in the wrong direction. It would be a massive tax increase on investment capital and, as such, would discourage investment. Rather than raising capital gains up to the tax rate of regular income levels, we should be lowering both tax rates. That would provide more incentive for investors to buy into American businesses and create more jobs and more wealth for everyone.