Why Raising Taxes on Private Equity Won’t Increase Tax Revenues

Tennille Tracy does

her sums over at DealJournal today, and comes to the conclusion that the

private-equity tax increase would raise maybe $2 billion a year for the US fisc:

"almost like pocket change" in comparison to the $1.65 trillion in

total tax receipts in 2003.

In fact, the chances are that the net amount raised would actually be much

lower than $2 billion.

One of Paul Krugman’s readers explained why, in some hard-to-follow

language on Krugman’s Money Talks page.

Don’t worry if you don’t follow, I’ll try to explain after the quote.

Michael Plouf, Essex, Conn.: I have invested in hedge funds

for 15 years, and I agree with everything you wrote

about taxation of hedge fund carried interests. It is a subject which industry

spokesmen have fairly successfully obfuscated.

However, you may be unaware of a tax policy complication that applies to this

issue. As a matter of general tax principle, one party’s income is another

party’s expense. I now get a tax deduction subject to a double haircut on

Schedule A for the 2 percent management fee. The carried interest portion

of the fee merely reduces my long- and short-term capital gains by 20 percent.

If the hedge fund manager is taxed at the ordinary income rate for the 20

percent carried interest, I should be entitled to take that as an investment

expense deduction, just like the 2 percent fee. Given the high marginal tax

rate of most hedge fund investors, the net benefit to the Treasury of taxing

carried interests at ordinary rates is likely to be insignificant if the income

equals expense principal is maintained. If that principal is ignored, I think

it’s fair to argue that it would constitute a sort of double taxation.

It is not true that the carried interest unfairly gets favorable capital gains

tax rates without there being capital at risk. Rather, hedge fund managers

take a slice of the return, taxed accordingly, on their investors’ capital

at risk.

Paul Krugman: OK, I’ll try to digest that.

Never mind the "tax deduction subject to a double haircut on Schedule

A" and all that. The key thing to realize is this: private equity managers’

2-and-20 fee structure is split into a 2% management fee and a 20% performance

fee. The principals pay income tax on the 2% management fee, but they only pay

15% capital gains tax on the 20% performance fee, which is known as "carried


From the point of view of an investor in the funds, the 2% management fee is

an expense of the funds, and can be deducted against taxes. The 20% performance

fee, however, because it’s structured as "carried interest", is not

treated as a fund expense, and so is not deductible.

If Congress enacted a law which treated the 20% performance fee as income for

the fund managers, then that fee would overnight become an expense of the fund.

But don’t take my word for it. Let Peter Orszag, director of

the Congressional Budget Office, explain:

Tax Carried Interest as Ordinary Income When Realized. A

second option would be to continue to allow deferral but to view carried interest

as a fee for services provided and therefore tax the income distributed to

the general partner as ordinary income. Carried interest would thus be taxable

to the general partner as ordinary income and deductible as an expense incurred

to earn investment income to the limited partners.

This is worth repeating. Carried interest thus be taxable to the general partner,

yes. But it would also be deductible – as an expense incurred to earn

investment income – to the limited partners, who are the investors in

the fund.

What this means is that the net revenue to the US from implementing this policy

would be tiny: what you gain in taxes on general partners, you lose in taxes

on limited partners. Net-net, there would probably be a gain, since private-equity

principals pay high rates of income tax, and many limited partners are endowments

and foundations and other entities which don’t pay tax anyway. But the gain

would likely be much smaller than Tracy’s $2 billion a year.

On the other hand, it means that anybody claiming that this change to the tax

code would reduce returns to private-equity investors actually has things completely

wrong: it would, rather, increase the after-tax returns to tax-paying

private-equity investors.

(By the way, none of this posting would have been possible without the invaluable

help of DealBreaker’s John Carney,

via instant message. But I’m not even going to attempt to explain his

idea about carried interest being replaced by non-recource zero-interest loans

from the limited partners to the general partners.)

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