The Senate Finance Committee held another hearing Tuesday on the taxation of carried interest at private equity and venture capital partnerships and hedge funds. I looked quickly through the prepared testimony–it’s three law professors saying the current (low) tax treatment is ridiculous, a venture capitalist in Denver saying he wants to be taxed more (really; his name’s William Stanfill in case you want to buy him lunch), and three private equity types saying they don’t want to be taxed more.
I was far more interested, though, in a paper that I think was released Monday, by University of Chicago Law Professor David A. Weisbach. It’s the first piece that I know of that defends the current tax treatment of private equity paychecks with any kind of intellectual seriousnessness.
My main academic guide in this debate so far, Vic Fleischer of the University of Illinois, wrote in a blog post Tuesday that “it’s safe to say that there is an academic consensus among tax profs on the issue: the status quo is problematic, and it should be addressed.” He went on:
[T]his isn’t a bunch of lightweights; nor is it a group that generally believes in higher taxes, or more redistribution. We tend to believe in a broader base and lower rates, and that’s one way of viewing carried interest reform. There are really few academic voices in dissent; the most prominent voice in dissent had his research sponsored by the Private Equity Council, so I’m not sure he counts on this issue.
That “prominent voice” he’s talking about is Weisbach, and his paper was indeed sponsored by the recently formed private equity lobbying group. But I figure it’s still worth looking at the man’s arguments.
As best I can tell (I am not, in case you hadn’t figured it out yet, a tax lawyer), Weisbach makes two main points. One is that the dividing line between capital gains (taxed these days at 15%) and ordinary income (taxed at up to 35%) is never entirely clear, so tax scholars tend to reason by analogy. Fleischer and the other members of his academic consensus stress the analogy of executive stock options, the gains on which are (with some very limited exceptions) taxed as ordinary income. Weisbach prefers to liken private equity partners to company founders, whose stock profits are taxed as capital gains.
I tend to lean toward the Fleischer camp: The tax advantage we give to true entrepreneurs is a special one, and shouldn’t be extended willy nilly to every well-paid man in a suit who claims that he’s taking risks (I’m talking to you, John Snow). But it really isn’t clear cut. When I described this debate to a friend I ran into at lunch today, he asked, “Why on earth are executive stock option gains taxed as ordinary income?” To which I responded: “Because the Supreme Court ruled in 1945 that they should be.” Case closed, but not very satisfactorily.
Weisbach’s other big argument is that changing the tax treatment of carried interest will simply cause private equity firms to twist themselves this way and that to avoid taxes:
The result would be less efficient and transparent capital structures, an increase in tax controversies, and little or no additional revenue.
Fleischer, in his influential paper on the matter, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” also envisions that many firms will take steps to avoid some of the tax burden. But he describes this as a relatively benign and in some ways more transparent process in which the partners in a private equity firm would borrow money, interest free, from the outside investors to buy the customary 20% stake in a fund. They would then pay ordinary income tax on the value of the interest they weren’t paying, but capital gains on all the profits they made. Weisbach implies that this would be a terribly messy way to run a private equity firm. I simply don’t know nearly enough to judge whether he’s right.
There were a couple of other interesting things in Weisbach’s paper. One is the factoid, borrowed from a recent paper by Andrew Metrick and Ayako Yasuda, that two-thirds of the payments to private equity firm insiders are from management fees and transaction fees (which are taxed as ordinary income) and one-third from carried interest. I find it hard to believe, though, that this is the case at the top firms like Blackstone and KKR. In Blackstone’s IPO prospectus, it says that the paychecks received last year by its top executives (CEO Steve Schwarzman got $398 million) were entirely “based on their respective percentage interests in the profits of our firm and their allocated shares of the carried interest or incentive fees payable in respect of our investment funds.”
Weisbach also notes, repeatedly, that the whole concept of capital gains is pretty fuzzy:
Unfortunately, there is little if any conceptual clarity governing the distinction between capital gains and ordinary income. Without a solid rationale for the distinction (and one that roughly tracks current law), it is difficult to make principled arguments with respect to any given return.
In economic theory it’s pretty clear what a capital gain is and why you would want to give favorable treatment to capital investment. But once you get into the nitty gritty of the tax code it’s much harder to figure out where to draw the line between capital gains and income, and you begin to harbor subversive thoughts about whether it’s really all that productive to draw the line at all. As economist Alan Blinder wrote in the NYT Sunday, the Tax Reform of 1986 did away with that line for a few years, taxing capital gains and ordinary income at the same 28% top rate,
and it did not end capitalism as we know it. In fact, the gross domestic product in 1987 and 1988 grew at about the same rate as in 1985 and 1986, and the investment share of G.D.P. barely budged.
[I]t is hard to imagine a justification for changing current law unless the fundamental distinction between capital gain and ordinary income is revisited.
I think he meant that as an argument-ender. But maybe it’s just the beginning.
Update: Fleischer e-mails:
I’m pretty frustrated with Weisbach, as it allows the PE guys to create the impression of academic discord, when in fact the only thing we disagree about is the mechanics of the reform. Weisbach is right that line drawing is difficult, but that doesn’t mean it can’t be done. We do it all the time in tax law, and the capital gains preference necessitates that we find a way to distinguish between labor income and investment income.
Update 2: Weisbach responds:
There is academic discord, contrary to Victor. For example, Howard Abrams just published a fine article that argues that current law should not be changed. In the meeting the Senate Finance Staff had with academics and practitioners, I took the exact same position and had not at that point been retained by the Private Equity Council or anyone else. In fact, that is why the PE guys retained me – because I already agreed with their position! We should focus on substantive arguments rather than motives.