Monday, October 1, 2012

One Thing We Can Learn from a 14% Tax Rate

One thing we can learn from a 14% tax rate

The candidacy of Governor Romney is a teachable moment on the business of private equity.  It illustrates how a fairly sensible tax policy can morph into a loophole.   I’m talking about the capital gains treatment afforded “carried interest.” 

Here’s how it works: investors agree to share a portion of their profits in the deals managed by private equity.   Those profits are given preferential tax treatment instead of being taxed as ordinary income, even though the private equity partners did not invest anything tangible in order to get a share of the profits.  The same treatment applies to real estate and hedge fund managers, although hedge funds usually don’t qualify for capital gains treatment because they don’t hold securities long enough to get it.

Going Out the Door (1997)
The special tax treatment afforded carried interest began reasonably enough when Congress decided that entrepreneurs who create businesses should receive capital gains treatment even if they only contribute their “sweat” to forming the business.  Imagine an entrepreneur with no money who goes into business with a wealthy patron who invests all the cash, and they agree to split any profits.  Should the profits earned by the entrepreneur’s innovation and creativity be taxed as ordinary income?  No, it seems sensible to afford them the same tax treatment as the investor.

Private equity and other professionals grabbed hold of this tax benefit.  Although they weren’t the creative geniuses creating new products in their garages, they donned the mantle of the “entrepreneur” and had the special tax treatment applied to them.  When the tax incentive was first created the private equity industry was small and the benefit went largely unnoticed.  However as private equity was able to raise multi-billion funds, the capital gains benefit began to cost taxpayers a lot of money, creating a tax benefit for millionaires and billionaires.    A reasonable tax policy had become a full-blown loophole.

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Governor Romney’s benefit and those of other retired private equity executives is even more egregious.  At least the active partners in a private equity firm have to work (arrange deals, sit on boards, restructure the company) in order to gain the special tax treatment.  Retired partners don’t do anything at all – they simply receive a share of the profits.  The Governor’s 14% tax rate is, at least in part, a huge wind-fall.

The Obama Administration has tried to close the carried interest loophole and run into the political power of private equity.  The industry, of course, claims that they are entrepreneurs (an insult to every true entrepreneur), and argue that without the special tax treatment they might not be willing to take the risk of operating private equity funds.  This is an absolutely laughable claim.  As I’ve previously pointed out, private equity makes big money on fees, and gets carried interest as a bonus.  Whether carried interest is taxed at 15% or 35%, private equity will be more than happy to manage private equity funds and receive 20% of the profits.

The carried interest loophole is a warning that neither President Obama nor Governor Romney are going to have an easy time closing loopholes in an effort to reduce the deficit.  Powerful interests like private equity are the kinds of campaign contributors that will make it next to impossible.

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