Now that there is a bill in Congress to change the taxation of managers of hedge funds and private equity funds, the lobbyists have been going crazy. And they are getting to some of the Congress--Senator Schumer, who raised more than a million from the private equity and hedge fund industry, has reassured the industry that he will resist the effort to tax these funds fairly. See Raymond Hernandez & Stephen labaton, In Opposing Tax Plan, Schumer Breaks with Party, NY Times, July 30, 2007. Schumer says he is "torn between the need to protect an industry ...and the need to generate revenues to finance government programs." He's at least being honest--it's no free market but a tax subsidy to the wealthy private equity funds. But the tradeoff isn't just revenues, it's the basic fairness of our tax laws.
The issue is two-fold: should these firms retain their exemption from being treated the same as corporations when they go public and should the managers of these firms continue to be able to receive capital gains treatment (depending on the nature of the partnership's assets) when they are paid on their "profits interest" in the partnership, which is their compensation for providing services.
On the first issue, it seems obvious that Blackstone and its ilk are active management firms and not passive investment companies. The 20-year-old publicly traded partnership provision with its exception for investment income should be modified to treat companies like Blackstone as corporations.
On the second issue, there is both a fairness and an efficiency concern with the current treatment. The fairness concern is the inequity of taxing compensation to equity fund managers as though it were a return on an investment, when they are making no investment of their own. In a society that is growing increasingly unequal, with the top 1% bringing in most of the gains over the last few years, and the rest of us at best holding stagnant, it is simply unconscionable to continue to provide these managers such a tax subsidy. It certainly isn't necessary--managers will continue to manage and "entrepreneurship" will not die off in America if managers have to pay the same tax on their compensation as ordinary workers must pay.
The efficiency concern is the distortion of markets when one particular type of activity (the buying, cutting out of jobs and assets and then flipping of companies at considerable profit) is unduly rewarded by a lower tax burden than other types of activities, resulting in too much of the low-tax activity. It is not clear at all that leveraged buyout firms are doing the U.S. economy much of a service. They clearly are doing their managers a service--making millions and sometimes billions of dollars. But the private equity funds treatment of the assets they purchase and resell (sometimes very fast) is not necessarily beneficial to the economy and certainly isn't to the individual workers whose lives are permanently affected. This point was raised by Bill Klein on Dan Shaviro's blog about carried interests, and I think has been noted elsewhere in the discussion.
The Wall Street Journal online ran an article on the 30th by Phil Kerpen, called "The Smart Way to Soak the Rich." Kerpen implies that the idea of taxing private equity investment managers on their compensation in the same way that we tax janitors and lawyers is "nothing more than a punitive tax on those the congressment perceive to be making too much money." That sounds like spin to try to convince everyone that this is some kind of inefficient class warfare rather than a reasonable and fair response to an unfair tax subsidy that has developed in light of the way "profits interests" in partnerships are treated. It is interesting to see that the Wall Street Journal, which generally proclaims itself a bastion of "free market" ideology, can be so strongly in favor of a tax subsidy. The Kerpen articles goes on to make other unfounded assertions, such as the claim that Sarbanes-Oxley and "excessive litigation" are pushing companies out of the public markets. Balderdash--do you see General Electric going private? Kerpen also claims that the lower capital gains rate of taxation on managers' profits interests is reasonable because it will "encourage risk-taking entrepreneurship and capital formation." I suspect managers will keep right on managing even if they do have to pay tax, but the claim of entrepreneurship and capital formation is doubtful. The managers aren't using their own money--they are getting capital gains treatment on money others invested.
Kerpen goes on to raise the specter of an end to the capital gains preference. Boy, I wish that were true, but regretably it isn't likely anytime soon, even if John Edwards has courageously called for it and Len Burman has written an op-ed in the Washington Post, End the Break on Capital Gains, Washington Post, July 30, 2001, A15. pointing out the difficulty of categorizing something as a capital gain. The preference doesn't make any sense at all--it doesn't encourage entrepreneurship, but it does get rich guys off the tax hook, which raises our sense of unfairness.
"In fact, the tax break on capital gains does more harm than good. The overall level of saving responds little to tax rates. And enough investment is financed from sources unaffected by individual income taxes -- such as pension funds, insurance companies and foreigners -- that the direct taxation of capital gains of
stakeholders doesn't matter much." U.S.
"What's more, entrepreneurs would get a significant tax break even without the low rate on gains. Unlike employees who pay as they earn, entrepreneurs can postpone their tax until they sell a business. In the case of private equity, for example, a large portion of the general partner's compensation is deferred until the assets are sold. Delaying his tax bill for many years amounts to an interest-free government loan -- a powerful incentive to earn income that way."
But this carried interest deal isn't really about the capital gains preference. That's just a strawman argument that Kerpen is raising to divert people from the real issue. What the carried interest argument is about is which category these managers belong in--capital gains because it is a return on investment or ordinary income because it is a fee for services. There are borderline cases, but this isn't one, in my opinion. These managerial activities are clearly services, and the profits interest is just another fee for services, not a return on an amount put at risk. It should be taxed like any other fee for services.
The Wall Street Journal also ran a "debate" between AFL-CIO Associate General Counsel Damon Silvers and Sterling Capital Partners board member and Chicago School of Business Professor Steven Kaplan. Kaplan claims that "private-equity funds earn money in two ways--through management fees and through a share of the profits on the companies in which they invest." (Note that this statement implies that the profits are really capital interests in the partnership, but in fact most of the equity fund managers are earning a "profits" interest on shares in a partnership that are handed to them as compensation, not investments from their own pockets. The fee vs profits interest distinction is by virtue of the way the rules work, not by virtue of a significant investment made in the partnership.) Kaplan reports the Metrick and Yasuda study that indicated that the "average" fund earned only about 40% of its compensation from its profit share so "it is hardly the case that private-equity funds avoid ordinary taxation." That is misleading. The fact that ordinary taxes may be paid on the part that is characterized as a fee doesn't mean that ordinary taxation isn't generally avoided on the part of the compensation that is classified otherwise. It is that treatment of the "profits interest" as not being compensation that is the issue under discussion. Kapaln makes many of the arguments made by avid Weisbach in his July article on carried interests.
David Weisbach's industry-backed "study" available on the Private Equity Council website makes two points: 1) labor involved in private equity investments is the same type of labor that is intrinsic to any investment activity and 2) even if there were good reasons for changing the tax treatment of carried interests, it will be "complex and avoidable".
As to the first point, Weisbach first equates a fund manager who gets paid with a "profits" interest with an investor who trades stocks for himself and has a capital gain on the sale. It is surprising to see someone of Weisbach's caliber glossing over the considerable differences between these two situations. We don't tax the investor who trades for himself on his compensation income because that is imputed income. We tax him on his gain from the sale of the asset in which he has a capital investment. We also don't tax the homeowner who repairs his plumbing on his imputed compensation. But we do tax plumbers when they perform those services for others. The equity fund manager is not like the private investor--he is not performing management services for himself, so it is not a question of imputed income, and he is not receiving a return on investment, since he has nothing invested of his own. The equity fund manager is like the plumber who performs services for others. So we should tax the managers' income from the private equity partnership as compensation and not as a capital gain.
Weisbach expands his point by asserting that the private equity managers are just entrepreneurs who seek financing from partnership investors. This further elaboration brings up the problem with capital gains generally, since the "core distinction created by the capital gains regime cannot be eliminated" --unless, I would say, we admit that we cannot justify the ordinary versus capital category distinction, acknowledge that it is primarily a redistribution-upwards subsidy for the wealthy, and eliminate it, as we did in the 1986 tax reforms. The activities we think of as investments that yield capital gains are merely various positions on a continuous spectrum from "pure" labor to "pure" investment profits. It can get fuzzy in the middle and hard to identify. It's true that entrepreneurs like Bill Gates put a small investment and a lot of sweat equity into developing an idea and then, if it pays off down the road, may have a significant capital gain on their investment. We don't divide out the amount attributable to sweat and the amount attributable to their investment. Which place on that spectrum should manageres who earn carried interests be situated in? Weisbach makes the distinction seem harder than it is in this case, from my perspective. These managers are less like entrepreneurs and more like service providers whose work is to manage others' money. The analogy with corporate stock options and stock compensation is telling. The employee performing services who receives stock options is taxed on those options as ordinary income.
Weisbach says it makes no sense to try to take away the capital gains treatment because managers of private equity funds could just finance their investments with debt rather than with limited partners. There would be a number of drawbacks to that arrangement, including the transaction costs for debt issuance and complexity of debt covenants and, perhaps most important, the fact that debt holders generally get a substantially lower return than the investors in these partnerships are striving for. That requires a significant contingent feature based on profits of the enterprise on the debt. Given the extraordinary leverage of most private equity funds and the large contingent feature on any restructuring of the partnership interest as a loan, there might also be a substantive question whether the debt of the limited partners to the general partner (and the general partners' subsequent contribution of that debt to the partnership) would be respected for tax purposes. If the general partner is too highly leveraged, the debt might be recharacterized as a joint venture, with the manager running the venture (and receiving compensation income).
Weisbach's statements about the importance of the carried interests to incentivize managers sound a little too much like industry PR. First, the incentives of big money (and status and all that) would still be there even if carried interests were taxed as compensation. Second, being taxed at half the rate that ordinary folk are taxed would incentivize a number of different industry workers, but that would just mean that ordinary income and capital gains should be taxed at the same rate. It doesn't justify a tax subsidy to one group.
Weisbach acknowledges that there has been considerable controversy over the proper treatment of a profits interest in a partnership. He raises the spectre of taxation of a profits interest upon receipt, but that is not the issue here either. The real question is whether profits partners should get to have capital gains treatment. The best solution is to tax their distributive shares as ordinary income, as Mark Gergen proposed at the first Senate Finance Committee hearing on carried interest.
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