Carried Interest Tax Study: Part II

Carried Interest Tax Study: Part II

November 20, 2007

I just finished Part 2 of the U.S. Chamber study on the impact of the proposed tax changes on the economy. Like Part 1, it 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. In addition, Part 2 has updated data, some empirical analysis and a more in-depth and up-to-date look at the sectors, markets, and people that would be affected by this change.

Here is the Introduction:

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

In today’s polarized political climate leading up to the 2008 elections, a number of presidential candidates and members of Congress have singled out private equity sponsors, venture capital funds, hedge funds, and other businesses organized using limited partnership structures for punitive attention. They are proposing more than a doubling of income tax rates on the general partner’s contractual share of profits, known as “carried interest,” from long-term capital gains rates to ordinary income levels. On October 25, Chairman Charles Rangel of the House Committee on Ways and Means proposed a tax bill that the New York Times described as “a massive overhaul of the American tax system with serious implications for the private equity and hedge funds industries.”

Then, on November 1, 2007, the House Ways and Means Committee passed H.R. 3996, an $81 billion tax package billed as the “Temporary Tax Relief Act of 2007,” on a 22-13 party-line vote. This bill contained a provision to tax all general partner income, including the long-term capital gains component, as ordinary income—which, according to their calculations, would raise $25.6 billion in tax revenues over ten years. Treasury Secretary Henry M. Paulson Jr. has said that the White House opposes the plan, asserting in a statement that it “would dramatically raise taxes in ways that in my judgment would hinder America’s ability to compete in the global economy.”

It may not be a coincidence that the Dow Jones Industrial Average Index fell 360 points the same day. Or that the same week, reflecting the climate of rising tax rates, Cisco announced7 a strategic initiative with state-owned China Development Bank to invest in innovative high-growth Chinese companies; Morgan Stanley announced that it raised a $1.5 billion Asia private equity fund; the China Investment Corporation announced it was in discussions to buy stakes in three more large U.S. private equity funds; Carlyle laid out its China strategy; CITIC, China’s largest securities firm, said that it would buy a stake in Bear Stearns; General Motors announced it would build a major research and development (R&D) operation in China; and Ford announced R&D alliances with two Chinese universities.

This is taking place at a time when the U.S. capital markets are caught in the grip of the subprime mortgage crisis, banks are trying to deal with $300 in illiquid leveraged loan commitments, and analysts are worried about the possibility of recession.

The Chamber would like to better understand how carried interest affects the U.S. economy as a whole and how different sectors and industries may be impacted by the proposed tax increase. The Chamber approached Rutledge Capital to conduct a study of these issues. Rutledge Capital has conducted policy impact studies for the Chamber in the past, and has twenty years of experience in the private equity industry, including structuring partnership agreements and raising and investing two private equity funds.

In early September, the Chamber released Part 1 of the study, which presented a preliminary macro-level survey of the impacts of proposed changes in the treatment of carried interest. This paper incorporates the earlier report and presents the final results of the study. The structure of the paper is as follows: First, we define carried interest, look at the history of private equity, examine which industries rely on limited partnerships to structure investments, and show the size of the asset base investing through partnerships as well as how fast it is growing. We then outline the major proposed changes in tax treatment, analyze the likely impact of a tax increase on the economy, and look at who bears the burden of a tax increase—the general partner, the limited partner, or the operating company being financed. Next, we examine the channels through which the proposed tax increase would impact the capital markets, including prices, rates of return, and level of investment. Finally, we look at the broad impact of the proposed tax changes on the overall economy, jobs, incomes, investment activity, and tax revenues.

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The executive summary and full report are also available at the U.S. Chamber website.

John Rutledge

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