The Real Scandal in Private Equity? It's the Taxes

Mitt Romney likely gets a huge tax break on his income, even though he's a mega-millionaire, because of a strange and unfair law that gives special privileges to private equity managers (Read the case for private equity here)



Presidential frontrunner Mitt Romney has been taking a shelling from both sides of the aisle for his time spent at Bain Capital, the private equity firm he headed in the 1980s and '90s. While running Bain, Romney practiced what Rick Perry has called "vulture capitalism," and his critics have accused him of leveraging his bought-up companies with debt and using that debt to pay dividends to investors before finally leaving the companies bankrupt and hemorrhaging jobs.

Romney's largely basing his campaign on his time in the private sector, so the work Bain did during his tenure (and what has gone on there since) has garnered a significant amount of attention. The other GOP presidential candidates, as well as many Democrats, have piled on to portray Romney as the second coming of Gordon Gekko, while conservative commentators have come racing to his defense.

The record of private equity firms, such as Bain Capital, suggests that their creative destruction might add value to the economy, but sometimes leaves companies stripped while investors walk away with millions. But the real scandal at the heart of the industry is the way in which private equity managers receive special treatment in the tax code.

Managers of private equity firms like Romney are often paid under an arrangement in which they receive both a set fee for their management, as well as a share of the profits that the firm makes for investors. While their management fees are taxed at normal income tax rates, the share of investor gains that go to a private equity manager (called "carried interest") are treated as capital gains, and thus taxed at a top rate of 15 percent. (Hedge fund managers and partners in real estate ventures also benefit from receiving carried interest.)

The argument for a lower capital gains rate is that it encourages investment. Whether that's true or not, private equity managers are allowed to pay the capital gains rate on the profits they make managing someone else's money, not for any risk that they take themselves. Treating carried interest as capital gains is an unjustifiable tax break that needs to be eliminated.

Congress has attempted to close the carried interest loophole on a number of occasions, with the Democrats passing legislation to close it three times when they controlled the House of Representatives. But intense lobbying and Senate intransigence has kept the tax giveaway in place.

Senate Republicans like Sen. Orrin Hatch (R-UT) claim that changing the tax treatment of carried interest would somehow cause a drop in private equity activity. But as the venture capitalist Fred Wilson put it, closing the carried interest tax loophole won't dry up any money for investments, because the tax on the source of capital wouldn't be changing.

"Wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return," Wilson explained. "And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees."

Former Office of Management and Budget Director and current Citigroup Vice Chairman of Global Banking Peter Orszag said that the carried interest loophole is akin to a famous actor's portion of a movie's revenue being taxed as capital gains, a proposition that most people would hopefully find absurd. Citizens for Tax Justice opined that carried interest "is clearly compensation for services and not a return on investment," and that private equity managers "should pay income taxes at ordinary rates on their compensation, just like everyone else, from the folks who sweep their floors or answer their phones to CEO's exercising stock options and professional athletes getting playoff bonuses."

Thanks to a lucrative retirement package, Romney is still making millions from Bain, much of which is likely being taxed as carried interest. (While Romney has refused to make his tax returns public, he's said that all of his income is taxed at investment rates.) Analysts have estimated that Romney's tax rate is about 14 percent, lower than that of many middle class families.

Leaving aside the questions over whether Romney and Bain's modus operandi adds value to the economy, there's certainly no value added by letting private equity managers treat the paycheck they receive from investors as capital gains: that particular tax loophole just lets very wealthy money managers avoid paying the top tax rate, for no real reason.