NCPA - National Center for Policy Analysis


May 7, 2007

The Congressional tax committees have set their sights on the private equity market as a source for new tax revenues.  Senators Max Baucus (D-MT) and Charles Grassley (R-IA), the chairman and ranking minority member of the Finance Committee, will soon hold "informal meetings" to ponder a 133 percent tax hike on private equity firms, says the Wall Street Journal.

Senator Grassley says he suspects "subterfuge" that allows fund managers to underpay their taxes. Under the current system:

  • Managers charge fund investors a 1 or 2 percent management fee for finding high-return business opportunities and orchestrating the portfolio.
  • Those fees are taxed at personal income tax rate of up to 35 percent; but fund managers also typically lay claim to a 20 percent slice of the fund's future profits.
  • That return is called "carried interest" and is taxed at the long-term capital gain rate of 15 percent.
  • Congress is considering reclassifying that income as labor compensation and taxing it at regular income tax rates.

That's bad tax policy for a lot of reasons, says the Journal. "Carried interest" is long-term, risk-based investment income derived from future profits. Those profits are anything but a sure thing. Private equity managers get nothing from their equity holding until investors get all of their money back plus a negotiated return -- which is a lot different than an upfront fee or a guaranteed wage or salary that comes as a paycheck every two weeks.

In reality, says the Journal, this move should be seen in its broader context, which is the first skirmish by the left in the political war over the Bush tax cuts, as well as the future of capital gains and dividend taxes in the United States.

Source: Editorial, "Assault on the Investor Class," Wall Street Journal, May 7, 2007.

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