The Futility of Taxing The Carry

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Our Capitol Hill lawmakers don’t feel your pain. Despite the recent turmoil in the financial markets and the bloodletting at many so-called “quant” funds, lawmakers are putting pressure on the Fed not to cut interest rates and continue to push ahead with plans to raise taxes on private equity firms. A new study from a Penn Law professor, however, suggests that the proposed tax hike will not generate very much by way of revenues for the government.
Part of the reason that raising taxes on private equity won’t generate more revenue is that fund managers are likely to change the way they are compensated. Carried interest will decrease while fees increase, and since the fees are tax deductible business expenses, the tax effect is a wash.

About $200 billion a year is invested every year in private-equity funds and between $12 billion and $17 billion in carried interest is granted, Knoll wrote. Taxing that carried interest as ordinary income would generate between $2 billion and $3.2 billion in additional taxes annually, he said.
Private-equity firms probably would find ways to avoid the added tax burden, Knoll said. The firms may raise fees on wealthy individuals, who can deduct the higher fees, or shift costs to the companies in their portfolios, he said.
"For such companies, the payment of a contingent fee to a private-equity firm in exchange for its assistance in selecting the directors, hiring the managers, and helping to restructure and operate the business would likely qualify as an ordinary and necessary business expense,'' that can be deducted from income, Knoll wrote. Such a strategy may generate ``little or no net increase in tax collections.''

Buyout Firm Tax Boost Won't Raise Revenue, Study Says [Bloomberg]
Download pdf file of Knoll's paper [SSRN]

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