Why private equity will have to pay up

June 28, 2007, 10:16 PM UTC
Fortune

In a contentious debate the fun begins when one side or the other starts slinging mud to confuse people. It has started in the battle over taxation of “carried interest,” otherwise cast as whether partners in investment partnerships ought to be paying a higher tax rate. (In an earlier post, Tax the Rich, I provide links to a handful of other articles that review the “Blackstone (BX) tax” fairly thoroughly.)

The obfuscation began this week in response to a bill filed last week in the House by Rep. Sander Levin that would remove the capital-gains treatment for carried interest, which is the portion of profits that private-equity partnerships take when they distribute winnings to their investors. Opponents of this proposal cleverly, but disingenuously, are trying to frame the debate as Congress trying to raise the rates on ALL capital gains. The Wall Street Journal has a good round-up today, and here are the money quotes, deep in the article:

In the House, bill opponents are being marshaled by Rep. Eric Cantor (R., Va.), a member of Mr. Rangel’s tax-writing committee and a big recipient of campaign support from the financial-services industry. He hopes to portray the legislation as the first step by Democrats toward repealing the 15% rates on capital gains and dividends.

“I don’t think people realize how much this has become a proxy fight for the 15% capital-gains rate itself,” said David Hirschmann, the president of the capital-markets division of the U.S. Chamber of Commerce.

Mr. Cantor, who is the top vote-counter for Republicans in the House, could win votes from most Republican lawmakers if he successfully defines the issue as a fight over the capital-gains rate, which the Republican-controlled Congress approved and Mr. Bush signed into law in 2003.

See, the interesting thing here is that neither Levin nor anyone else who is looking at this issue has said anything about changing the capital gains rate. They’re only looking at changing how carried interest is taxed.

Economist and TV personality Larry Kudlow posted a similarly dishonest article at the National Review Online in which he said that raising the tax rate on “risk capital” is just the first step toward eliminating the preferential treatment for capital gains altogether.

In his efforts at confusing people, Kudlow at least has put his finger on the issue with the expression he has fabricated, risk capital. Private equity shops, which include venture capital firms, argue that the profits their partners make years after they make an investment should be considered a capital gain because they’ve taken a risk. In fact, the risk is in reputation and time only, not capital. (If they do invest capital, nobody is arguing that shouldn’t be subject to capital-gains treatment.) At issue is how to tax the money they make if their investments — with other people’s money — pan out. The obvious answer: the same tax rate other rich people pay when they make money, 35%.

In an editorial this week, the New York Times summed up the reasoning for this change:

With income inequality surging along with the need for tax revenue, the bills’ supporters rightly conclude that it is untenable for the most highly paid Americans to enjoy tax rates that are lower than those of all but the lowest-income workers.

Confusing sloganeering aside, the issue is really that simple.