Carried Interest and Chicken Little

At his news conference Thursday, President Bush, big surprise, came out against raising taxes on the "carried interest" profits that flow to venture capitalists and other private equity general partners.

I'm no private equity basher - venture capital is essential to innovation in the U.S. economy, and leveraged buyouts can boost competitiveness at lagging companies in ways the public markets don't allow.

But it's hard to swallow the arguments against taxing carried interest at regular income rates. Here's why...

Bush's rationializations about ensuring tax consistency in business partnerships an absence of logic, but even if he knows better, the issue is complicated enough that he can get away with it. (Should business profits be taxed at all? Maybe not, but that's a totally different argument.)

Quick background: VC, LBO and other private equity general partners invest millions of dollars from institutional investors in companies they hope to take public or sell to another buyer sometime during the life of a ten year fund. They make money two ways.

First is their management fee. Each year, the general partners charge about 2 percent of invested capital. The fee won't make partners rich in the eyes of their own social set, but it does provide them with a salary that would cause most Americans to feel very wealthy indeed. It's taxed as regular income, no debate.

Individual private equity partners often contribute their own cash to the investment funds, but those small amounts are true equity investments and no one argues they shouldn't get capital gains treatment.

Next is carried interest, where the big money is made. After the investors get back their original slug of capital, all ensuing are split two ways: 80% to the investors, and 20% to the private equity firm. Remember, the firm and its partners have contributed no financial capital in return for this 20 percent carry. Some VCs have argued on Capitol Hill that the carry represents "sweat equity." Others regard the carried interest as a fee for service. To them, no capital invested should translate into no qualification for capital gains treatment. It's hard to argue against the logic.

But why argue hard logic when fear mongering is so much more effective? The private equity lobby is painting visions of economic disaster. No evidence is offered to support this view. It's important to note that the limited partners -- the investors who provide the vast majority of original capital -- would not see their taxes go up a cent if carried interest were taxed at regular income rates.

There are few occupations as lucrative as private equity, so if correcting policy to tax fee for service as regular income would upset the private equity business, the Chicken Littles need to tell us exactly how and why the economy would suffer. Maybe they're right. But so far, they've not made a compelling case.