Whack Private Equity, Wound America

Blackstone's Stephen Schwarzman is likely taxed at lower rates than you or me. Is that fair?

The reason Schwarzman likely pays lower rates is that the vast portion of his income comes not from his Blackstone salary--it comes from Schwarzman's share of Blackstone's "carried interest" profits.

Which are taxed at the capital gains tax rate of 15%.

Which drives populists crazy. It seems unfair.

But I would argue that fairness is the wrong metric. In today's hyper-competitive global economy, capital can--and will--move at lightening speed, always seeking higher return.

Most national economies today are lowering their tax rates. America, strangely, is on a path to hike rates.

Being a Silicon Valley guy, I've always thought the tax rate for capital gains was the crucial lever that moved the economy. Availability of risk capital is a must for an economy that calls itself entrepreneurial. America's tech and entrepreneurial booms took off in 1979 after the Steiger Amendment lowered the rate from 49% to 28%.

But most Democrats and a few Republicans want to raise the cap gains rate. Or effectively raise it for professional risk capital firms--private equity, venture capital, oil and gas partnerships, etc. How? By taxing a partner's carried interest at the higher income tax rates, not the lower capital gains rate.

Call this fair if you like. But if you do, be an adult and take responsibility for the consequences.

Our friend John Rutledge (a semi-regular on Forbes on Fox) has studied the issue and predicts some of these consequences:

• Raising taxes on carried interest would decrease investment activity in any industry where partnerships are the main form of organization.

• Increased taxes on carried interest would translate over time into slower business formation, less innovation, less productivity and lower paychecks.

• Raising taxes on carried interest would result in very little additional tax revenue, while increasing risk, wasting resources and decreasing efficiency

Quadruple Whammy: Who would pay?

• General partners would pay, through lower after-tax income--smaller struggling funds would be hit hardest while larger established funds would be able to pass more to their limited partners.

• Limited partners would pay through higher partnership costs and lower after-tax returns.

• Beneficiaries would pay through lower pension benefits and more volatile portfolios. In 2006, there were:

♦ 10.5 million retirees in the 20 largest public pension funds invested in private equity

♦ 3.8 million members in the 20 largest corporate pension funds invested in private equity

• Entrepreneurs and owners of small portfolio companies would pay through less available financing and lower prices paid for their companies.

• Everyone pays in lost asset values. The JTC estimates an additional $3.01 billion in tax revenues. This implies a $171 billion loss in asset values.

• Selectively raising tax rates on long-term capital gains will drive capital offshore, costing American jobs and reducing American incomes. In today’s global economy, countries have to compete for the capital they need to grow.

Highlights: The Impact of Increasing Carried Interest Tax Rates on the U.S. Economy

• What is advertised as an attack on Wall Street will actually have its biggest and most damaging effects on Main Street.

• Limited partnerships are the cornerstone of the American way of organizing and growing businesses.

I agree with John Rutledge. Slap higher taxes on private equity and you will drive risk capital offshore. You will deeply wound American innovation and entrepreneurial vitality.