Reforming the Taxation of Carried Interest: Revenue Modelling
By Arun Advani, Sebastian Gazmuri-Barker, Sanaya Mahajan, Cesar Poux and Andy Summers
‘Carried interest’ (or ‘carry’) is one of the main forms of pay in the private equity (PE) industry. Only around 0.01% of the UK population (6,440 individuals) reported any carried interest between 2017 and 2023, but over that period their total carry exceeded £22 billion. Carried interest is extremely concentrated amongst top executives. In 2020, the top 100 executives received an average of £15 million in carry each and paid an average effective tax rate of 29% on their total income and gains (including gains on co-investments taxed at 20%).
Carried interest is currently taxed as a capital gain at a rate of 28%. In June 2024, the FT quoted the then Shadow Chancellor Rachel Reeves as saying: ‘“I don’t think it is right that … what is essentially a bonus is taxed at a lower rate than employment income, when you’re not putting your own capital at risk”. Since entering government, Labour has reiterated its Manifesto pledge to “take action in respect of the ‘carried interest’ loophole” by taxing carried interest like other ‘performance-related rewards’ and has said it will announce reforms in the upcoming Autumn Budget.
Debates around the appropriate tax treatment of carried interest have centred on a perceived tension between ‘fairness’ and fiscal expedience. It is hard to make the case for taxing carry at lower rates than – for example – the bonuses of bankers or hedge fund managers, except on grounds that doing so is necessary to keep PE executives from leaving the UK. It is therefore unsurprising that the focus of the PE industry and media has been on the risk of mass exodus if the Government sees through its Manifesto commitments.
Ahead of the upcoming Autumn Budget, there remains significant uncertainty about how much potential reforms could raise. In its Manifesto, Labour claimed an additional revenue of £565 million per year by taxing carry like other ‘performance-related rewards’. However, prior to the General Election, the Conservative Government’s ‘Opposition Policy Costing’ (OPC) estimated a revenue loss of up to £900 million per year from Labour’s plan. Until now, these competing claims have not been subject to any independent evaluation.
In this paper, we assess how much revenue could realistically be raised from increasing the tax rate on carried interest. This debate has so far been distorted by a lack of quantitative evidence on key characteristics of the carry population relevant to their mobility, with public discourse instead driven exclusively by anecdotes and assertions from industry insiders. This report aims to provide a corrective based on analysis of de-identified tax data covering all individuals who received carried interest between 2017-2023.
Policy assumptions
Taxing carried interest as a ‘performance-related reward’
The Government’s indication that it plans to tax carry like other ‘performance-related rewards’ is ambiguous. Statements made prior to the 2024 General Election seemed to imply alignment with employee performance-related rewards such as bankers’ bonuses, which are currently taxed at an effective rate of up to 53.4% (including Employee and Employer National Insurance Contributions). However, such statements have been widely interpreted as seeking to align the tax rate on carried interest with Income Tax on earnings, which is currently a top rate of 45%. Our main modelling is based on taxing carried interest at a 45% rate, although we also provide estimates at other rates between 28% to 53%.
International aspects of carried interest taxation
Our modelling assumes that under the new Foreign Income and Gains (FIG) regime for new arrivals, foreign carry will continue to be exempted for the first four years of residence. Consistent with the aim of taxing carry like a ‘performance-related reward’, we expect foreign carry to continue being defined based on where management services were performed. There is also an important policy choice over how (if at all) to tax carried interest arising to former residents who have performed management services in the UK. Although taxing former residents could significantly reduce the revenue impacts of emigration, the Government has so far not indicated any intention to pursue this policy so we do not account for it in our modelling.
Estimating the tax base
We first estimate the tax base for carried interest in 2019/20. This is not quite as straightforward as simply totalling up reported carried interest from tax returns, because we must also account for: (1) carried interest that has been ‘misclassified’ as residential property gains on tax returns, leading historically to an underreporting of carried interest (although no underpayment of tax); and (2) foreign carried interest of remittance basis users who have been resident in the UK for more than four years, which will become taxable under the new FIG regime but is currently not required to be reported to HMRC under the existing non-dom regime (and is also not subject to UK tax).
We then uprate the 2019/20 tax base to 2025/26 to obtain an estimate of the ‘static’ tax base in the first year of the reform, absent any policy changes. Previous estimates have used the projected growth rate in aggregate capital gains published by the Office for Budget Responsibility (OBR); however, the distinctive characteristics of carried interest make this an inappropriate reference point. Instead, we use determinants that are more specific to the PE industry, following Macfarlanes LLP (2024) who apply a methodology developed by Phalippou (2024). Using this approach, our projection of the tax base for 2025/26 is 42% higher than when using the projected growth in aggregate capital gains.
Behavioural responses
The Opposition Policy Costing published by the Conservative Government in May 2024 was based on estimates of the overall behavioural response to previous changes in the tax rate on dividends (at the additional rate) and other capital gains. We think that these are an inappropriate proxy for responses to changes in the tax rate on carried interest, because this type of pay has very different characteristics from other types of investment income and gains, and carry recipients are a highly specific population.
Instead, our approach seeks to assess each type of behavioural response separately, with a particular focus on emigration since this has been emphasised as the most important factor by the PE industry. Unlike the OPC, we draw on the on the specific characteristics of carried interest and the carry population, using relevant quantitative evidence wherever possible. In absence of quantitative evidence, we make aggregate behavioural adjustments drawing on our understanding of the policy context and dynamics of the PE industry to assess the direction and magnitude of specific responses.
Emigration
Whilst the image of PE executives as highly international and mobile has some element of truth, we find that there has also been some hyperbole about the potential emigration response that is not supported by the quantitative evidence. Three main factors drive this conclusion:
(1) For most carry recipients, the effect of the reform on their total take-home pay would be small. This is because the bottom 80% of carry recipients receive on average only around one third (35%) of their total pay from carry. Even amongst the top 100 best-paid executives, the carry share is still only 60% on average, meaning that an increase in the tax rate on carry from 28% to 45% results in a reduction in take-home pay of ‘only’ 16%.
(2) Although carry recipients are indeed highly international, they are mostly settled in the UK. Almost half of all carry recipients are foreigners, broadly in line with other top paying positions in the UK financial sector. However, over 90% of carry going to foreigners is received by executives who have lived in the UK for 10 years or more, who are therefore likely to be relatively ‘sticky’ in their location decisions.
(3) Carry recipients are no more mobile than other top earners. After five years’ residence, only around 5% of foreign carry recipients leave each year, declining to 1-2% per year for the longest stayers. Whilst private equity executives clearly travel a lot for work, the quantitative evidence does not suggest a population that is highly mobile in terms of where they live.
These insights can be integrated within a structural model of emigration that allows us to estimate the likely response of carry recipients based on evidence from past reforms affecting the taxation of top earners in the UK. Even in a ‘worst case’ scenario (using the most pessimistic plausible parameters), an increase in the tax rate on carried interest from 28% to 45% only results in a 7.3% reduction in the number of carry recipients living in the UK. Around half of the resulting revenue reduction is due to the cross-base effect on Income Tax: we assume that emigrants not only stop paying UK tax on their carried interest, but also on all other sources of income. Even accounting for this, ‘post-emigration’ revenue would be negative only if at least two out of every five foreign carry recipients (39%) left as a result of the reform, far exceeding our plausible worst case scenario.
Other responses
We also assess the impact of other behavioural responses including: (1) retiming of carry payments; (2) tax planning and avoidance strategies; and (3) effects on labour supply (hours, effort, retirement) of PE executives. There is little or no existing quantitative evidence available to estimate these margins of response separately. Consequently, we qualitatively assess their impact and then apply an aggregate reduction to the total ‘post-emigration’ tax base. This adjustment is necessarily impressionistic, so we consider a range of adjustment percentages, according to ‘low’, ‘central’ and ‘high’ response scenarios. This adjustment equates to a reduction in the total tax base of between 5% (low) to 15% (high) if carry is taxed at a 45% rate. We assume that these other responses would be proportionally smaller for smaller changes in the tax rate.
‘Post-behavioural’ revenue estimate
We estimate that under our central scenario for behavioural response, increasing the tax rate on carried interest to 45% would raise additional revenue of £0.8 billion per year using the 2025/26 tax base. However, this estimate is subject to high uncertainty, so we also provide estimates for our ‘worst’ and ‘best’ case scenarios, resulting in a plausible range of between £0.3 billion and £1 billion in additional revenue. These estimates are only for the direct revenue effects of the reform and do not account for indirect effects on the wider economy. They are also subject to the limitations and uncertainties discussed below.
In Appendix A, we also provide estimates for alternative tax rates on carried interest between 28% and 53.4%, which is the effective rate on employment income. In our worst case scenario, we find that the revenue-maximising (‘Laffer’) rate is between 44% to 47%, although increasing the rate above 35% only raises an additional £100 million in revenue, excluding indirect effects. On our central and best case scenarios, we find no Laffer effect below 53%. However, this finding should be treated with caution given that our modelling is not well-calibrated to account for tax rates on carried interest above 45%.
Main uncertainties and assumptions
Migration response
The extreme concentration of carry makes the aggregate revenue effect of reforms sensitive to the idiosyncratic responses of a small number of top executives. Our modelling accounts for the key characteristics of top executives and estimates individual-level responses, but nevertheless there is a high degree of statistical uncertainty. We also do not account for coordinated responses at firm level. This factor could cut both ways since ‘bad leaver’ clauses make uncoordinated emigration more difficult than in other industries. Nevertheless, we recognise that coordinated responses could be important amongst firms that have multiple European offices. Finally, our migration estimate does not account for the impact of the reform on immigration. Over the short to medium term, this impact is likely to be small because only 1% of carried interest and 1.5% of other pay (amongst carry recipients) goes to new arrivals to the UK.
Indirect effects
Our estimates assume that emigrants’ jobs are not replaced and there are no spillover effects on other jobs. Over the longer term, labour market adjustments could compensate for or exacerbate this effect. To the extent that emigration results in a reallocation of work outside the UK, there would be a negative impact on supporting industries such as legal and financial services, although this co-dependence is also one of the factors leading to the agglomeration effect, which tends to make wholesale relocation of PE firms (or offices) more difficult and less likely. Finally, because the tax treatment of carry recipients does not depend on where their investments are located, wider impacts on UK investment would depend on the extent of ‘home bias’ by PE executives, and whether PE is the marginal investor.
Impact of policy choices
Our modelling assumes that the only policy changes are an increase in the tax rate on carried interest under the existing statutory framework, and the application of the new 4-year FIG regime to carry. Other policy designs could result in more or less revenue being raised. A co-investment threshold would reduce revenue by preserving preferential tax rates for some carried interest; the effect on revenues would depend on take-up, which in turn would depend on the specific design. Conversely, the Government could increase revenue and reduce emigration by taxing emigrants in respect of carry earned prior to departure. This could be achieved either by treating emigration as a deemed disposal of carried interest entitlements or by taxing former residents on carried interest attributable to management services performed in the UK.