Private equity wins, U.S. creditors lose

December 7, 2010

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.”


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.)


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It’s time to start flying all US flags upside down as a symbol of the distress and siege of the country by the financial industry. The same industry that has damaged the world economy and is holding the US hostage to their insatiable demands. SOS, SOS, SOS.

Posted by Greenspan2 | Report as abusive

A broken model will always be a broken model. In 2006, our leaders were dead wrong that our economy was healthy, but little economic thinking has changed. Tragically, both parties still look to the fraudsters on Wall Street for support. As Reagan said, “There they go again.” We are repeating a proven formula for breeding locusts.

Posted by loguealator | Report as abusive

As an investment manager in real estate and a small businessman the carried interest I have in a number of partnerships came about because of the money I invested on the front end of the deal. It is not true that the general partner had no capital at risk. In the real world it takes labor and capital to create deals and jobs. Why shouldn’t I get capital gains treatment like other investors?

Posted by lionprop | Report as abusive

Saft is right on the money here. One line stands out as particularly crucial and dead on: that the lobbyists managed to pull off, “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.”

Ever wonder why Congress falls for such obvious claptrap so easily? Because their constituents do. And why to their constituents fall for it over and over? Because it is built on a fallacious belief that is very closely bound up with our self-image, our idea of who Americans are. That self-image is that by rugged individualism, we can all make ourselves successful at whatever we want to be.

Now it should be obvious how false this really is: just look around you at how few people really do manage to become successful imitators of the heroes of Horatio Alger stories. Yet somehow, so many people never notice. Even those who do notice are ashamed to admit it, even to themselves: it is the way we are so often told we have to be.

But the same thinking lies behind the renewed popularity of Ayn Rand novels these last 2 years, too. Her heroes also were paragons of rugged individualism triumphing over all obstacles, especially over Socialist obstacles.

Posted by Syllogizer | Report as abusive

Nobody falls for anything, the hedge fund and PE etc. lobbies spend millions to buy the votes of the politicians who might parrot the line if asked but do not in fact believe it. Guaranteed that only a small portion of the voters have any idea what this is.

The pro middle class Democratic party had 2 years of full control to fix this and avoid a year of no estate tax but they did nothing, can you guess why, and do not expect anything to change with the house changing hands either. Money talks.

There will be no meaningful budget reform until it is forced upon us by bond investors and trading partners because no one will willingly give up anything that they get from (or avoid paying to)the government, and then it will be catastrophic.

Posted by david1000 | Report as abusive

Sorry, Saft is way off base. We must be consistent in Tax Law. If you are given a share of a partnership as the “reward” for running said partnership and thus share the same risk of the other partners what you get paid in is the the same as for the other partners: its character is “preserved”. Capital gains distributed get taxed as capital gains (the “lower rate”) and any QUALIFIED dividends get the same “lower” rate. Interest and other “goodies” preserve their character as “ordinary income”.
What Saft’s Bolshevikian “friends” want to do is “re-characterize” the distributions of the carried interest crowd as Ordinary Income. Re-characterization is a Cardinal Sin in my book; I am no friend of Hedge Funds which I regard as the modern version of the illegal-since-1933 Stock Market Pools (of which one future-Ambassador Joseph P Kennedy was the last person to legally operate one). But I am an ardent enemy of “re-characterization”; it is exactly as if the Democrats were to limit the residential mortgage deduction to the extent the homerowner is “paying rent to himself”–don’t laugh, I have heard “imputed rent” seriously discussed by liberals.
So, if you hate managing partners of Hedge Funds–outlaw giving them shares of the partnerships they manage (it’s a form of insider trading anyways, as are employee stock options). Don’t do it by arbitrarily turning partnership distriutions into ordinary income. Bet Saft is next going to promote imputed rent, or the idea that any money the govt. allows the taxpayer to keep is a tax expenditure.
I think Reuters should hire some new correspondents; they’re sounding just like the NY Times.

Posted by Redshield | Report as abusive

I am a dyed in the wool conservative, fiscal that is…and this guy hit it dead right. The hedge fund lower tax scheme is awful for banks, companies and people. The only winners are hedgefund managers! Shame on the GOP for letting this happen!

Posted by venturen | Report as abusive