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Taxing Private Equity

Monday, March 31, 2008

Since its inauguration, the 110th Congress and its Democratic majority have been searching for additional revenue to pay for a controversial expansion of the state children ’s health insurance program (or s-chip), increased education subsidies, and costly adjustments to the Alternative Minimum Tax ( amt). To that end, Congress has considered two bills that increase taxes on private equity firms. The Baucus-Grassley bill, S. 1624, was introduced on June 14, 2007, and would ensure that publicly traded partnerships providing investment advice pay the corporate tax. A week later, Ways and Means Chairman Charles Rangel and Congressman Sander Levin introduced H.R. 2834, which would explicitly treat carried interests as “ordinary income,” not capital gains. Neither of the bills appeared to be attracting enough support, and so on October 25, Congressman Rangel introduced the controversial Tax Reduction and Reform Act of 2007, H.R. 3970, which would reduce corporate tax and gradually repeal the amt, among a host of other changes — all paid for by a new surcharge on high-income earners. This bill also included the substantive entirety of Rangel ’s earlier bill, H.R. 2834, although it did not incorporate the Senate bill. None of these bills had been passed in either chamber, but by December 12, both Senate and House had passed a far more modest tax bill, H.R. 3996, the Temporary Tax Relief Act of 2007. This latter legislation made no changes to private equity taxation, dealing instead with the routine “patching” of the amt. The fundamental problems highlighted by the original Senate and House bills, however, remain unresolved.

The usual melodrama has accompanied the bills’ proposal. Proponents cite the 25 private equity managers whose additional tax under the bills could pay 80,000 New York school teachers for three years.1 Another likens the U.S. income distribution to that which preceded the French Revolution.2 Opponents explain how private equity funds benefit pension funds,3 while others, including “Magic” Johnson, fear a setback for black rights if private equity funds pay more tax.4

The bills are potentially popular. Private equity firms employ few people relative to other industries, and publicity surrounding the large incomes of some fund managers has arisen amid a general disquiet at the supposedly rising level of income inequality in the United States. But the bills have academic origins too; a widely cited piece by Professor Victor Fleischer has framed the policy debate.5

Because the bills relate to the application of current tax law, as opposed to a new tax or rate change, the usual tax-change protagonists have been conflicted or absent. The Business Roundtable and the Financial Services Forum, for instance, have stood on the sidelines, while current and former treasury secretaries and economics professors have publicly disagreed about the bills.6 Moreover, because the bills are complicated — relating to definitions of income, the tax requirements of different business entities, and the role of capital gains tax — many commentators mistakenly conflate the two bills’ provisions. But they are actually quite different, regardless of their genesis. In short, the Senate bill is about taxing businesses, while the House bill is about taxing people.7  This article discusses the provisions of the two bills from an economic perspective, assuming no prior knowledge of private equity. Both bills draw attention to the excessive ambiguity and complexity of the U.S. tax code.

Private equity loophole?

Businesses can organize themselves in different ways. Smaller businesses tend to be sole-traders, larger firms partnerships, and the very largest companies (companies traditionally have a legal identity of their own, meaning owners cannot lose more than they have invested). Most people know of these three broad classes, but probably not the wide range of types within each.8 One of these types is known as a “publicly traded partnership” (ptp), or sometimes as a “master limited partnership.” This type can offer favorable conditions. For example, ownership units can be traded on a public exchange, such as the New York Stock Exchange, yet ptps may not be liable for corporate income tax. Instead, partnership profits may flow through directly to the owners, who are then taxed at their appropriate income tax rate. ptps can therefore avoid the “double taxation” problem, where a company pays a 35 percent tax on its profits, say, and then shareholders pay income tax on the distributed profits.

This generous tax treatment of ptps used to be available to a wide range of businesses. Unsurprisingly, many began to organize themselves as ptps. But in 1986, concerned by the erosion of the corporate tax base, Congress revoked the exemption for all but a few types of ptps. In addition, it made it difficult for businesses already established as corporations to convert to ptps. However, any ptp whose income was more than 90 percent “qualifying” — that is, stemming from interest, dividends, rents, property sales, or profits from operations in primary industries — remained exempt from corporate tax. The Baucus-Grassley bill would remove this exemption, subjecting such ptps to corporate income tax.

Private equity funds first emerged in the 1960s, but only recently have they grown large enough to consider buying the largest telecommunications company in Canada, Bell, and the third largest car manufacturer in the United States, Chrysler.9 Indeed, these funds can now raise over $200 billion annually.10 Private equity funds invest in new businesses (in which case they are often referred to as venture capital funds) or purchase larger businesses with a view to reselling them later at a profit. They normally take a role in their management commensurate with their investment. This active role often leads to significant cost reductions in acquired firms, and often attracts very critical attention: Germany ’s labor minister, Franz Müntefering, in 2005 famously referred to private equity firms as “locusts.” But as the U.S.’s own Private Equity Council is quick to point out, private equity firms can make significant contributions to economic growth and corporate efficiency.

In 2005, Germany’s labor minister famously referred to private equity firms as “locusts.”

In almost all cases, private equity funds are organized as limited partnerships, where the limited partners provide capital (money), while the general partner — a private equity firm, in this case, which is often organized as a partnership itself — comprehensively manages the assets of the fund. The limited partners are so named because they cannot lose more than they have contributed to the partnership: They have limited liability but no management rights. For its services the general partner is normally rewarded in two ways: a fixed management fee from the limited partners (often 2 percent of fund assets per year), and a right to future profits of the fund (often 20 percent), the “carried interest.” Indeed, “2 and 20” is a common industry expression describing such payments. A single private equity firm, whatever its legal organization, can be the general partner for multiple private equity funds, based on its size and managerial capabilities.

Certain private equity firms, such as Blackstone and Fortress Investments, have been so successful since the mid 1990s that their owners have wanted to realize their success by “going public.” Most successful firms desire to go public eventually: Private owners want to be rewarded for their efforts by selling some of their stake. Furthermore, by obtaining a public and separate legal status, a firm can more easily raise capital in the future, obtain wider recognition, and gain limited liability. But, unlike partnerships, public companies generally pay corporate income tax.

But some businesses can obtain these benefits without paying corporate income tax, by becoming ptps and demonstrating that more than 90 percent of their income is “qualifying.” Fortunately for private equity firms, a carried interest is essentially a right to various “gains or losses from the sale or disposition of capital assets held for the production of income, ” according to the irs, and the latter is one component of qualifying income,11 and one of the two types of income private equity firms receive. The other, management fees, are not classified as qualifying income, yet comprise up to two-thirds of private equity firms ’ income.12 However, prospective private equity ptps can overcome this problem by creating a set of wholly-owned subsidiary companies known as “blocker corporations.” In such cases, the ptp acts as general partner to a range of private equity funds. The carried interests arising from these funds flow directly to the ptp (qualifying income), while the management fees (not qualifying income) are paid to the subsidiary blocker corporations, which in turn distribute these fees as a dividend (qualifying income) to the parent ptp. Thus the ptp satisfies the qualifying income test, and avoids corporate income tax.

Attentive readers might demur; surely blocker corporations would have to pay corporate income tax on the management fees before distributing them as dividends to the parent ptp? Goodwill, however, can be used to eradicate this tax liability. When the original partners organize as a ptp and sell part of their firm to the public, they create goodwill (the selling price minus the book value of the firm). This can be freely transferred from the ptp to its wholly-owned blocker corporations, which in turn use the goodwill to reduce their own corporate tax liabilities. Goodwill can be amortized (written-off) over a 15-year period. Thus, tax owed by the blocker corporations can be reduced dramatically, to the point where many firms obtain a tax refund.13

The corporate tax exemption for ptps with qualifying income arose so investors in passive-investment ptps would not be not taxed three times.14  In fact, Blackstone and Fortress needed to convince the sec that they were not passive “investment companies” to avoid the associated regulation and reporting requirements stipulated in the Investment Companies Act ( 1940). Blackstone actually told the sec that it was a “global asset manager and provider of financial advisory services . . . including corporate and mergers and acquisitions advisory, restructuring and reorganization advisory and fund placement services ” — in other words, not a passive holder of securities, and hardly a mutual fund.15

Thesec’s objective criteria for determining investment companies relate to firm assets, not income, in contrast to the qualifying-income test in the tax code.16 If more than 40 percent of a firm’s assets are investment securities, it is deemed an investment company. It is extremely serendipitous for prospective private equity ptps that carried interests — a significant portion of their assets when valued — are not classified as investment securities. Thus, certain ptps avoid designation as investment companies because carried interests make up more than 60 percent of their assets.

Evaluating the Senate bill

The baucus-grassley bill  prevents firms that “directly or indirectly . . . [provide] certain investment adviser and related asset management services ” from using the qualifying income exemption.

Given the U.S. tax code and the Investment Company Act (1940), the Baucus-Grassley bill is an attempt to remove an inconsistency from the overall tax framework, whereby a business can appear to be a passive investment firm to the irs, yet successfully claim to be an active investment firm to the sec. In 1986 lawmakers probably did not expect that legal definitions would be used by private equity ptps to avoid both sec regulation and irs taxation. Regardless, the current arrangement likely facilitates an economically distortionary subsidy to particular investment advisory businesses. Entrepreneurs should enter an industry for intrinsic economic factors, not for tax reasons. Presently, private equity firms can obtain favorable taxation arrangements, while other businesses, even those that perform economically similar roles (like Mergers & Acquisitions branches of investment banks), endure heavier taxation.

In any case, this controversial tax-raising measure will not raise any tax, at least in the short-term. The bill provides a five-year grace period from the bill ’s introduction, during which Fortress and Blackstone (the first private equity firms to have successfully become ptps) would not be subject to any corporate tax. Going forward, the passage of such legislation would make ptps less attractive to successful private equity firms. Indeed, almost all existing ptps are involved in industries that qualify for the corporate income tax exemption: oil, gas, energy, forestry, and real estate.17  This raises two questions. Why do we allow the exemptions for oil, gas, and other primary industries in the first place, and, more broadly, why do we have this legal form at all?

The other exemptions Congress permitted in 1986 are indirect subsidies to businesses engaged in primary industries. These are as hard to justify as those related to investment firms, and should be removed by the same logic. First, in terms of economic equity, all exemptions permitted in 1986 should be removed and the corporate tax rate lowered commensurate with any increased revenue. Second, that only exempt businesses chose to remain ptps after the 1986 reform must say something about the economic usefulness of the ptp structure otherwise. Its existence provides additional complexity and, clearly, opportunities for regulatory arbitrage.

The Baucus-Grassley bill is reasonable at a technical level, but its introduction is a reminder that parts of the current tax system are inconsistent and contain implicit subsidies to various industries. Thus, to the U.S. ’s long-run detriment, the tax regime unnecessarily distorts real economic activity and facilitates tax avoidance.

Carried interests and private equity

Just as businesses  organize themselves in different ways, they earn different types of income. We casually classify income informally in a variety of ways: wages, salaries, rents, grants, royalties, fees, profits, and capital gains. For tax purposes, however, income is classified into three broad groups: “ordinary” income, corporate income, and capital gains income. Income is thus classified jointly by the type of recipient and the type of income.

Corporate income includes profits and capital gains earned by legally incorporated businesses. These have been taxed at approximately 35 percent since the 1986 tax reform.18 The distinction between ordinary income and capital gains income, which applies to individuals, is more complicated. Capital gains are derived from the sale of an asset. If the asset has been held for more than one year the seller is entitled to a reduced capital gains tax rate of 15 percent (this is supposed to encourage long-term investment). Ordinary income includes personal income derived from labor services. The latter is normally pre-determined, like wages and salaries (yet can include performance-related components), and attracts a top marginal rate of 35 percent.19

Partnerships are a popular structure for a wide range of U.S. firms, from traditional accounting and law partnerships, to those in manufacturing, trade, and private equity. In 2005, around 2.8 million partnerships were registered with the irs and controlled around $13.7 trillion in assets, 56 percent of which related to the finance, investment, and insurance industries.20  Besides their favorable tax treatment discussed above (no corporate tax), partnerships afford owners a degree of flexibility and freedom from regulatory constraint. As discussed, private equity funds are almost unvaryingly limited partnerships.

To the U.S.’s long-run detriment, the tax regime distorts real economic activity and facilitates tax avoidance.

This flexibility contributes to the success of private equity firms, and manifests itself in the binding “partnership agreement,” in which partners determine among themselves how any profits will be split. Such divisions may be independent of the partners ’ capital contributions. Why would any rational limited partner contract to receive profits out of proportion to his own financial contribution? Section 707 of the tax code even contains specific provisions for payments to partners who provide services to the partnership, either in their capacity as a partner or otherwise. Both of these provisions, however, treat any such payments as ordinary income. A better way to reward general partners providing services is to provide them with “sweat equity,” another term for “carried interest.”21

Sweat equity has a long pedigree, going back to the U.S. oil and gas partnerships of the 1920s, and British maritime partnerships of the nineteenth century.  In essence, where one partner has expertise in the partnership’s business, other partners “pay” the managing, or general, partner a specified share in the future profits. In other words, the limited partners pay the general partner “equity” for his “sweat.” For the financially minded, it is akin to the limited partners’ giving a call option on the future capital value of the partnership to the general partner in return for his effort. Empirically, this “partnership profits interest,” its legal name, has been equal to 20 percent of future profits. This interest is provided without the general partner ’s necessarily having to provide any capital of his own.22

Both the general partner and the limited partners benefit from this arrangement. The limited partners are able to pay the manager by simply diluting their future return. They don ’t need to make any large immediate payment; moreover, the general partner’s interests become more aligned with their own. The general partner is motivated by the potential to earn significant profit without capital risk.

The character of partnership profits is traditionally determined at the partnership level, before flowing through to the individual partners.23 For example, if a partnership makes a capital gain on assets it has held for longer than one year, partners pay capital gains tax at 15 percent, in proportions specified in the partnership agreement. A short-term capital gain, on the other hand, would see the partners, general and limited alike, pay capital gains tax at the short-term 35 percent rate.

The “problem” with carried interest

The taxation of  carried interest conflates three potentially contradictory implications of the tax code: the classification of income as capital gains or ordinary income, the determination of partners ’ income at the partnership, or entity, level, and the dependence of the tax system on realizable events. The House bill effectively proposes to shift the emphasis among these.

Whether carried interests produce ordinary income or capital gains has attracted the most controversy. We think of profit from the sale of assets as the essence of a capital gain, and carried interests do give general partners a right to future capital gains generated by the sale of partnership assets. Yet the profit (or loss) from an asset sale is also thought to belong to the owner of the asset, who pays the applicable capital gains tax: 15 percent if held for more than one year. But general partners currently pay the capital gains tax rate on their carried interest income, even though they do not own the assets whose sale generated the income. That is, they have a partnership “profits interest” rather than a “capital interest.”

By contrast, the limited partners have a “capital interest,” which gives them the shared and sole right to the liquidation value of the partnership. Indeed, limited partners hope to make a capital gain on their private equity investment, but risk losing their capital. General partners (the private equity firms) risk only their time and effort. Their economic role is similar to that of ceos who manage corporations on behalf of shareholders. Blackstone admitted to the sec that it is a “provider of financial advisory services.”

A relatively low capital gains tax is meant to encourage risk-taking and entrepreneurship. As Stephen Moore and John Silvia put it,

If the tax on the return from capital investments — such as stock purchases, new business start-ups, and new plant and equipment for existing firms — is reduced, more of those types of investments will be made. Those risk-taking activities and investments are the key to generating productivity improvements, real capital formation, increased national output, and higher living standards.24

A relatively low capital gains tax rate encourages limited partners to risk more capital. That is, capital gains tax is designed to affect the decisions of those who risk capital, not those who manage it. A lower rate does not encourage general partners to risk more capital; they are generally not directly risking any of their own to begin with. But the favorable tax treatment of carried interests does encourage individuals to become private equity managers, and firms to restructure themselves in such a way that their behavior fits the legal definition of private equity.

No one disputes that carried interests are uncertain and performance-related forms of remuneration, unlike fixed management fees. However, performance-related pay is not sufficient to justify special tax treatment. Many occupations provide performance-related remuneration: ceos are awarded stocks, stock options, or bonuses based on their performance, while musicians and actors are paid royalties related to their commercial success. Yet none of these income streams is subject to capital gains tax.25

Opponents of tax changes for private equity managers,26 and even the U.S. Treasury in its Senate committee submission,27  discuss the sole trader whose entrepreneurial efforts expand his business to the point where he decides to sell. Any profit is taxed at the capital gains rate; indeed, the supposedly harsh impact of capital gains tax on the sole trader is often used as a rhetorical device in associated public debates. The behavior of private equity managers, so the argument goes, is very similar to that of the sole trader. The differences arise only from a different legal structure. Otherwise, the private equity manager actively manages businesses day-to-day, building them up, adding value, and selling them at a profit, just like the sole trader. Ergo, private equity managers should be taxed like sole traders.

This analysis overlooks a key point. The sole trader risks the capital that he has invested in the business, plus any additional borrowings he has made to start his business. Were his project to fail, he would lose his capital and still have to pay back any loans. Far from being a case for the status quo, the sole trader is a reminder that carried interests might be undeserving of capital gains tax treatment. The general partner experiences no concomitant risk of capital loss or pending loan repayments; his potential loss is the opportunity cost of his time.

Although this examination suggests carried interests should be taxed as ordinary income like other performance-based income, sections 83 and 702 of the U.S. tax code confound such a conclusion. Section 702(b) states that “the character of any item of income, gain, loss . . . included in a partner’s distributive share . . . shall be determined as if such item were realized directly from the source from which realized by the partnership. ” General partners are partners in the partnership, whether they have a partnership profits interest or a partnership capital interest. The long-term capital gains tax rate is certainly the correct tax rate to apply when a partnership sells assets it has held for longer than one year. Therefore, the general partner pays capital gains tax on the portion of the partnership ’s profits that are long-term capital gains.

Capital gains tax is designed to affect the decisions of those who risk capital, not those who manage it.

Section 83 of the tax code, which deals with the taxation of property transferred in connection with services rendered, would require that tax be paid on receipt of a partnership profits interest. The right to 20 percent of future profits in a private equity fund, even if they are uncertain, certainly has a value greater than zero, even if this value is difficult to ascertain. In 1971 the Federal Court ruled in Diamond vs. Commissioner that such transfers, “with a determinable market value,” should elicit a tax payment. The irs decided in 1993, however, that such events did not provide determinable values, and ruled that transfers of partnership profits interests to general partners did not constitute a taxable event.28  The tax system is driven by realizable events.

Where does this leave us? We can see the “problem” presented by carried interest. It sits at the intersection of three potentially contradictory parts of the tax code. Presently, section 702, containing the partnership provisions, appears to trump sections 83 and 1, which deal with property transfers and ordinary income, respectively.

Recent discussion has focused on three ways to “fix” the problem of carried interest; each effectively emphasizes a different provision.29 One proposal gives precedence to section 83, and would impose taxation of carried interests when granted using complicated option pricing or benchmarking formulas. Another would maintain the preeminence of the partnership provisions, but stipulates that partnership profit interests are effectively acquired by an interest-free loan from the limited partners to the general partner. The general partner could therefore pay ordinary income tax on an imputed interest rate on such a “borrowing.” Carried interests would remain treated as capital gains in the hands of the general partner.

Evaluating the House bill

The levin-rangel bill, however, takes the third and simplest approach, and explicitly proposes that carried interest income be treated as ordinary income for tax purposes, 702 and ignoring section 83. Essentially, for partners who possess an “investment services partnership interest” — where a partner provides a “substantial quantity” of investment management advice or administration relating to “securities, real estate or commodities” — any related income “shall be treated as ordinary income for the performance of services.”30 The only exception is where the general partner has provided capital to the partnership and the allocation of income is “reasonable.” In these cases, only the portion of income allocated to the general partner that is out of proportion to his capital contribution would be taxed as ordinary income.

The bill attempts to ensure more consistent tax outcomes for individuals who provide services, and at the same time reinforces the idea that capital gains tax is for individuals who risk their own capital, not for those who manage it. This seems reasonable, but it is not necessarily the “right” outcome. Because the tax code has potentially overlapping and contradictory provisions, the current treatment is not “wrong,” but rather gives preeminence to perhaps more obscure partnership provisions.

Like the Senate bill, this bill presents a number of problems. First, there is no effective date in the bill, which could result in a series of court cases to establish an interpretation. Will the income from carried interests already granted be permanently exempt, or will carried interest income be affected from some date in the future, or the past?

Although not quite as impotent as the Senate bill, the Levin-Rangel bill is likely to raise little money. If carried interests are taxed at ordinary income rates for performance of services, and not at capital gains rates, then limited partners could make a tax deduction of that same amount against their own ordinary income as a cost of doing business.31 In other words, there would be no net additional income for the government, but simply a transfer of wealth from the general partner to the limited partners: General partners ’ ordinary income would go up, and limited partners’ ordinary income would go down by the same amount. This simple analysis assumes that both general partners and limited partners are subject to the same marginal tax rate on this income. In reality, around 20 percent of U.S. private equity investment arises from wealthy individuals, another 20 percent from corporations, and the remainder mainly from tax-exempt institutions.32  Only the first group could obtain a beneficial, offsetting tax deduction from the proposed bill. Corporations have no preference between offsets to ordinary income or capital gains, because they pay the same rate of tax for both, while tax-exempt institutions do not make any tax deduction because they pay no tax.

The U.S. tax code is over 16,000 pages, ten times the length of War and Peace and without an appealing plot.

Accounting for the ability of some types of limited partners to make offsetting tax deductions, Michael Knoll of the University of Pennsylvania estimates that H.R. 2834 would raise somewhere between $1.9 and $2.8 billion of extra tax revenue.33 This figure is paltry, given the size of the U.S. budget and the bill’s political origin as a tax-raising measure. Moreover, these figures do not account for consequent behavioral changes, which would further reduce revenue. For example, by making private equity investment more attractive to individual investors relative to tax-exempt investors (since the former could obtain a tax deduction from ordinary income payments to general partners, which is more valuable than the current deduction available against capital gains income), individual investors would be relatively more likely to invest in private equity, and tax-exempt investors less.

Commentators have suggested specific, sophisticated ways in which private equity can be structured to avoid the proposed tax treatment.34 Many of these involve limited partners’ making “loans” to general partners equal to 20 percent of a fund’s capital, which are then invested in the fund. Such an arrangement would give the general partner a full partnership capital interest, just as the limited partners have. Any income earned by the partnership would be legally taxed at the long-term capital gains rate, just as it is now, regardless of H.R. 2834.

Finally, the economic incidence of tax changes is unlikely to reflect the legal incidence. Some of any tax increase on general partners will be borne by limited partners, with the exact extent depending on the economic tug-of-war that occurs between general and limited partners when contractual arrangements are made. At one extreme, general partners might successfully demand an increased carried interest to offset the additional tax owed. In this case, the tax would then be borne largely by tax-exempt investors, which include pension funds and mutual funds. Having ordinary Americans, through their pension funds and mutual funds, pay the increased tax on private equity managers is hardly the outcome desired by the bill ’s proponents.

Simpler and more transparent

The baucus-grassley and Levin-Rangel bills, whatever their individual merits, are case studies in the economic costs of tax complexity and the perverse incentives in the U.S. tax system.35

The Senate bill highlights the special tax consequences of ptps, which offer favorable tax outcomes for certain types of businesses, including those involved in private equity, oil, and gas. This complexity effectively subsidizes these industries, diverting economic resources away from more economically deserving areas and raising taxes elsewhere to fund the subsidy. The Senate bill attempts to exempt private equity from this subsidy — but raises the question of why we have other implicit subsidies, and indeed why we have the ptp form at all.

Firms publicly indicate their legal structure so customers and suppliers understand the nature of the firm they are dealing with, in terms of its liability and its public responsibilities. The proliferation of so many different business forms makes a mockery of this. How can anyone, except a trained tax professional, understand the behavioral implications resulting from the nuanced differences between a publicly traded partnership, say, and a limited liability partnership? These various legal forms instead function as covert subsidies to particular industries.

The inherent contradictions in the tax code, strikingly evidenced by the sec’s and irs’s different definitions and the confusion over whether partnership provisions take precedence, will continue to result in a waste of economic resources. A simpler, more transparent set of tax rules would render the search for profitable contradictions fruitless, freeing up smart people to make real, positive contributions to the economy.

The House bill is yet another reminder of the problem of having different tax rates for different types of income. Whenever capital gains are taxed at a different rate from so-called ordinary income (or corporate income, for that matter), economic resources will be devoted to re-classifying income. Fewer and similar rates of tax would reduce the resources wasted trying to game the system. In the case of capital gains tax, it is a moot point whether the rate should be lower or higher than ordinary income tax, or indeed whether it should be taxed at all. Since its introduction in 1921, no other tax has attracted as much controversy, or been changed as often by Congress. Carried interests may be the most economically efficient way to reward private equity managers, but the form of remuneration should be decided on its economic merits, not to satisfy some legal definition of income.

Congress cannot determine who will ultimately bear the incidence of specific taxes. Just as some of the corporate tax on Wal-Mart is passed on to its customers in the form of higher prices, raising taxes on private equity managers will at least partly result in higher taxes for pension funds and other tax-exempt investors.

That the two bills will raise next to no revenue is also symptomatic of the tax system ’s unnecessary complexity. In a simple tax system, it would not be possible to impose new taxes without actually raising tax. In a simple system, agents could less easily hide behind subtle provisions, and routine “patching up” would be unnecessary. Evidently, complexity allows government to increase taxes or covertly subsidize particular industries more easily. And it creates uncertainty about the interpretation of existing tax laws and deleterious speculation about future ones, which in turn stifle real economic activity.

The vast majority of congressional bills never emerge from the committee stage, and that fate likely awaits these two bills. Rather, any potential benefit from these bills will stem from their role in highlighting the need for broader reform, and their education of citizens about current tax arrangements, which few understand. Congress would do well to observe Adam Smith ’s dictum, as relevant today as it was in the eighteenth century, that “the tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person. ”

The U.S. tax code — at over 16,000 pages, ten times the length of War and Peace and without an appealing plot — does not meet these clarity and consistency objectives. Public equity would best be served by a wholesale simplification of the current tax code, not piecemeal, ineffective attempts to patch up a Byzantine system.

1 Steven Kaplan and Damon Silvers, “Trading Shots: Taxing Private Equity,” </<span class="italic">Wall Street Journal(July 24, 2007).

2 Ben Stein, “The Hedge Fund Class and the French Revolution,” New York Times (July 29, 2007).

3 Steve Forbes, “Private Equity, Public Benefits,” Wall Street Journal (July 25, 2007).

4 Jessica Holzer, “bet Founder Blasts ‘Class War’ on Tax,” The Hill (July 31, 2007); and James Quinn, “‘Magic’ Throws Tax Opinions in the Ring,” Daily Telegraph (London, September 7, 2007).

5 Victor Fleischer, “Two and Twenty: Taxing Partnership Profits in Private Equity,” New York University Law Review (forthcoming, 2008).

6 Stephanie Kirchgaessner, “Lobby Groups Shun Private Equity Tax Fight,” Financial Times (July 29, 2007).

7 Obviously, people ultimately bear the brunt of all taxes, but legal incidence can vary.

8 Others include limited partnerships, general partnerships, and limited liability partnerships, s-corporations, and c-corporations. Each has its own attendant regulations and tax implications.

9 Private equity funds are often confused with hedge funds. Private equity funds hold their investments for a longer period of time, normally more than one year. Much of their earnings is therefore taxed at the long-term capital gains tax rate. In contrast, hedge funds buy and sell securities frequently, rendering the long-term capital gains rate irrelevant. Moreover, the word “fund” in this article denotes a pool of money (for the economist, capital) available for investment; it does not imply any particular legal form. Likewise, “firm” refers to a business interest generally, not any one legal form.

10 Peter Orszag, Congressional Budget Office, “The Taxation of Carried Interest,” testimony before the Senate Committee on Finance (July 11, 2007).

11 U.S. Internal Revenue Code (tax code), Section 7704(c).

12 Andrew Metrick and Ayako Yasuda, “The Economics of Private Equity Funds,” Swedish Institute for Financial Research conference on “The Economics of the Private Equity Market” (September9, 2007).

13 David Johnston, “Loopholes Sweeten a Deal for Blackstone,” New York Times (July 13, 2007).

14 “Passive” investment ptps mainly invest in companies that pay corporate income tax. When such a ptp makes distributions to its owners, they would pay income tax on the distributions. Given the ptp itself is not adding economic value beyond acting as a pooling vehicle for investors ’ funds, a third layer of tax on the ptp is thought excessive.

15 Andrew Donohue, Securities and Exchange Commission, “Testimony Concerning Initial Public Offerings of Investment Managers of Hedge and Private Equity Funds ” before the Senate Committee on Finance (July 11, 2007).

16 It is interesting that Blackstone and Fortress were able to value their carried interests to the sec’s satisfaction, yet the difficulty of evaluating carried interests is often touted as the main impediment to taxing such interests when they are granted.

17 See the membership list of the National Association of Publicly Traded Partnerships, http://www.naptp.org/Navigation/Membership/Membership_Main.htm (accessed March 5, 2008).

18 Actually, corporate income tax is only paid by c-corporations. s-corporations, like partnerships, do not pay tax at the entity level. Further, the U.S. has a progressive corporate income tax system: The 35 percent rate does not arise until annual profit exceeds $10 million. Somewhat bizarrely, corporate income tax is 39 percent for some profits below $335,000 and 34 percent from there until $10 million.

19 These definitions ignore a whole raft of exemptions, exclusions, deductions, and other technical details.

20 Staff of Joint Committee on Taxation, “Present Law and Analysis Relating to the Tax Treatment of Partnership Carried Interests, ” Joint Committee on Taxation (July 10, 2007).

21 The term “carried interest” is used almost exclusively in relation to private equity and hedge funds. The limited partners are thought to “carry” the interest of the general partners. “Sweat equity” refers to any partnership arrangement where one partner is given a stake in the future profits of partnership in return for effort.

22 Sometimes general partners provide their own capital, although it is always less than 20 percent, and often token.

23 Tax code, Section 702.

24 Stephen Moore and John Silvia, “The abcs of the Capital Gains Tax,” Cato Policy Analysis 242 (October 4, 1995).

25 One class of stock options, known as “incentive stock options,” are treated as favorably as carried interests; however, a cap of $100,000 per year pertains to the value of the granted underlying stock.

26 David Weisbach, “The Taxation of Carried Interests in Private Equity,” University of Chicago Law School Olin Working Paper 365 (2007<).

27 Eric Solomon, U.S. Treasury Department of Public Affairs, “Testimony of Treasury Assistant Secretary for Tax Policy” before the Senate Committee on Finance (July 11, 2007). 28 Howard Abrams, “Taxation of Carried Interests,” Special Report, Tax Notes (July 16, 2007).

29 See Orszag testimony for a clear summary of the three proposals.

30 H.R. 2834. This would also be subject to self-employment taxes: Medicare and social security, which would bring the effective marginal rate about the headline 35 percent. 31 Chris Sanchirico, “The Tax Advantage to Paying Private Equity Fund Managers with Profit Shares,” University of Pennsylvania Institute for Law & Economics Research Paper 07–14(2007). 32 Michael Knoll, “The Taxation of Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income, ” University of Pennsylvania Institute for Law & Economics Research Paper 07–20 (2007). 33 Knoll necessarily makes a slew of assumption to reach this figure, relating to the volatility, size, term, and specifications of carried interests.34 Weisbach, Knoll, and Abrams all offer discussions. 35 For a more general discussion, see Scott Hodge, Scott Moody, and Wendy Warcholik, “The Rising Cost of Complying with the Federal Income Tax Code,” Tax Foundation Special Report 138 (2006)

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