NRI Fellow  John Chapman

In an economy with $47 trillion in financial assets, how important is the $2 trillion private equity (PE) sector to economic growth in the United States? Does the tax structure for the sector matter, with respect to its potential impact on growth? Indeed, specifically, how harmful would an increase in taxes on private equity profits be in terms of growth? This essay offers perspective on this taxation issue, borne of the insights of classical economics as well as modern public finance theory; and, presented below is a template for thinking about how proposed tax changes on private equity will affect the broader economy.

First, some background: any tax legislation must be mindful of the macroeconomic environment, and September 2007 finds global financial markets in flux. In the United States, the Dow Jones Industrial Average topped 14,000 on July 17, only to fall back some 10% due to investor fears led by sub-prime mortgage market defaults. A wide range of financial institutions holding mortgage paper suffered losses, from U.S.-based hedge funds and mortgage lenders to European banks, and a few have collapsed. Countrywide Financial, the largest mortgage lender in the U.S., has announced 12,000 job cuts from a total employee base of 60,000, and approximately 50,000 other jobs in financial services have been lost since August 1. The August jobs survey of U.S. non-farm payrolls showed a net decline of 4,000 in August--the first in four years - and benchmark commodity prices are rising in step with a declining dollar.

With markets now presuming action by the Federal Reserve to lower interest rates, the Dow has recovered to a trading range above 13,300, albeit with increased volatility. In the midst of this uncertainty, the United States Congress has returned from August recess to take up several pressing fiscal issues, among which are a series of tax increase (or decrease) proposals: everything from foreign corporate withholding, to the Alternative Minimum Tax (AMT), to expiration of college-tuition and various sales-tax deductions, to increases in "sin", oil & gas lease, and gasoline taxes are under consideration. Any change in tax law has the potential to impact economic growth, and foremost among the proposals to be considered this Fall are increases in taxes on the profits of various investment firms structured as standard or master limited partnerships (e.g., private equity [buyout and venture capital] firms, hedge funds, or real estate MLPs). Generally taxed at "preferential" rates akin to capital gains (15%), the Chairmen of the Senate Finance and House Ways & Means Committees are entertaining legislative proposals to increase these PE profit tax rates to corporate or ordinary income levels (topping at 35%).

Indeed, Senator Max Baucus (D-Montana), who chairs the Finance Committee, has already introduced S. 1624 along with ranking Republican Charles Grassley (R-Iowa); this bill would hike the tax rate for any publicly-traded private equity firm (e.g., Blackstone Advisors) to 35%, or the effective corporate tax rate. Meanwhile H.R. 2834, introduced by Sander Levin (D-Michigan), is even more onerously inclusive; it would increase the rate to 35% for all firms in the private equity and venture capital sectors utilizing the limited partnership structure.

The battle lines for the coming policy debate have already been drawn: in brief, proponents such as Senator Baucus or Congressman Rahm Emmanuel (D-Illinois) claim that private equity partnerships operate like traditional money managers performing a service for fees (which are taxed as ordinary income, up to 35%), and thus have been the beneficiary of a loophole which now needs to be closed. Some academic scholars such as tax law professor Dan Shaviro of New York University concur with this sentiment, while others, such as economist Alan Auerbach of the University of California at Berkeley, admit that returns to institutional investors funds will be lowered, but only marginally. More broadly, there does not seem to be wide populist opposition to a tax increase which would seemingly fall upon allegedly wealthy Americans.

On the other hand, private equity professionals point to the sure outcome of higher taxes on PE profits as consisting of lowered returns for limited partner investors (e.g., pension funds, endowments, wealthy individuals), and less capital and liquidity in the sector. Defenders of private equity assert that these effects would be due to higher fees and a more adverse risk-return profile, the necessary concomitant of which will be lower job creation, lower mobility of capital, and lower economic growth. Finally, tax hike critics say, the unfairness of this issue would be borne by the industry's professionals; leveraged buyout and venture capital investments are the quintessence of patient risk capital in pursuit of capital gains. If dollars from the same bucket flow to limited partners as capital gains, so should they to the general partners who drove the speculative investment.

Given the above, how should we think about proposed tax changes? To answer this question we will first summarize private equity organizational and transaction structures, and then proceed to think systematically about taxation in this sector (comments in this essay will refer mainly to buyout and venture capital funds, but the discussion of taxation effects apply equally well to hedge funds or other limited partnerships).

Private Equity Defined, Its Importance as an Economic Institution, & Its Taxation

"Private equity" is a term which actually connotes two distinct types of investment: early-stage venture capital (say, of biotechnology or software start-ups), and later stage investment in mature-industry companies, whether a minority stake or a complete buyout of the firm. Private equity firms are formed as limited partnerships, in which entrepreneurial promoters (acting as general partners, or GPs) raise capital from institutional investors (e.g., pension funds, endowments, insurance companies) who are the limited partners (or LPs), and deploy this capital into multiple companies over a 10-14 year life of the partnership. In both VC and buyouts, managers in these companies have significant equity stakes and other incentives to create value, prior to an exit or liquidity event (e.g., an initial public offering, or sale to an industry acquirer).

Today there are over 2,000 private equity firms of all types in the U.S., managing over $2 trillion in leveraged capital. While small as compared to public equity markets, venture capital and buyout firms have an outsized influence on American business and finance: in recent years over one-third of all mergers or acquisitions have involved PE firms, and some of America's most storied companies are venture-backed (e.g., Google, Genentech). The buyout sector has driven changes in corporate governance, capital allocation, and business strategy which have carried over into publicly-held companies, while the venture capital sector has rationalized the processes of new business formation. Both aspects of private equity, then, are efficient institutional responses to the needs of a modern capital-using economy with an ever-growing division of labor and ever-extending division of knowledge. And, both offer increasing liquidity for U.S. and global capital markets, which engenders more efficient (and wealth-creating) deployment of capital. Finally, both enhance another key institution, entrepreneurship, which is the driving force of a market economy and the wellspring of wealth in civilized society.

Private equity partnerships are set up in fairly uniform fashion with respect to legal liability and profit sharing (and this arrangement is common to hedge funds, real estate, et al.): the GPs are legally in control of fund disposition and investment strategy, and make all entry and exit decisions; GPs also sit on boards of investee companies and provide monitoring and strategic oversight as well. They typically charge a management fee (1-2.5% of total assets committed) and transaction or consulting fees for their oversight (the latter paid by each investee company),and receive a carried interest in the eventual profits of the partnership (usually at or near 20% of total profits). The carried interest, or carry, is paid out, however, only after a preferred return is paid to the LP investors (typically in the 8-9% range), who then receive the bulk of residual profits (viz., roughly 80%).

It is this carried interest which is the focus (target?) of politicians seeking tax law changes; currently, because the carry constitutes part of the speculative profit from the partnership's investments, it is taxed as a long term capital gain (15%, or the same rate as the LP interest). The legislative proposals mentioned above seek to increase the tax rate on the carry to 35% (other cash compensation to the GPs such as the management fee are taxed as ordinary income, up to 35%); proponents such as Professor Shaviro argue this is appropriate due to its fee-for-service nature, and hence should be taxed as ordinary income. Professor Auerbach in turn testified that while the tax increase might result in higher fees assessed to LPs, that this would be negligible in cases where LPs had only a small portion of assets deployed in private equity investments; politicians in favor of the tax increase also have indicated effects would be negligible.

Insights From the Economics of Taxation Inform the Debate About Private Equity

Optimal tax policy has been a subject of debate since Adam Smith and David Ricardo promulgated the building blocks of modern economics--which factors of production or which entities to tax, and how to tax them, has been the subject of debate for over 200 years. The following insights are of use in thinking through the taxation of PE profits:

Because of the focus from Smith to Karl Marx on the distribution of income and returns to various factors of production (all in connection with explaining an erroneous labor theory of value), classical economists recognized four basic types of income corresponding to the canonical factors of production: wages accruing to labor; interest accruing to capital (whether in the form of stocks or bonds); rents accruing to land (and its owners); and, profit accruing to entrepreneurship (i.e., the promoters and organizers of income-generating ventures such as private equity deals). While the focus of writers such as Marx was on the relative justice inherent in the distribution of this income across these factors, for our purposes it is important to recognize the progression of thinking from this paradigm to the present issue: specifically, the Austrian Eugen von Bohm-Bawerk, in his three volume Capital and Interest (1884-1889), was the first to detail the importance of time in developing a capital-intensive structure of production (viz., specialization occurs as markets for capital goods develop in a production chain to produce ultimate consumer goods). Because of the time lag involved in production, capital investment was inherently risky (and as Bohm-Bawerk argued against his immediate target, Marx, therefore was deserving of commensurate return); later, other Austrians such as Joseph Schumpeter, Ludwig von Mises and 1974 Nobel Prize winner F.A. Hayek extended this idea by highlighting the role of the entrepreneur, in initiating risky ventures in the face of (a) pervasive uncertainty, and (b) limited, dispersed knowledge of resource supply and demand conditions (the Austrian writers also understood that the distinction between capitalist and entrepreneur was artificial; in the real world, the two were often concatenated into one risk-taking entity, as per GPs in private equity).

These writers thus forcefully articulated the crucial importance of risk capital and entrepreneurship to a growing economy, and extended the understanding of classical writers as to the importance of capital investment in engendering productivity growth, which alone is the source of increasing wealth in an economy. To say this differently, not all cash flows from different sources are created equal. Capital is one factor of production, but it is the controlling factor; entrepreneurial skills are embodied in time-dependent capital investment as well, and thus cash flows derived from these factors have traditionally been treated more favorably in tax codes in many market economies around the world. It is important to note that modern-day advocates of tax increases on private equity profits fail to appreciate the importance of capital formation and entrepreneurship, and instead assume that, statically, production and wealth creation will somehow just "happen". But in fact, risk, trial-and-error, loss, and highly variable returns are the nature of the capitalist process; this process, which Israel Kirzner refers to as one of discovery, is the source of the progress of civilization, and empirically has been shown to be both responsive to tax policy, and better effectuated in a low-tax regime with stable property rights.

For the most part then, over time, U.S. tax policy came to recognize the importance of capital formation to long run economic growth, and to treat forms of capital more benignly than labor. The focus here has been on income flowing to two ultimate uses: consumption, or saving. While policy has varied widely over time, most economists agree that tax-treatments which favor saving over consumption will induce capital formation and hence long run growth. UCLA economist Arnold Harberger informed the debate with important research describing the excess burden of taxation, more commonly known as its dead weight loss - this was a measure of the lost economic activity, both production and consumption, due to the tax wedge. In an important paper in 1962, Professor Harberger described a simple but realistic model in which corporate income taxes--ultimately a tax on capital--lowered the firm's capital/labor ratio, and hence long run growth in productivity (this engendered a long empirical literature in taxation effects up to the present day--see Taxes and Wages on how wages in manufacturing respond to corporate taxes. Harberger and others ultimately argued for a tax regime which should be as neutral (non-distortive to relative prices) as possible; in the private equity context, this is an important insight because the ideal is for PE investors to make forward-looking investments irrespective of their own particular tax circumstances, and instead focused solely on the merits of the proposed transaction.

Specifically, then, U.S. tax policy has been geared toward taxing of cash flows bracketed into two groups: capital gains, which are cash flows received based on increased value of capital assets; and, ordinary income, which is, essentially, everything else: e.g., wages, tips, commissions, interest on debt. Capital gains have, as is true currently, usually received more favorable tax treatment as a spur to capital investment, though economic activity has been responsive to changes in marginal tax rates on ordinary income as well.

Implications for Policy on Taxation of Private Equity

Given the above we are now prepared to think crisply about the taxation of private equity GPs and their carried interest:

(1) What is carried interest? From the foregoing it is clear that, in a definitional sense, the carried interest represents a capital gain: it can only arise if the value of the firm, in which the private equity has been placed, increases. LPs are taxed at 15% on this passive, long-term holding (receiving roughly 80% of any distributed profits including a preferred return), and historically GPs are taxed equivalently.

Senator Baucus and Congressman Levin contend, however, that this carried interest was earned with no underlying capital investment; it is purely cash received from services performed, because the LPs supply most of the ingoing capital. For them, carried interest is no different than, say, a 100% self-employed commissioned sales professional such as a realtor, who has earnings taxed at ordinary income rates. To put this in the language of the classical economists, is carried interest more akin to wages accruing purely to labor power (to use Marx's term), or is it akin to cash flows accruing because of an increase in capital asset value?

(2) A continuum between pure ordinary income and pure capital gains--It seems clear that there are shades of gray with respect to income flows: University of Chicago tax law expert David Weisbach argues that a Bill Gates-type entrepreneur has, like the GPs in private equity, effectively no capital investment in a business like Microsoft, which is bootstrapped from a garage; should all of Gates' cash flows from Microsoft, therefore, be taxed at ordinary income rates? Similarly, Weisbach describes a capitalist-entrepreneur (say, a private equity GP) who borrows money to capitalize an investment fund; the GP, after returning the loan, keeps any profits from the fund and is taxed at capital gains rates, in deference to the fact that such a profit residual is indeed a capital gain. Weisbach offers yet another analogous example: a junior partner who receives entry into a law firm partnership receives an immediate economic gain which is not taxed, and at year end receives a portion of partnership cash flows without a prior capital contribution; these earnings are taxed as a capital gain. His larger point is that traditionally, U.S. tax law has looked favorably upon income emanating from entrepreneurial activity as a capital gain, and/or in cases where labor is combined with capital to produce the gain; Weisbach points out that it is impossible to distinguish flows specifically due to labor and those to capital, and hence policy errs on the side of liberality and simplicity.

To put this in the context of the value added by the GP of a private equity firm, how much value is provided by the GP in terms of deal selection; monitoring of management; strategic advice and oversight; delivery of human, financial, or marketing resources; and other services, versus what all this would cost the LP to "rent" on the managerial labor market? Seen in this light, with all the time-dependent risk involved, it seems absurd to think about carried interest as ordinary income akin to a biweekly salary at General Motors.

(3) What will be the effect of this tax increase if it happens? It is impossible to say with precision just how this tax increase would affect the PE sector in terms of magnitude, but this much we can predict in terms of direction: just as the $2 trillion sector has had positive "leverage" on public markets and business practices out of all proportion to its size in global capital markets, so will it have a negative effect beyond all proportion if enacted. For one thing, some of the tax increase will be passed on to the LPs in terms of higher fees, lowering returns, perhaps moreso than Professor Auerbach suggests. Lower capital will thus come into the sector from this, as well as exits by GPs, who will at the margin leave the business rather than face more onerous taxation. This will lower liquidity (and capital efficiency) in the sector. Starkly, the lower amount of capital in the business will deflate corporate valuations, including those involved in public company M&A--this will have a negative wealth effect on shareholders. Less directly but as importantly, the competitive whip provided by private equity to incumbent managements to deliver results or be removed will be marginally lessened, decreasing corporate productivity growth; viz., the governance effects of PE will be lessened. Lastly, for the venture capital sector, less capital will mean less innovation borne of risk-taking.

Summary

Private equity is an institutional response to the need for efficient capital formation to support entrepreneurship in a modern capital-using economy with an advanced degree of specialization and division of labor. Buyout and venture capital firms play roles of investment selection, monitoring, performance measurement, and strategic oversight which cannot be offered by traditional intermediaries such as banks. PE firms also channel and deploy capital in ways which optimize the efficient bearing of risk, in investments which are often long-lived and stretched into an uncertain future.

It is true that there appears to be a "continuum" of cash flow types to individuals, ranging from pure ordinary income at one end, to a pure capital gain at the other. However the U.S. tax code has traditionally looked favorably upon all forward-looking capital investments, and has treated GPs akin to LPs, and GPs similarly to other cases or structures of capital gains borne of an ingoing zero capital account or basis (e.g., a Bill Gates-bootstrap entrepreneur).

Given that the proposed Senate bill deals only with PE firms who become public, this issue may have been raised at this time because of the IPO of Blackstone Group, and the personal enrichment of Blackstone founder Stephen Schwarzman therefrom. If so, Mr. Schwarzman has created what economist Mike Jensen has called a "negative externality" for the entire industry. Good economics does not always make for good politics, but at a time of macroeconomic uncertainty or even turmoil, raising taxes on the progenitors of so much entrepreneurial energy in our economy, and on an institution with outsized importance to economic growth over the last 25 years, makes little sense. Finally, to the degree there are cash flows to individuals which are borne of entrepreneurial risk, but where the asset at risk is time, as opposed to capital (money), perhaps the best policy response (per Bohm-Bawerk) is to reclassify such earnings as capital gains, as opposed to ordinary income. The self-employed 100%-commissioned professional is surely more at risk than his salaried counterpart in corporate America, after all, but it is from such efforts that great enterprises have been born.

John L. Chapman is an NRI fellow at AEI.