A money for nothing theory of taxing carry

After the numbers on who gets what in the Blackstone IPO were outed (see my discussion yesterday) it didn’t take a genius to predict there would be a story about Steve Schwarzman’s shower curtains, or some such thing. Sure enough, today’s WSJ has a story about $400 stone crabs, squeaky rubber shoes, and several other important policy issues concerning the going private king.

Surely this will play a role in the Congressional “debate” on taxation of private equity partners’ carry. As Holman Jenkins writes today:

Having picked up their papers and noticed the riches now being realized by private equity partnerships, various observers (labor, journalist, academic) have begun to complain that this treatment is inappropriate and preferential.

Basically the point of these critics is that the carry is like the gain on executive stock options and so should be taxed as ordinary income rather than, as under current law, like ordinary income. My colleague Vic Fleischer summarizes the arguments back and forth.  I'm not convinced that the current treatment is wrong, but wouldn't have been scandalized to learn that it was the other way, either.

But does anybody think that this is going to be settled on the basis of the academic niceties of the distinction? As Jenkins suggests, there’s a big pot of money, and stories about filthy rich capitalists make it politically vulnerable. Enter the politicians with threats to take a chunk. The noise translates into campaign contributions in an election year. Fred McChesney has called this game “rent extraction” (actually, the book version is appropriately titled “Money for Nothing”).

Jenkins gamely makes the case for incentivizing private equity, because contra what you often hear, what they do is actually valuable. I’m sympathetic, but I think the chances of convincing anybody who doesn’t already believe this are about nil. The point to take away is that this really is, basically, a game.

Which is what gives me some sympathy for tax and regulatory arbitrage. Arbitrage in this context is multiple ways of accomplishing equivalent economic goals with different tax and regulatory consequences. Carry is arguably an example of arbitrage. Another is the Blackstone IPO, which has been structured to avoid the corporate tax.

Some people would say this activity is at least borderline dishonest and erodes the good work of government. I would say it’s the market’s response to the sort of political maneuvering described above. Arbitrage is game-playing by the taxed and regulated that makes taxation and regulation more difficult.  This may reduce the potential for rent extraction, or force government to make real policy distinctions that can be used to fend off arbitrage maneuvers.  That’s not to say that any activity that can be characterized as arbitrage is legitimate, but simply that before condemning arbitrage, we need to put it in its political context.

Comments

[save_the_rustbelt]

Tax avoidance is legal, if not always ethical or economically efficient.

Passing new tax legislation is the usual response to large avoidance schemes.

Going public is not a really good route for keepng tax avoidance quiet.

[The Epicurean Dealmaker]

I fail to see, pace Holman Jenkins, why the professional members of private equity fund general partners need special tax incentives to do their job.

The capital gains tax preference does not accrue to the limited partners who provide the money, but rather to the hired hands who select and manage the fund investments for them.

Especially now, it is not clear to me that any special non-market incentives are required to stimulate the private equity juggernaut. And--word to the wise--I would not suggest arguing the opposing position: anyone who does will only look disingenuous at best and foolish at worst.

http://epicureandealmaker.blogspot.com/2007/06/tax-breaks-for-everyone.html