The Ethics of Taxation Trilogy: Part III – Carried Interest and Taxing Private Equity

Recent debate on the ability of private equity managers to claim their income as capital gains and therefore, be taxed at the lower capital gains tax rate raises ethical questions about the U.S. federal tax system.

Maybe public awareness of Mitt Romney’s income taxes, Herman Cain’s radical 9-9-9 tax plan, or the Occupy movement’s mantra of the bottom 99% versus the top 1% income earners has also catalyzed interest in the ethics and logic of the country’s current tax system. In a 2011 Pew Research Center poll, 59 percent of respondents said the tax code was so flawed that Congress should completely change it.[1]

The current federal tax code in the United States spans nearly 70,000 pages. There are numerous loopholes, subsidies, and alleviations in the tax code. One such loophole creating public controversy and heated debate is the ability of private equity managers to claim their income as capital gains and therefore, pay only a 15 percent income tax rate.

I.          The Private Equity (PE) Carried Interest Tax Loophole

Private equity or PE refers to ownership of mostly, privately held companies.  Private equity in general takes on two forms of investment: start-up venture capital, and leveraged buyouts or capital expansion of existing businesses.  Leveraged buyouts are financial transactions in which public corporations are purchased and then converted into private corporations. Leveraged buyouts or LBOs are typically financed through debt such as bank loans and bonds.  In addition, the acquirer in a leveraged buyout also raises capital to finance some of the acquisition. Money from pension funds, endowments and the issuance of low rated bonds are pooled to provide the necessary capital for such operations. In general, the amount of debt used to finance LBOs far exceeds the amount of equity.

After purchasing a corporation, private equity firms make changes to the corporation’s management, its strategy, and perhaps its business model. This restructuring is done with the ostensible goal of achieving greater efficiency and therefore, profits. In pursuing greater economic efficiency, lay offs and restructuring are common practice. The end goal is to sell the arguably, revitalized company either to another party or to take it market in a public offering. In doing so, private equity firms can make handsome profits when the sale price exceeds the initial purchase price of the company. Private equity managers, when successful, generate income from such transactions in the form of carried interest. Carried interest is the share of the profit from the sale of the company that goes to the manager of the private equity firm that bought and then sold the company.[2]

Private equity managers are then able to claim this income as capital gain. Capital gain refers to the difference between an asset’s adjusted purchase price and selling price when the difference is positive[3]. A long-term capital gain is achieved once the asset has been held for more than 12 months and creates profit. Such gains, are taxed at 15 percent rather than the normal 35 percent income tax bracket that such managers would otherwise be forced to pay.

II.          Argument for keeping carried interest tax loophole for PE

Proponents argue the capital gains loophole for PE investors is ethically defensible because the rule results, overall, in greater benefits to a greater number of people. Thus, they justify the rule using a consequentialist utilitarian argument.

Currently, there are 2,600 private equity firms in the United States and their investments are spread among 15,000 companies. Private equity firms are necessary sources of capital that help facilitate enterprise efficiency, which in turn creates jobs and helps grow the economy.

For example without proper investment capital, the Silicon Valley technology boom, with its ensuing jobs growth, and the remarkable rise of the technology sector in the U.S. economy, may not have occurred.

However, not all business ventures are successful and as a result investments often go unrewarded. Policymakers and economists alike recognize this risk and understand the important role capital plays in the growth of an economy. Measures are needed to incentivize investment. Hence, the aforementioned tax breaks for investors.

Advocates believe the ability for private equity managers to claim their profits as capital gains helps to accelerate investment, and as a result benefits the entire economy by promoting business ventures, increasing employment, and increasing economic efficiency.

Without such tax exemptions, the risks may be seen as outweighing the reward and investments will slowly decline. Consequently, one may see a decreasing volume of entrepreneurial activity and stagnating job growth.  Particular sectors of the economy, such as real estate, categorize profits as carried interest. Indeed, 46 percent of total carried interest in the United States comes out of the real estate sector. If the tax treatment for carried interest is eliminated, this sector, it is argued, will suffer from lack of investment and fail to grow. [4]

III.         Argument for eliminating carried interest tax loophole for PE

Opponents to the tax loophole for PE argue the loophole is unfair because the reduced tax rates benefit the wealthy but penalize the less well-off. In other words, opponents use justice theory to support their case that the tax loophole for PE is unethical.

Economists and policymakers point out multiple flaws in taxing income as capital gains for private equity managers. Opponents of this tax exemption claim the money these fund managers make from LBOs is clearly compensation for their services. Therefore, such money should be taxed the way compensation for other services are—as ordinary income.[5]

Economists note the difference in taxation between those whose incomes depend on labor and those whose incomes derive from capital gains. Studies reveal the bottom 80 percent of households get less than 4 percent of their income from capital. For those in the top quintile, however, 16 percent of their income comes from capital. And among the top 1 percent the capital gains as a percentage of income rises to 35 percent.[6] These statistics reveal the wealthy have been benefitting from the current tax system that imposes higher taxes on labor rather than capital.

Proponents of change favor fair or progressive tax codes such as President Obama’s, Buffet Rule, which requires those making $1 million a year or more to have an effective federal tax rate of at least 30 percent, while raising the top statutory tax rate for those with incomes over $250,000 to 39.6 percent from 35 percent. [7]

Congress has inadvertently created and upheld an unethical tax system that discriminates and unequally rewards the citizens of this country. Some may say, the rule benefits most members of the legislative branch.

While it may be logical to incentivize investment through tax exemptions for private equity managers, the tax rule allowing exemptions is unethical because it is unfair. The tax exemptions, loopholes, and ambiguities present in our tax system reflect the inability to differentiate and discriminate between a citizen’s means of income.

IV.       Policy Recommendations

By instituting a flat tax rate or equal income percentage tax, exemptions will cease to exist and each citizen’s income is taxed at the same percentage rate regardless of how it was obtained.  Those falling below a certain low-level of income will not be required to pay taxes. By focusing on equality, our tax system can be re-structured in such a manner that is both financially and ethically sound.

Critics argue that flat tax or equal percentage systems place burdens on the lower and middle class by removing deductions and expanding the tax base to include every level of income. Opponents also believe that such a system simply continues to exacerbate the rising income inequality levels in America.

However, a recent study done by the National Center for Policy Analysis, shows that a flat tax rate of 17 percent allows every income group to gain, with the greatest gain in percentage terms (7.6 percent) going to the lowest-income Americans. Increased economic activity takes place as the government retains 1.8 percent more in revenues from taxation. [8]

In sum, capital investment is necessary for a healthy economy. However, the way our current tax system is structured to promote capital investment requires more thought, especially from an ethics perspective.

BY: ANTHONY RAYMOND