Someone calling himself The Epicurean Dealmaker has determined that I need to “spanked” for something I wrote Wednesday, and it pains me to admit that this TED is right. Actually, it doesn’t pain me all that much to admit that he’s right, since the opportunity to have my more ill-considered arguments swatted down by knowledgeable readers before they cause too much damage is one of the main reasons I decided to start blogging. But I really don’t want to be spanked by Ann Coulter, as he recommends. Can we please arrange an alternative punishment?
Anyway, here’s what I wrote:
I’ve become more and more convinced that the private equity boom of the past decade in the U.S. has been driven in large part by tax arbitrage. By buying corporations and then loading them up with enough debt that they no longer have any taxable earnings, then paying their partners with “carried interest” that for reasons that have more to do with history than logic is taxed as capital gains instead of as ordinary income, the private equity firms are doing an end run around the U.S. tax system.
TED’s response to the first part is that any corporation can take advantage of the tax code’s bias for debt over equity (because interest is tax deductible and dividends aren’t), and the fact that private-equity-controlled companies avail themselves of that advantage to a greater extent than publicly traded firms doesn’t mean that the tax code is driving their success. It just means they’re acting more rationally. Fair enough.
As for my implication that taxing partners’ carried interest at capital gains rates is some kind of major factor behind the private equity boom, TED writes:
[A]ll this tax preference really does is encourage more people to become PE professionals, since it allows an ambitious finance professional or hanger on to pay (lower) taxes on his or her labor as if he or she were an investor, rather than a common wage slave like a CEO or investment banker. But the limited partners who pony up the vast majority of funds used in the PE business already get capital gains treatment on their investments—like every other slob with a Charles Schwab account and 300 shares of Microsoft—so capital gains treatment for carried interest has the exact effect of nada, zilch, zero on their decision to allocate funds to that asset class.
I don’t think “nada, zilch, zero” is quite right, because the lower taxes paid by private equity partners enable investors in private equity funds to employ better talent for less money than if they were, I dunno, putting their cash in mutual funds. But still, I was pretty clearly wrong to write that “the private equity boom of the past decade in the U.S. has been driven in large part by tax arbitrage.” I actually had hemmed and hawed over that “in large part.” For a while I had it as “in part,” which wouldn’t have been entirely wrong. But whatever. TED is in large part right; I was in large part wrong.
The flip side to his argument, by the way, is that the private equity guys are probably full of baloney when they argue that taxing their carried interest as ordinary income would have some sort of devastating effect on the business. Oh, and The Epicurean Dealmaker appears to be a very good blog. If you’re into epicurean dealmaking–and maybe even if you’re not.