November 8, 2012

On Private Equity Taxation, Consider Side Effects

By David Robinson

Herald-Sun guest columnist

DURHAM

As we reach the last few days of the presidential election and the debates  between President Barack Obama and Gov. Mitt Romney reach a crescendo, it is  increasingly likely that the subject of private equity taxation will continue to  garner attention.

Many Americans were shocked this fall to learn that Mitt Romney’s effective  personal tax rate was 14.1 percent. How could a captain of industry pay less  than half the marginal tax rate an upper middle-class American family would pay?  It is certainly fodder for populist tax reform. The fact that management fees  are taxed as ordinary income – essentially about 50 percent once Medicare, state  and local taxes are factored in — while carried interest is taxed at the capital  gains rate of 15 percent creates a giant wedge favoring the wealthy. Clearly we  need to close this egregious loophole, and get these guys to pay their due.  Right?

Wrong. The issue is not whether it is morally outrageous for Romney to face a  low effective tax rate because most of his money is generated through equity  investments as opposed to ordinary income. Suppose it is outrageous. Nor is the  issue the inherent difficulty in singling out private equity general partners  for this special treatment, which seems to be the desire of everyone who is  trumpeting such policy proposals. Suppose it’s easy to treat private equity  general partners differently than other equity investors. Nor is the issue the  fact that the capital gains have already been taxed once at the corporate level,  although that’s certainly true.

The issue is who will actually end up paying the tax at the end of the day. When  gasoline, or cigarettes, or alcohol, or anything else is taxed, the tax is  ultimately shared by both the producers and the consumers of the product being  taxed. When gasoline taxes go up, the driver pays part of the tax in the form of  more expensive gasoline, and the oil company pays part of the tax in the form of  less gas sold.

The same dynamic is at work in private equity. General partners are, after all,  middlemen. If they face higher taxes, they will pass some of the costs on to  limited partners in the form of higher fees, and they will also pass some of the  costs onto portfolio companies in the form of more stringent contracts and less  overall capital available. As a result, the extra tax imposed on private equity  general partners will be borne by general partners, limited partners, and  portfolio companies alike, all to differing degrees

Read more:  The Herald-Sun – On private equity taxation consider side effects

 

David Robinson is a professor at Duke University’s Fuqua School of Business.