The Impact of the Proposed Carried Interest Tax Change

The Impact of the Proposed Carried Interest Tax Change

September 11, 2007

The U.S. Chamber is hosting a briefing on Thrusday, September 13, 2007 at which I will discuss our recent study on the impact of the proposed carried interest tax change. The study examines the broad economic impact of the proposed changes in the treatment of carried interest, who bears the burden of a tax increase, and the effects on the capital markets.

Here is the Executive Summary:

Analysis of the Impact of Increasing Carried Interest Tax Rates on the U.S. Economy

Members of congress have recently proposed to increase the tax rate on the general partner’s share of a limited partnership’s profits, known as carried interest, from the longterm capital gains rate of 15% to ordinary income tax rates of up to 35%.

The Partnership is the cornerstone of the American way or organizing business and investment ventures. In 2004, 15.5 million American investors were partners in more than 2.5 million partnerships holding $11.6 trillion in assets to engage in business and investment ventures in the U.S.

Academic evidence for the positive productivity and financial performance effects of private equity on U.S. companies is unequivocal. Companies backed by private equity have better governance, and are more profitable, more productive, and faster growing.

Venture capital has had an extraordinary record in creating new businesses, new technologies, new business models, and new jobs. Venture-backed companies accounted for $2.3 trillion of revenue, 17.6% of GDP, and 10.4 million private sector jobs in 2006. Venture-backed companies grow faster, are more profitable, and hire more people.

Real estate partnerships have increased the availability and lowered the cost of capital to build homes, shopping centers, office buildings, and hospitals for American families and businesses. In 2006, investors provided $4.3 trillion in capital to the U.S. real estate sector, mainly through partnerships by private investors ($451 billion), pension funds ($162 billion), foreign investors ($55 billion), life insurance companies ($30 billion), private financial institutions ($5.1 billion), REITs ($315 billion), and public untraded funds ($37.4 billion).

Carried interest is a core element of partnership finance in every sector of the US economy engaged in capital formation, including real estate, private equity, hedge funds, healthcare, retail, distribution. Increasing tax rates on long-term capital gains income designated as a General Partner’s carried interest would alter the long-accepted tax principle that partnership income flows through to the partners who pay tax based on the character of the income received by the partnership.

Increasing the tax rate on carried interest would lead to wholesale changes in the structure of partnership agreements including loan-purchase arrangements and shifting general partner costs to portfolio companies; incremental net tax collections would be small.

To the extent the tax increase could not be avoided by restructuring, the costs would be borne by all members of the investment process including general partners as lower aftertax income, limited partners and their beneficiaries as higher costs and lower after-tax returns, and owners and employees of portfolio companies as lower business valuations. Increasing carried interest taxes would disrupt long-standing business practices in U.S. capital markets and risk undermining America’s preeminent position in the world as a leader in invention, innovation, entrepreneurial activities, and growth. Raising tax rates would reduce the amount of long-term capital available to the US economy and undermine investment, innovation, entrepreneurial activity, and productivity.

Raising tax rates on the long-term capital gains of limited partnerships will drive capital offshore, reduce the productivity of American workers and the ability of US companies to compete in global markets. It will cost American jobs and reduce American incomes.

In today’s global economy, countries have to compete for the capital they need to grow. Raising tax rates on long-term capital gains of US partnerships would hang a “not welcome here,” sign on our door.

Foreign governments have learned that ample supplies of capital are the key to creating the rising incomes and economic growth their people are demanding. They are becoming more capital-friendly every day, changing tax and regulatory policies to reduce risk and increase returns for foreign investors who bring capital to their countries. They are waiting for us to make a mistake that would drive our capital offshore and into their welcoming arms. Raising tax rates on long-term capital gains for America’s partnerships is just the mistake they have been waiting for.

The Full report is also available at the U.S. Chamber of Commerce site.

John Rutledge

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