When the Senate bill to raise taxes on publicly traded private-equity partnerships first appeared, I suggested that it could be the precursor of legislation to hike taxes on all investment partnerships. And so it was.
Rep. Sander Levin (D., Mich.) has introduced a bill that would raise taxes on all partnership performance fees from the capital-gains rate, currently 15 percent, to ordinary income-tax rates, currently as high as 35 percent. If successful, this measure could lead to the elimination of the capital-gains tax rate for everyone, replacing it with much higher personal rates. The ramifications of this are dire for the U.S. economy, federal revenues, and ordinary investors.
Blackstone LP’s initial public offering a week ago had raised the ire of senators who looked to score political points by increasing taxes on private-equity partnerships that go public. A bill introduced by senators Max Baucus (D., Mont.) and Chuck Grassley (R., Iowa) would have forced partnerships that go public to pay corporate tax. Putting aside the fact that the portfolio companies Blackstone owns already pay corporate tax, and that partners, including those who buy into the now-publicly traded partnership, pay individual taxes on partnership income, this misguided tax hike would do real damage to regular investors. In particular, it would give partnerships a strong incentive to stay private, sidelining many grassroots investors from the private-equity boom.
Baucus-Grassley is a real threat that should be taken seriously. But in truth it directly affects only a small number of partnerships that are publicly traded or wish to be publicly traded. That’s why, in order to satisfy their appetites for ever higher tax rates, legislators are turning to broader tax hikes on carried interest.
Carried interest refers to the performance fees that limited partners pay the general partner so that they can participate in the upside of their investments and have their incentives aligned. The most common arrangement for investment partnerships — including hedge, private-equity, and venture-capital funds — is the 2/20 structure. When limited partners (usually pension funds, university endowments, and wealthy individual investors) invest in a fund, they typically agree to pay the general partner who runs the fund an annual fee of 2 percent to cover management costs. They also agree to give the general partners a piece of the upside, the capital gain, if the investments are successful. That portion of the capital gain, typically 20 percent after the original investment and a specified rate of return is paid out, is known as the carry, or carried interest.
The management fee is earned income, and is taxed as such. But a capital-gains treatment for the carried interest is appropriate since it is capital income. And since the carry represents a portion of the fund’s capital gain, taxing it at the full individual rate would exacerbate the double-taxation of capital gains, since the portfolio companies already pay corporate tax.
Additionally, taxing carry as ordinary income would represent an enormous tax hike that would drive investment partnerships out of the U.S. and force limited partners to offer higher pre-tax participation to general partners, lowering returns for millions of Americans whose pensions are invested in private equity and removing critical support, via buyouts, from the stock market.
If all this is not bad enough, the trend is toward something even worse: The same people who think the capital-gains tax on carried interest is a loophole also believe the capital-gains tax for all investors is a loophole. Sen. Ron Wyden (D., Ore.) has already introduced a bill that would close that so-called loophole by taxing capital gains at ordinary income-tax rates.
The misguided rationale for this policy is that fairness requires taxing income, whether it comes from capital or labor, at the same rate. But capital income already is subject to the 35 percent corporate tax rate before being distributed to investors as capital gains or dividends, making even the current 15 percent cap-gains rate an unfair double tax. (If the corporate tax were repealed, as former Ways and Means chairman Bill Thomas has suggested, capital gains could be treated as ordinary income, although it still should be inflation-adjusted to avoid the taxation of phantom gains.) Since capital investment entails substantial risk-taking, it is desirable — and should not be discouraged by high taxes. Former Federal Reserve chairman Alan Greenspan repeatedly advised Congress that the correct capital-gains tax rate is zero.
But now we’re headed dangerously in the opposite direction.
Raising the capital-gains tax to 35 percent, or even 40 percent or more should the Democrats successfully raise income-tax rates, would dramatically reduce the after-tax return on stock investments, which would be a great impediment to stock markets. It would significantly raise the cost of capital, drying up investment in many innovative, entrepreneurial companies. It also would hit the U.S. Treasury hard, contrary to the conclusions of the static-revenue scorekeepers. History is an excellent guide here: Every capital-gains tax hike in the past thirty years has led to lower federal revenues, while every cap-gains tax cut has led to higher revenues.
Investors need to weigh-in against tax hikes on capital now, and hold the line on private equity. If private-equity partnerships take a hit from higher capital-gains tax rates, it won’t be long before regular investors feel the full force of the blow.