The WSJ reports that the politicos are reconsidering the idea of ending capital gains treatment of private equity managers' "carry":
A concern raised by some Democrats is whether a new tax increase on fund managers will hurt returns for public-employee retirement plans. Joe Dear, executive director of Washington state's largest government-employee pension plan, predicted that any tax increase would be passed along to investors in the form of higher management fees. If so, pension funds and other investors would see a decrease in their returns.
Of course if the managers can't pass on the tax, this might deter some deals altogether, which would also be bad for these investors.
A general lesson: the more America invests, directly or indirectly, the more they become part of the capitalist class, and the less capitalists will be attractive targets for populist politicians.
Of course, as I've argued, the tax idea might have been all along just a tactic to extract compaign contributions.
It helps that the tax plan was never necessarily such a good plan on basic tax theory. David Weisbach has a short paper (HT Caron) in which he says that the idea that the managers are performing services for the buyout fund which should trigger the ordinary income rate "is not consistent with basic principles of the tax law."
Weisbach argues that the labor involved in private equity investments "is the same type of labor that is intrinsic to any investment activity." Like any investors, they decide what to invest in, arrange financing, and decide when to sell. It shouldn't make a difference that he's using the limited partners' funds, because this is essentially no different from borrowing from them -- i.e., buying on margin. If the tax is going to be based on the partnership structure, then the managers will just avoid the tax by using debt. And if the argument is that the managers should pay the limited partners for the use of their money, that's what the managers are doing already: the limited partners are getting the hurdle rate plus a share of gains above that, which is pretty sizable return.
Dan Shaviro argues (also HT Caron) that the tax should depend on the nature of the manager's activity -- whether he's producing gains through restructuring (like a private equity manager), which are already taxed at the entity level, or (perhaps like a hedge fund manager) simply outsmarting the market. Society may be better off encouraging the former activity than the latter activity.
I don't have a firm opinion on either of these approaches to the problem. With respect to the Weisbach idea, it may be worth noting that the limited partners arguably play a different governance role than creditors, which may or may not be relevant to how the manager ought to be compensated. As to Shaviro, I'm not sure that the distinction between what the hedge fund manager and the private equity manager (or VC manager?) does can be translated into a workable tax rule.
What is clear is that the issue is not nearly as clearcut, either conceptually or practically, as it has seemed so far in the press and in Congress. So it's good Congress is having second-thoughts.
Too bad there was no time for such thinking before Congress blundered into SOX.
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