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Lobbyists Battling Over Carried Interest Debate

by Mike Godfrey,, Washington

26 September 2007

A recent analysis from Washington's Center on Budget and Policy Priorities has rubbished the idea that increased taxes on private equity would reduce investment in minority-owned businesses and low-income communities, an idea put about by private equity lobbyists.

The study asks why, if Congress is concerned about under-representation of women and minorities in that industry, it should address that concern with a tax break for all private equity fund managers. 'Why should managers’ compensation be subject to lower tax rates in this particular industry, when women and minorities take on managerial roles in many industries, and are under-represented in many industries?' wonders the report.

Lobbying on behalf of the industry by the Access to Capital Coalition and the Private Equity Council - a Washington lobbying group established last year by 11 buyout firms including Blackstone - seems to have provoked a backlash from some members of Congress. After lobbyists visited Representative Stephanie Tubbs Jones (D - Ohio), who serves on the Ways and Means Committee and is prominent in the attempt to increase tax rates on carried interest, to persuade her that the lower tax rate increases development in depressed communities, she complained that the lobbying was inappropriate. "The legislation is not the vehicle in which to be successful with the argument," said Ms. Tubbs Jones.

Ways and Means Committee chairman, Representative Charles Rangel (D - New York), agreed: "It's going to be hard for me to draft a minority and women set-aside to rip off the system,'' he said.

Earlier in the month, the House held a panel on the vexed question of the tax treatment of income, or carried interest, earned by limited partners, principally in the private equity industry. The debate is focusing on whether, in the case of private equity partners, their earnings should be treated as investment income and taxed at the capital gains tax rate of 15%, or ordinary income taxed at 35%.

The consensus of the panel, which consisted mainly of academics and tax experts, seemed to be slanted in favor of the latter opinion. In written testimony, Peter R. Orszag, Director, Congressional Budget Office, stated that most economists would agree that at least some part of carried interest is performance based rather than a return on financial capital invested, and therefore should be taxed accordingly.

"That perspective would suggest taxing at least some component of the carried interest as ordinary income, as most other performance-based compensation is currently treated, regardless of the nature of the underlying investments generating the profits of the fund," Orszag testified.

Eugene Steuerle, Co-Director, Urban-Brookings Tax Policy Center, and Former Deputy Assistant Secretary of the Treasury for Tax Analysis in the Reagan Administration said that Congress could take an important step towards solving the problem of carried interest "by amending Section 702(b) to provide that a partner’s distributive share shall be treated as ordinary income when it is compensation for services rendered by the partner to the partnership." He also stated that Section 1402 a should be amended to make this income subject to the self-employment tax.

Mark Gregen, Professor of Law at The University of Texas School of Law, claimed that there was "widespread agreement" among tax professors and economists that "the status quo is an untenable position as a matter of tax policy".

Meanwhile, over in the Senate, the Finance Committee held its third meeting on the issue of carried interest, which explored claims that a tax hike on carried interest would be passed on to the pension companies that invest in private equity funds, and ultimately to the pensioners themselves.

Finance Committee Chairman Max Baucus observed that observed that in July 2006, American pension plans held $350 billion in alternative investments, including private equity and hedge funds. "That is a lot of money," he noted. However, at this time, defined benefit pension plans had more than $5 trillion in assets, meaning that less than 7% of their pension assets were held in alternative investments. In 2006, about 10% of hedge fund capital came from US pension plans.

"This data says to me that hedge funds and private equity funds may need pension funds more than pension funds need private equity or hedge funds," Baucus stated. "And that means that hedge funds and private equity funds may not have the economic power simply to pass along increased costs to pension funds."

However, tax experts believe that at least some of the tax hike on carried interest will be passed on to pensioners, although it is unclear to what extent the measure would erode investments.

"In short, the proposed tax changes, if they can effectively be enforced, would be progressive but also would reduce returns to investors, including pension funds, somewhat," testified Dr. Alan J. Auerbach, Professor of Law and Economics, University of California at Berkeley.

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