May 05, 2007
Taxing Private Equity: Do the Right Thing
Posted by Victor Fleischer

I'm off to DC to present Two and Twenty at Monday's closed-door briefing of the Senate Finance Committee (i.e. mostly staff from Senate, House, JCT, and also some practitioners and other academics).  I don't have any special insight on where the politics of the issue are headed, but I'm pleased that the staff indeed seems to be in fact-finding mode, as this Reuters story suggests:

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said the world has changed since tax rules for private equity funds were written and acknowledged that the committee is looking into the tax issue.

Baucus declined to say whether the committee's review would eventually result in legislation changing the tax treatment of carried interest in private equity ventures.

"We're trying to do what is right here," Baucus told reporters.

Worth noting that the interest is bipartisan.  Senator Grassley (R) was the first to pipe up on this issue. 

Probably the simplest fix is to just change the tax treatment of carry into ordinary income.  But it's also possible, as a policy matter, that we might be better off with my "cost of capital" method or some blended rate that provides more of an entrepreneurial risk subsidy, similar to an 83(b) election for common stock. 

It's also unclear whether a legislative proposal should be targeted to hit only private equity, or should also cover hedge funds, real estate, venture capital, and other investment funds.  (It's hard to see how or why one would single out only private equity; a subsidy for venture capital could be justified, although there are probably better ways to target a subsidy than through the tax treatment of carry.) 

Lastly, while it's clear that raising the tax rate on fund managers would increase the marginal incentive to move overseas, it's not clear how we should estimate or account for that effect. 

It's not crystal clear what the right thing to do is.  But it's nice to see a wide range of tax policy options being considered, with an emphasis on getting the policy answer right before worrying about the lobbying brigade (which in this case includes, among other groups, the SEIU, the Private Equity Council, and venture capital and real estate groups).  The staff's sensible approach reminds me of Showdown at Gucci Gulch, which of course is the best tax-related book ever.

I'll report more next week as time permits.

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