Private equity wins, U.S. creditors lose
James Saft is a Reuters columnist. The opinions expressed are his own.
The move to reform taxation of billions of dollars in so-called carried interest paid to hedge fund and private equity executives is dead and prominent among the mourners should be investors in U.S. debt.
A country that can’t even get it together to ensure that some of its highest paid people pay as much proportionally in tax as their secretaries and personal trainers is a country with very little hope of effecting meaningful budgetary reform.
Suffice to say that the long bond didn’t sell off on news that U.S. Senate Finance Committee Chairman Max Baucus has dropped a higher carried interest provision from his since-defeated tax bill, a sign that the Democrats have effectively given up hope of the measure. The news should, however, make holders of U.S. debt even more willing to sell to the Federal Reserve, currently buying Treasuries often and in size. The script has been written for tax and spending reform over the next two years and for lenders to the U.S. the story does not end happily.
As it stands private equity and other investment managers pay the lower capital gains rate on “carried interest,” their share of the takings when a holding such as a start-up or turnaround is sold at a profit. That means many pay taxes for the bulk of their compensation for their labor at a lower rate than many middle-class earners, an injustice so patent as to be seemingly unarguable.
Arguable of course it was, and the private equity industry mounted a lobbying campaign that has had a return on investment most of us can only dream of, painting the proposed reforms as an attack on funding for innovative job-creating start-up businesses and even, unbelievably, as against the best interests of pension savers. And while I am sure that the anti-carried-interest lobby is talented, well funded and smart, I doubt very much that they are that much better than the lobbies that will work against most other tax rises or spending cuts over the next two years.
The industry argued both that a rise in tax on carried interest would fall on the savers putting money into the industry and on the businesses that it finances, but this is far from evident.
“The tax on carried interest is a tax on the fund mangers and not the enterprise. In competitive markets the burden of taxation is borne by the employee. If (fund managers) could demand more they would already be doing it,” said Victor Fleischer, an associate professor of law at the University of Colorado, whose work on tax policy underpinned the original effort to reform carried interest treatment in 2007.
“This encapsulates the political problems in our country, this is why it is difficult to get good public policy done.”
A GIANT MISALLOCATION OF TALENT
Some even argued that even if a higher tax on carried interest fell solely on investment managers this was bad policy because it would drive talent from the industry, to the detriment of all of us who are depending on it to earn enough so that we can keep the heat on once we retire.
Besides being maddeningly self serving, this argument is probably just about the opposite of true.
Something that lowers hedge fund and venture capital compensation, especially if it is done via righting an inequity, is precisely what the U.S. needs.
Over the past generation out-sized compensation in financial services has, in combination with other factors, driven an increase in financial engineering and other activity that has not driven growth, has not allocated capital well and has served as an effective tax, or rent charge, on the rest of the economy.
So if you are telling me that eliminating the carried interest tax break means that the smart people won’t go into finance, then I’ll take it. That’s what prevailed in the U.S. in the 1940s through the 1960s, periods when growth was robust, well distributed and less liable to be financed with too much debt. Let those with great quantitative skills go into engineering not securitization, and the best managers go to GM rather than Carlyle Group.
So, the death of carried interest tax reform is indicative of two large negatives for the U.S. economy, and by extension for holders of U.S. debt.
First, despite the crisis there are few signs that the financialization of the economy will be reversed. Indeed, most policy changes since the storm broke are aimed at supporting that industry rather than effectively controlling its size and risk.
Second, the political process in the U.S. shows few signs of being able to effectively grapple with the unpleasant choices presented by the debt built up these last 40 years.
At some point, probably not soon, this will become apparent in the Treasury market.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)