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Closing the Private Equity Loophole

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President Obama’s 2015 budget calls for closing the tax loophole that lets partners in private equity firms pay low taxes on compensation tied to their performance as PE fund managers. This pay, so-called ‘carried interest,’ is taxed at the lower capital gains rate rather than as ordinary income. Obama and others have proposed this reform before, but now the chances of its passage have improved.

First, Dave Camp, Republican chairman of the House Ways and Means Committee also proposes taxing ‘carried interest’ as ordinary income. And second, with wages stagnant or falling for a large share of the American workforce and national attention focused on reducing inequality, the President proposes to use the revenue from closing the loophole to expand the highly successful Earned Income Tax Credit program, which reduces the hardships of poverty for 13.5 million low-income workers – including non-custodial parents and older workers age 65 or 66.

Closing the loophole will benefit the economy far beyond the more than $3 billion in tax revenue it would raise over the next 10 years.  The ‘carried interest’ loophole is problematic not only because it is unfair but more importantly because it rewards and encourages risky behavior that can lead companies bought by private equity into financial distress. When private equity funds buy a company, they typically make the purchase with 70 percent debt (using assets of the company as collateral) and 30 percent equity, which comes almost entirely from their investors. Private equity partners themselves put up only $1 to $2 for every $100 dollars of equity contributed by their investors. Yet, responsibility for repaying the debt falls on the acquired company. Neither the PE fund nor the PE firm behind the deal has any responsibility for paying back the loans. Despite this small investment, PE partners collect a whopping 20 percent of the gains when the company is subsequently sold. It is these profits that are taxed at the capital gains rate.

The private equity firm is wagering that it will sell the company at a profit. If the wager pays off, the high level of debt magnifies the returns to private equity. The low tax rate on these returns further increases the payoff. The downside of high debt is that it increases the likelihood that the company will face financial distress or even bankruptcy. The costs of such distress, however, fall not on private equity but on the company’s other stakeholders – its lenders, vendors and other creditors, its employees and retirees, and its customers and communities it serves.

This is a classic case of ‘moral hazard.’ The PE partner, who makes all of the investment and strategic decisions, captures a disproportionate share of the gains on the upside and has very little to lose should the deal turn sour. The decision maker thus has the incentive to take excessive risks and load up the company being acquired with debt. And the current tax loophole rewards this behavior by making it even more lucrative. Reducing this tax incentive for PE to take outsized risks at other people’s expense would improve the functioning of the economy.

Private equity defends its tax break by arguing that this income is not guaranteed. But this is true of all performance-based pay – the car salesman’s commission, the waitress’s tips, the financial analyst’s bonus. Yet these are taxed as ordinary income. As Camp’s proposed legislation noted, “For the tax law to be applied consistently, the profits derived by such an investment partnership … (generally referred to as a carried interest), should be treated as ordinary income.“

The defense of the tax break by the PE industry’s lobbying group is even less credible. In its 2013 video it compares PE partners to a young woman who starts a bakery, paying herself very little and plowing everything back into the business. As the founder, she eventually cashes in this sweat equity when she sells the bakery, and pays capital gains taxes on her profit from the sale. We are supposed to believe that PE partners similarly underpay themselves in order to grow the businesses they invest in, and so should similarly be able to cash in their sweat equity and treat the profit on the sale as a capital gain.

The analogy doesn’t pass the laugh test. The collective earnings of the three founding partners of the Carlyle Group was $750 million in 2013. About 60 percent of this – $470.4 million — came from carried interest. Leon Black, co-founder and CEO of Apollo Global Management, earned $546.3 million in 2013, of which $177 million was carried interest.

When Obama first proposed doing away with private equity’s tax preference, Blackstone’s Stephen Schwarzman compared this to Hitler’s 1939 invasion of Poland.  The response this time has been more circumspect. No wonder. Ending the PE tax break will make it possible to increase the EITC for childless workers to $1,000 for those with annual incomes under $18,000. It is hard to argue that this is somehow unfair. Private equity’s attempt to stifle discussion by prematurely declaring the proposal dead-on-arrival is out of touch with popular concerns over inequality. The gross disparities in income between those who benefit from the tax break and those who would benefit from closing this loophole make clear what is at stake.

Eileen Appelbaum is a senior economist with the Center for Economic and Policy Research. 

Roesmary Batt is a Cornell University professor. They are the authors of the forthcoming book, “Private Equity at Work: When Wall Street Manages Main Street.”

This article originally ran on The Hill (Congress Blog).

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