Moving the tax debate forward

Shortly before the weekend kicked off our sister title Private Equity International published a follow-up response to “End this futile debate”, an op-ed piece arguing that a GP’s share of profits made on investor capital should be taxed as income, not capital gains.

The response letter followed an in-house debate in which due consideration was given to points raised by readers, both publicly and during background conversations or interviews. In all, PE Manager readers generally took a technical approach in their responses, both when defending the status quo and arguing against it.

A common talking point they raised went to the heart of why a lower capital gains tax rate exists in the first place. Many said the lower rate was designed to encourage investment in the economy, and fund managers enjoy partial ownership in, and perform sophisticated services for, a firm doing just that.

Other readers argued that line of thought misses the target. A capital gain, they said, represents income from previously taxed capital, meaning owners should only be taxed on real economic gains, thus the lower rate. This is a non-issue in compensation for services, labour, human capital, call it what you will. However, often missing from that argument was why private investment fund managers were being singled out, as the logic ostensibly captures all types of equity compensation treated under the capital gains regime. 

The in-house view, however, acknowledged private equity firms invest valuable time and energy in portfolio companies, but questioned the practical reality behind a favourable tax rate on their disproportionate share of the gains, which was more akin to a performance bonus than a capital gain.

Another compelling question to consider, which speaks to the first point raised above, is whether the tax code needs to incentivise fund managers the way it does entrepreneurs. In all likelihood, a carry tax switch to ordinary income will not result in any significant talent drain from the industry. Similar to well-compensated bankers, who are taxed under ordinary income rates, the private equity model offers sufficient incentive in its own right to attract quality human capital to its domain. It’s hard to think the same holds equally true for entrepreneurial risk activity.

The technical points and philosophical underpinnings of this debate of course deserve due consideration, but as the response letter argues, perhaps the most powerful case now to be made against the status quo is the political one. An ordinary income tax rate for carry strips private equity critics from a key point of attack. At a time of heightened scrutiny over the buyout model, why allow the “futile debate” around carry tax to grab the attention’s public in a damaging way? 

Politicians are beholden to their constituents, and whether for right or wrong, an attack on private equity on their part becomes an easy way to score points with the public every time Mitt Romney, or the next public-facing private equity figurehead, reveals a 15 percent tax rate on their carried interest. Or as worded in the letter, whether for right or wrong: “Now is the time for the industry to accept that some sort of change is inevitable, and focus its efforts on trying to mitigate that change. It must engage, and engage realistically.”