Why Raising Taxes on Private Equity Won't Increase Tax Revenues

Tennille Tracy does her sums over at DealJournal today, and comes to the conclusion that the private-equity tax increase would raise maybe $2 billion a year for the US fisc: "almost like pocket change" in comparison to the $1.65 trillion in total tax receipts in 2003.

In fact, the chances are that the net amount raised would actually be much lower than $2 billion.

One of Paul Krugman's readers explained why, in some hard-to-follow language on Krugman's Money Talks page. Don't worry if you don't follow, I'll try to explain after the quote.

Michael Plouf, Essex, Conn.: I have invested in hedge funds for 15 years, and I agree with everything you wrote about taxation of hedge fund carried interests. It is a subject which industry spokesmen have fairly successfully obfuscated.
However, you may be unaware of a tax policy complication that applies to this issue. As a matter of general tax principle, one party's income is another party's expense. I now get a tax deduction subject to a double haircut on Schedule A for the 2 percent management fee. The carried interest portion of the fee merely reduces my long- and short-term capital gains by 20 percent.
If the hedge fund manager is taxed at the ordinary income rate for the 20 percent carried interest, I should be entitled to take that as an investment expense deduction, just like the 2 percent fee. Given the high marginal tax rate of most hedge fund investors, the net benefit to the Treasury of taxing carried interests at ordinary rates is likely to be insignificant if the income equals expense principal is maintained. If that principal is ignored, I think it's fair to argue that it would constitute a sort of double taxation.
It is not true that the carried interest unfairly gets favorable capital gains tax rates without there being capital at risk. Rather, hedge fund managers take a slice of the return, taxed accordingly, on their investors' capital at risk.
Paul Krugman: OK, I'll try to digest that.

Never mind the "tax deduction subject to a double haircut on Schedule A" and all that. The key thing to realize is this: private equity managers' 2-and-20 fee structure is split into a 2% management fee and a 20% performance fee. The principals pay income tax on the 2% management fee, but they only pay 15% capital gains tax on the 20% performance fee, which is known as "carried interest".

From the point of view of an investor in the funds, the 2% management fee is an expense of the funds, and can be deducted against taxes. The 20% performance fee, however, because it's structured as "carried interest", is not treated as a fund expense, and so is not deductible.

If Congress enacted a law which treated the 20% performance fee as income for the fund managers, then that fee would overnight become an expense of the fund. But don't take my word for it. Let Peter Orszag, director of the Congressional Budget Office, explain:

Tax Carried Interest as Ordinary Income When Realized. A second option would be to continue to allow deferral but to view carried interest as a fee for services provided and therefore tax the income distributed to the general partner as ordinary income. Carried interest would thus be taxable to the general partner as ordinary income and deductible as an expense incurred to earn investment income to the limited partners.

This is worth repeating. Carried interest thus be taxable to the general partner, yes. But it would also be deductible – as an expense incurred to earn investment income – to the limited partners, who are the investors in the fund.

What this means is that the net revenue to the US from implementing this policy would be tiny: what you gain in taxes on general partners, you lose in taxes on limited partners. Net-net, there would probably be a gain, since private-equity principals pay high rates of income tax, and many limited partners are endowments and foundations and other entities which don't pay tax anyway. But the gain would likely be much smaller than Tracy's $2 billion a year.

On the other hand, it means that anybody claiming that this change to the tax code would reduce returns to private-equity investors actually has things completely wrong: it would, rather, increase the after-tax returns to tax-paying private-equity investors.

(By the way, none of this posting would have been possible without the invaluable help of DealBreaker's John Carney, via instant message. But I'm not even going to attempt to explain his idea about carried interest being replaced by non-recource zero-interest loans from the limited partners to the general partners.)