By: David Robinson, Landmark Fellow (The Fuqua School of Business, Duke University)
General partners in private equity are taxed differently than many other types of people in the economy. They pay ordinary income tax on the fee income that they receive in the partnership, but pay the lower capital gains tax rate on the carried interest they earn from the partnership’s investments. The fact that GPs can generate fabulous wealth and face relatively little in tax liability is a constant source of consternation among politicians and other observers of the industry. This seems to violate the most basic tenets of fairness: how is it that the super-wealthy pay so little in tax, while those who earn income through salary pay so much more? Why should a private equity executive pay so much less in tax than a doctor or a surgeon?
This issue has generated a considerable debate among legal and tax scholars. Many scholars here are concerned with determining how to draw the line between alternative types of activities subject to different tax rates. After all, practically no one wishing to increase the tax on private equity carried interest would argue that similar penalties should be imposed on job-creating entrepreneurs, yet strong analogies can be drawn between the actions of a firm’s direct owner and the GPs who own the firm indirectly through a partnership. Thus some distinction has to be made between direct ownership and ownership through a limited partnership.
The goal of this white paper is different. I am not concerned with which framing generates the most equitable form of taxation, because this question is ultimately connected to the statutory incidence of the tax. I am concerned with the economic incidence of the tax: how the burden of the tax will be distributed among the suppliers and demanders of private equity capital.
To see the distinction, forget about private equity for a moment. Think about the market for pizza. Imagine there is some benevolent social planner who raises the tax on pizza to help unshackle the world from its collective addiction to carbohydrates. In such a world, it seems relatively uncontroversial to point out that the tax burden will be shared by producers and consumers of pizza alike through a combination of higher prices and lower sales. If, after the tax is introduced, the price goes up a little and the quantity of pizza consumed goes down a lot, then the brunt of the tax has been borne by the pizza makers. If, on the other hand, prices go up a lot but the quantity consumed only falls a little, then the tax has been effectively passed on to the consumer. This is true regardless of whether the tax is collected from the store clerk at the point of sale, from the pizza maker, or at tax time from the consumer.
I am interested in transferring the seemingly innocuous logic of pizza taxation over to the private equity sector to see how the true cost of the tax increase will be borne by different market participants. My central argument is that the tax will be shared between portfolio companies, limited partners and GPs, irrespective of whether the tax is collected from the GP’s carried interest claim or through some other statutory mechanism. When we raise tax on GPs, we will be collecting some of the tax from future retirees in the form of lower investment returns on their pension savings. We will collect some of the tax from startups and companies undergoing restructuring in the form of more aggressive financing. And yes, some of it will be paid out of the pockets of the GPs themselves.
Ultimately we do not have the data necessary to provide sharp estimates of exactly how much of the additional tax revenue will be paid by portfolio companies and pension investors. This alone should be a source of concern to all market participants in the private equity sector. Nevertheless, by going back to basics, we can walk through a variety of different market scenarios and draw different conclusions about how the tax is shared based on how the market is structured. Using these basics we can then ask how changing taxes in private equity would change the outcomes that we observe in the market. Some of these changes will play out over the short run through changes in transaction prices, while others play out over the longer run through exit from the sector and evolving organizational practices.
The above is a brief synopsis of the white paper referenced in the title. It is not itself a complete record of that paper and cannot be relied upon in isolation. A copy of the full white paper is available upon request.
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