[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
FAIR AND EQUITABLE TAX POLICY FOR
AMERICA'S WORKING FAMILIES
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 6, 2007
__________
Serial No. 110-58
__________
Printed for the use of the Committee on Ways and Means
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COMMITTEE ON WAYS AND MEANS
CHARLES B. RANGEL, New York, Chairman
FORTNEY PETE STARK, California JIM McCRERY, Louisiana
SANDER M. LEVIN, Michigan WALLY HERGER, California
JIM McDERMOTT, Washington DAVE CAMP, Michigan
JOHN LEWIS, Georgia JIM RAMSTAD, Minnesota
RICHARD E. NEAL, Massachusetts SAM JOHNSON, Texas
MICHAEL R. McNULTY, New York PHIL ENGLISH, Pennsylvania
JOHN S. TANNER, Tennessee JERRY WELLER, Illinois
XAVIER BECERRA, California KENNY C. HULSHOF, Missouri
LLOYD DOGGETT, Texas RON LEWIS, Kentucky
EARL POMEROY, North Dakota KEVIN BRADY, Texas
STEPHANIE TUBBS JONES, Ohio THOMAS M. REYNOLDS, New York
MIKE THOMPSON, California PAUL RYAN, Wisconsin
JOHN B. LARSON, Connecticut ERIC CANTOR, Virginia
RAHM EMANUEL, Illinois JOHN LINDER, Georgia
EARL BLUMENAUER, Oregon DEVIN NUNES, California
RON KIND, Wisconsin PAT TIBERI, Ohio
BILL PASCRELL Jr., New Jersey JON PORTER, Nevada
SHELLEY BERKLEY, Nevada
JOSEPH CROWLEY, New York
CHRIS VAN HOLLEN, Maryland
KENDRICK MEEK, Florida
ALLYSON Y. SCHWARTZ, Pennsylvania
ARTUR DAVIS, Alabama
Janice Mays, Chief Counsel and Staff Director
Brett Loper, Minority Staff Director
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
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C O N T E N T S
__________
Page
Advisory of August 30, announcing the hearing.................... 2
WITNESSES
Leonard E. Burman, Ph.D., Director, Urban-Brookings Tax Policy
Center......................................................... 7
Jason Furman, Director, The Hamilton Project, Brookings
Institution.................................................... 21
Douglas Holtz-Eakin, Senior Fellow, The Peterson Institute, and
Former Director, Congressional Budget Office................... 35
______
Stephen E. Shay, Partner, Ropes & Gray LLP, Boston, Massachusetts 77
Leon M. Metzger, Former Vice Chairman and Chief Administration
Officer of Paloma Partners Management Company.................. 91
Janne G. Gallagher, Vice President & General Counsel, Council on
Foundations.................................................... 96
Suzanne Ross McDowell, Partner, Steptoe & Johnson LLP............ 99
Daniel J. Shapiro, Partner, Schulte, Roth & Zabel LLP, London,
England........................................................ 105
______
Peter R. Orszag, Director, Congressional Budget Office........... 151
C. Eugene Steuerle, Ph.D., Co-Director, Urban-Brookings Tax
Policy Center, and Former Deputy Assistant Secretary of the
Treasury for Tax Analysis, Reagan Administration............... 176
Darryll K. Jones, Professor of Law, Stetson University College of
Law, Gulfport, Florida......................................... 181
Victor Fleischer, Associate Professor of Law, University of
Illinois College of Law, Champaign, Illinois................... 188
Mark P. Gergen, Professor of Law, The University of Texas School
of Law, Austin, Texas.......................................... 199
Jack S. Levin, Partner, Kirkland & Ellis LLP, Chicago, Illinois.. 173
______
Leo Hindery, Jr., Managing Director, InterMedia Partners, New
York, New York................................................. 225
William D. Stanfill, Founding Partner, TrailHead Ventures,
Denver, Colorado............................................... 229
Orin S. Kramer, Chairman, New Jersey State Investment Council,
New York, New York............................................. 233
Jonathan Silver, Managing Director, Core Capital Partners........ 235
Adam Ifshin, President, DLC Management Corp., Tarrytown, New York 250
Bruce Rosenblum, Managing Director, The Carlyle Group, and
Chairman of the Board, Private Equity Council.................. 257
SUBMISSIONS FOR THE RECORD
National Association of Home Builders, statement................. 00
American Prepaid Legal Services Institute, statement............. 286
Chamber of Commerce, statement................................... 288
National Association of Publicly Traded Partnerships, statement.. 294
National Center for Policy Analysis, statement................... 300
National Taxpayers Union, Alexandria, VA, statement.............. 303
NGVAmerica, statement............................................ 306
FAIR AND EQUITABLE TAX POLICY FOR
AMERICA'S WORKING FAMILIES
----------
THURSDAY, SEPTEMBER 6, 2007
U.S. House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:10 a.m., in
room 1100, Longworth House Office Building, Hon. Charles B.
Rangel (Chairman of the Committee), presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
August 30, 2007
FC-14
Chairman Rangel Announces Hearing on
Fair and Equitable Tax Policy for
America's Working Families
House Ways and Means Committee Chairman Charles B. Rangel (D-NY)
today announced the Committee on Ways and Means will hold a hearing on
fairness and equity in the Tax Code. The hearing will focus on a number
of tax fairness issues, including the tax treatment of investment fund
managers and the impact of the alternative minimum tax on working
families. It will also examine the reasons why investment funds are
being organized offshore. The hearing will take place on Thursday,
September 6, 2007, in 1100 Longworth House Office Building, beginning
at 10:00 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing. A list of invited
witnesses will follow.
BACKGROUND:
In 2001, President Bush introduced an economic stimulus package
that he said ``erases inequities in the Tax Code or eases inequities in
the Tax Code.'' At the time, there were divisions as to whether the tax
cuts would provide the stimulus effect and relieve inequities in the
Tax Code as suggested by the President. In addition to analyzing the
effects of the President's tax packages, there are other aspects of our
tax laws that are worthy of examination, including provisions related
to investment funds such as private equity funds and hedge funds.
Concerns have been raised about the manner in which investment fund
managers are able to structure their compensation. Others have observed
that current tax rules force investment funds to form outside the
United States. It is appropriate to perform a comprehensive examination
of fairness in the Federal income tax system to ensure that our tax
policy is working effectively and fairly for all of America's working
families.
In announcing the hearing, Chairman Rangel said, ``One of the
fundamental duties of the Committee on Ways and Means is to conduct
oversight of the Tax Code and ensure that our tax laws promote fairness
and equity for America's working families. This hearing will examine a
number of tax provisions to determine whether they are functioning
fairly and equitably.''
FOCUS OF THE HEARING:
This hearing will focus on a comprehensive examination of Federal
income tax fairness, with particular attention to investment fund
manager compensation and the effects of the alternative minimum tax on
tax rates.
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Chairman RANGEL. The Committee on Ways and Means will come
to order. I wish you all a good morning, and what a wonderful
opportunity for us to wish my very good friend, Sandy Levin, a
very, very happy birthday.
As most of you know, when the new Congress came into
effect, Jim McCrery and I had a lot of meetings to determine
within the jurisdiction of the Committee on Ways and Means just
what issues would lend themselves to bipartisan support. But we
were very conscious of the fact that within our own party there
was such strong policy differences that it would limit the
ability for us to work together.
There was one thing that was abundantly clear in our
discussions, and that is we had a responsibility, as the
constitutional revenue-raising Committee, to take care of the
problems that have been presented by the alternative minimum
tax. How we did that, of course, we have had and still do have
a difference of opinion. However, I would want to make it
public that we hope that the Republican minority would feel
comfortable in having input in changes and reforms in the
existing Code, notwithstanding the fact that ultimately you may
not be able to support the package. So, while there are some
revolutionary or different dramatic concepts as to which way
the Code should be going, we do hope--and we will have caucuses
on this where we can be candid and explain our positions--that
you may want to do the best you can with a code that you don't
like to perfect it, to make it at least more simple and more
fairer to the taxpayers if ultimately you cannot support that
package.
So, we have been driven by the alternative minimum tax.
There's been a lot of interest in the papers, however, about
the differences in which hedge funds and private equity funds
operators are taxed. This has not been the goal of this
Committee to target any of the tax provisions except the AMT.
But it's fair to say that since the AMT is such an expensive
revenue loser because the revenue we raised was never intended,
that naturally we have to look at the entire Tax Code to reach
the goal that we hope we can achieve, and that is to simplify
the system so at the end of the day whether you vote for it or
not, the taxpayer does not have to raise so many resources in
order to find out what they owe the Federal Government; to make
certain there's a sense of fairness so that the taxpayers would
realize that just having higher income doesn't mean that you
get more favorable rates, and that everyone that has to pay has
some sense that it's a fair system.
Of course, our overall objective should always be how we
can improve the economy of the United States of America and
therefore be in the position to raise the revenue to make her
as strong as we would want her to be. So, before I yield to the
Ranking Member, I want to thank Ritchie Neal for his
Subcommittee being out front and having hearings that provided
for the groundwork for the hearings that we're having today,
and again encourage Members of the Committee that if after the
conclusion of these hearings they believe that there was
something that had been missed, the fact that you may not be
able to support the final product should not inhibit you from
improving whatever product comes out of our Committee, and
hopefully the House.
So, Ritchie, let me thank you for the work that you have
done. Before I yield to the Ranking Member, I'd like to yield
to you.
Mr. NEAL. Thank you, Mr. Chairman, and thanks to Mr.
McCrery as well and to Mr. English as well. Clearly, the
hearings have been done in a bipartisan manner.
Mr. Chairman, this morning I delivered to you and to Mr.
McCrery a report on the two hearings held at the Subcommittee
level on the important issue of alternative minimum tax. Since
the AMT is going to be a major issue discussed during this
first panel today, I want to give a brief overview to the full
Committee on what we have learned.
The Ranking Member on our Subcommittee, Mr. English, and I,
both have a long history in trying to combat the growing
problem of AMT on middle-income families. I believe sincerely
that we both want to see some long-term solution enacted so
that we can frankly move on to other subjects.
We had two very good hearings at the Subcommittee level,
and the staffs worked together to find excellent witnesses
across the board. Our first hearing took a big picture look at
the issue, including testimony from a Treasury witness and the
taxpayer advocate. No one was in disagreement that AMT is a
real problem for this Congress and beyond.
Our second hearing focused on individuals and tax
practitioners who have had real life experience with AMT. We
heard from Maggie Rah, a constituent of mine from Chicopee,
Massachusetts, whose family income of $75,000 will kick her,
her husband and three kids into the AMT for 2007. Maggie told
us that the extra 1,300 in AMT taxes means no trip to Disney
World this year. We heard from Michael Day, a veteran
firefighter from Baltimore County representing the rank-and-
file firefighters, many of whom have or will be hit by AMT this
year. He referred to the AMT as a middle-class punch, and he's
right.
I have brought some slides to illustrate the problem that
Maggie and Michael identified. In slide one, this will show--
and it's from CRS, incidentally--it shows that the income level
at which taxpayers might expect to AMT for 2007. You can see
that a family of four taking the standard deduction and earning
$66,000 may well pay higher taxes in 2007 because of AMT.
Now let's step back and take a look at the national level.
Slide two. The next slide is from the Joint Committee on
Taxation. Joint Tax briefed our Members a few months ago and
prepared this data at the time. It shows that almost half of
the 23 million AMT returns for 2007 will be from taxpayers
earning between $100,000 and $200,000 annually. It also shows
that almost half of the taxpayers in the 75,000 to 100,000
income group will be affected by AMT.
The next slide, slide three, is another way to look at the
macro data. It's from the Congressional Budget Office, and it's
from 2005. But the spike when the patch expires is the same.
Note the huge jump in liability for taxpayers in the $50,000 to
$100,000 range, from almost nothing to 40 percent of that
income group. Also in the $100,000 to $200,000 range, you will
see a spike from about 15 percent to--listen to this--80
percent of taxpayers in that group.
These are people like Maggie Rah and Michael Day paying
more in taxes than they thought and losing the tax cuts that we
promised them.
Slide four, the next slide also from Joint Tax, shows
exactly how much of the recent tax cuts are lost to alternative
minimum tax. You'll see that almost 60 percent of the tax cuts
are taken back by $80,000 in income. But that those families at
$200,000 are only losing 35 percent of their cuts. The AMT has
a very skewed distribution.
Slide five, the next slide, is from CRS on this same topic
and highlights the takeback level in effect of AMT on a family
of four at various income levels. The results are the same as
Joint Taxes, but you can see going across the columns how it
seems that everyone was going to get a tax cut compared with
the 2001 tax level, but many, particularly those between
$80,000 and $150,000, got much less of a tax cut than was
promised.
As you saw in the earlier Joint Tax slide, those making
over $500,000 a year represent a tiny fraction of AMT returns
and therefore lose little, if any, of the promised tax cuts.
Last, let me conclude by using a slide from the Treasury
Department. You'll note that we were very careful not to use
any information or data from think tanks or partisan activity.
Instead, we depended upon the professionals who advise us very
day in a very important manner.
This slide, slide six, shows how the AMT will soon overtake
regular income tax in that it will cost more to repeal AMT in
2013 than the regular income tax. For those of us that are
gardeners, you can appreciate how difficult it is to get rid of
an invasive plant like kudzu or bamboo. The more you trim it,
the it seems to thrive. The AMT is the kudzu of our Tax Code. I
think we should stop trimming it and look for a permanent
solution in a bipartisan way.
Many have quibbled over whose fault it is, but I will note
for the record--and I had the staff go back and get the
document--when Wilbur Mills called up the conference report on
tax reform on November 22nd of 1969. The vote was 381 in favor,
2 opposed, and 50 did not vote.
This is a bipartisan problem. It demands a bipartisan
solution. I thank Chairman Rangel for taking up the issue once
again.
Chairman RANGEL. Thank you. Thank you. Again, I'd like to
publicly thank Jim McCrery for his effort to, at least on our
Committee, to have some degree of civility, even though it's
abundantly clear that our political persuasions do not allow us
to come together in agreement as much as we would like.
Having said that, we look forward to having as much input
that you can provide as we move forward to reform the Tax Code,
and we do hope if there's areas of concern that you have, that
you feel comfortable not only at the hearing, but Jim and I
intend to have caucuses where we can exchange with each other
changes we'd like to have made. So, at this point, I yield to
the Ranking Member, Jim McCrery.
Mr. MCCRERY. Thank you, Mr. Chairman. I do want to thank
you for holding this hearing today. It's going to be a hearing
that undoubtedly will cover a wide variety of tax topics, and
we all look forward to that. It's going to be a long day, I
think. So recognizing that, I'm not going to give a formal long
opening statement. I might submit something for the record with
your permission, Mr. Chairman. But I do want to compliment you
and your staff. Generally speaking, you all have been open to
us, open to our suggestions, even though you know we can't
support a final product sometimes, you have been willing to at
least take our suggestions and look at them. That has not
always been the case. You have surprised us a couple of times,
and I'm sure that was just an oversight on your part and it
won't happen again.
[Laughter.]
Mr. MCCRERY. So, thank you very much for the spirit that
you continue to exhibit in running this Committee both at the
Member level and the staff level. So, with that, Mr. Chairman,
I look forward to today's hearing and exploring a wide variety
of topics with the Committee.
Chairman RANGEL. We have an extraordinary list of
outstanding people that have adjusted their schedule in order
to bring their ideas with us. Most of you have national
reputations, and the Committee really appreciates the fact that
you're testifying publicly. As our staffs have asked that
hopefully we would ask you to exchange some ideas with us on
certain specifics if at the end of the day something had been
missed. But I want to thank you on behalf of the full Committee
for your dedication to your country and to this cause.
We have Dr. Leon Burman from the Urban-Brookings Tax Policy
Center; Jason Furman, Director of The Hamilton Project,
Brookings Institute; Douglas Holtz-Eakin, Senior Fellow, The
Peterson Institution, and of course we know him as the former
Director of the Congressional Budget Office.
We'll start with Dr. Burman. Most of you know that we do
have the 5-minute rule and that your entire statements without
objection, as well as the statement from--the opening statement
from the Minority Leader, will be placed into the record
without objection. Once again, we thank you and start off with
Dr. Burman.
STATEMENT OF LEONARD E. BURMAN, Ph.D., DIRECTOR, URBAN-
BROOKINGS TAX POLICY CENTER
Mr. BURMAN. Thank you, Mr. Chairman, Ranking Member
McCrery, Members of the Committee. Thank you for inviting me to
discuss the issues of tax fairness, the 2001-2006 tax cuts, and
the individual alternative minimum tax.
Economic inequality is rising dramatically. Middle-class
families are working harder than ever and productivity is
soaring, but almost all of the gains are going to a tiny sliver
of the population at the very top of the income scale.
What explains the rising inequality? Increased
globalization, information technology, the decline in labor
unions and the development of a winner-take-all society where
top performers receive almost all of the economic rewards are
all candidate explanations. None of these factors is likely to
reverse, so the trend in inequality appears inexorable.
This is a problem. First, it is demoralizing for families
to work so hard and fall further and further behind. Second,
even if you believe that most economic growth arises from the
efforts of a few highly talented individuals who deserve their
outsized pay, rising inequality spurs populist calls for
measures that could be very damaging to the economy, such as
trade restrictions.
By comparison, a progressive income tax is a relative
efficient way to reduce the disparity of aftertax incomes. But
at the same time that income inequality has been approaching
levels not seen since the Great Depression, the Federal tax
system has become much less progressive.
Congress has enacted more than $2 trillion in tax cuts
since 2001, disproportionately concentrated on the rich. In
2006, the bottom 20 percent of income earners got an average
$20 tax cut--three-tenths of a percent of their income. Most in
that income group got nothing. The top 20 percent got an
average tax cut of almost $5,800 or 5.4 percent of income. At
the very top where the big winners in the economic lottery
reside, the average tax cut was more than 6 percent of income.
The tax cuts had another unfortunate side effect: they
threaten to throw millions of American families onto the AMT.
Under current law, over 23 million taxpayers will owe AMT this
year. That's more than twice the number who would have been
subject to the tax if the Bush tax cuts had not been enacted.
The tax now hits families with very modest incomes and no
special deductions, as Mr. Neal pointed out. For example, a
couple with four kids earning $75,000 would see their tax more
than double in 2007 because of the AMT.
The AMT also--at least in theory--takes back a substantial
portion of the Bush tax cuts. Unless Congress prevents it, the
AMT will slice 20 percent off of those cuts in 2007. Because
they're on the AMT, that hypothetical family of six would get
no benefit from the lower tax rates or higher standard
deduction enacted in 2001.
Of course, Congress doesn't want to face the wrath of 23
million angry AMT taxpayers. If past practice is a guide, you
will again raise the AMT exemption for a year or two to spare
most of the middle class from the tax. I share Mr. Neal's view
that that would be an unfortunate response.
But this means that the 2001-2006 tax cuts were really a
lot bigger than budgeted. The total bill includes the cost of
the periodic, increasingly expensive patches. In 2007, the
patch would reduce revenues by over $50 billion. Put
differently, the AMT masked a big part of the tax cuts, and
probably allowed Congress to enact cuts much larger than it
would have, had all of the cost been considered.
The ironic fact is that even though the AMT appears to be a
money machine, it has actually undermined fiscal discipline by
hiding the full cost of large tax cuts.
The AMT has other notorious defects. It's hideously
complex. It actually raises marginal tax rates on most of its
victims, undermining economic efficiency. And It is unfair,
hammering married couples, especially those with children, and
disallowing legitimate deductions. It is the perfect storm of
bad tax policy.
So, what should we do? The best approach would be to
finance repeal of the AMT by broadening the tax base--for
example, eliminating the deductibility of state and local
taxes--rather than raising rates. Even better, AMT repeal could
be part of fundamental tax reform, but there are obvious
political challenges to either approach.
Fortunately intermediate options exist that would help a
lot. I have suggested financing AMT repeal with a surtax that
would apply only to high income taxpayers. It would be very
simple for taxpayers to comprehend and comply with. The
Committee on Ways and Means majority staff has reportedly
considered retargeting the AMT at those with very high incomes
and offsetting the revenue loss through an additional income
tax.
Any repeal or reform option should be budget neutral, as
the PAYGO rules require. Repealing the AMT without offsetting
tax increases or spending cuts would drain Federal tax revenues
just as the baby boomers start retiring, and demands on the
Federal Government begin to swell. Outright repeal of the AMT
without any other offsetting changes would reduce tax revenues
by more than $800 billion through fiscal year 2017 assuming
that the 2001-2006 tax cuts expire as scheduled. If the tax
cuts are extended, the revenue loss nearly doubles to almost
$1.6 trillion. Thank you.
[The prepared statement of Mr. Burman follows:]
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Chairman RANGEL. That 800 million loss in revenue based on
eliminating the AMT, this I'd assume that the President's tax
cuts that are supposed to expire in 2010 has expired?
Mr. BURMAN. Yes it does. The cost doubles if the tax cuts
are extended.
Chairman RANGEL. That would be over $1.5 trillion?
Mr. BURMAN. It would be almost 1.6 trillion, according to
our estimates.
Chairman RANGEL. So, somewhere along the line, we need some
economists to share with us, assuming the bill is revenue
neutral, as to what is the best way to distribute the tax
liability, either in the higher income people whose cut is
expected to expire on 2010, or to take the same amount of
moneys and have the middle class be able to enjoy the benefits
of that cut. Is that basically where you end up?
Mr. BURMAN. Yes. One of the ironic things about the AMT, as
Mr. Neal said, is that it actually doesn't affect very many
people in the very, very highest income levels. You're actually
more likely to be subject to the AMT if you earn between
$75,000 and $100,000 than if you earned over a million dollars.
It's an irrational tax system, especially given that it was
originally designed to make millionaires pay some tax.
Chairman RANGEL. Of course, if you took in consideration
changes in the child tax credit and the earned income tax
credit, you could have an even more equitable distribution of
the tax liability. Is that correct?
Mr. BURMAN. Sure.
Chairman RANGEL. Good. Director Furman from The Hamilton
Project, Bookings Institute. Thank you for being with us again.
STATEMENT OF JASON FURMAN, DIRECTOR, THE HAMILTON PROJECT,
BROOKINGS INSTITUTION
Mr. FURMAN. Thank you for having me again, Mr. Chairman,
Mr. McCrery, Members of the Committee, to talk today about how
to make our tax system more fair and equitable.
As you consider tax changes, I recommend keeping in mind
three factors. First, the direct impact of tax changes on take-
home pay. Second, the economic effects of tax changes on
before-tax incomes. Third, how the associated budgetary changes
will affect future taxes and benefits for working families.
Using an integrated approach, which I call dynamic
distributional analysis, all three factors can be incorporated
into a single variable--the change in the aftertax household
income. My testimony today applies dynamic distributional
analysis to assess the long-run economic impact of the 2001 to
2006 tax cuts on working families. The bottom line: My analysis
shows that even if you assume the tax cuts help the economy,
even if you assume they boosted incomes, even if you assume
that they partly paid for themselves through that, when you
take into account the financing of the tax cuts in the long
run, 74 percent of families would be left worse off with lower
aftertax incomes. If none of those rosy scenarios took place,
it would be even worse.
Let me now walk you through the three steps in this
analysis. First, the direct impact of the 2001 through 2006 tax
cuts. Making the tax cuts permanent would result in a 0.7-
percent increase in aftertax incomes for the bottom quintile,
and a 6.7-percent increase in incomes for the top 1 percent.
That translates into an increase in aftertax income inequality.
Second, I turn to the impact of the tax cuts on the
economy. Well designed tax cuts that are paid for without
increasing the deficit can have a modest positive impact on
growth. For example, Treasury studied the effects of making the
tax cuts permanent under the unrealistic assumption that they
were paid for with reduced spending. Their analysis concluded
that the tax cuts could raise national output by an amount
equivalent to raising the growth rate by 0.04 percent annually
spread over 20 years. Picture that. Instead of the quarterly
growth rate being 3.0 percent, it would be 3.04 percent, a
change that would be barely perceptible in data on the economy.
The recent tax cuts, however, were enacted in conjunction
with increases in spending and larger deficits. In this case,
economic models generally show that the result of the higher
debt is lower national savings, more foreign borrowing, less
capital formation, and ultimately lower national income.
Treasury itself found that given the current trends in fiscal
policy, the sooner we eliminate the tax cuts, the higher
national income would be.
Third, let's consider how the budgetary implications of the
tax cuts affect families. Every official scoring agency and
credible economist has consistently stated that tax cuts do not
pay for themselves through stronger growth. At best, stronger
growth may offset a small fraction of the cost of tax cuts. At
worst, tax cuts lead to higher debt, lower savings, hurting the
economy and magnifying their budgetary cost.
The recent revenue surprises do not alter this conclusion,
especially since we have seen so many revenue surprises that go
in the opposite direction, including positive revenue surprises
following the 1990 and 1993 tax increases, and negative revenue
surprises following the 1981 and 2001 tax cuts.
Tax cuts inevitably require reductions in government
spending or increases in future taxes. In either case, their
indirect budgetary effect serves to reduce disposable incomes
by reducing government benefits or raising taxes. Although some
of the costs could fall on future generations, much of them
will fall on the very same household that receives the tax cuts
today. For example, a person might get a $500 tax cut today but
lose $700 in present value terms in future Medicare benefits.
Finally, although many analysts have considered these three
channels in isolation, they should be combined together into a
single, consistent assessment. Table 3 of my written testimony
provides such an integrated assessment of making the tax cuts
permanent. As you will see under the most optimistic
assumptions, assuming that the tax cuts help pay for
themselves, three-quarters of households would still end up
with lower aftertax incomes if they were made permanent. This
is because for most families, the tax cuts and modest boots to
incomes are not nearly enough to compensate for the reduction
in future government transfers like Social Security, Medicare
and Medicaid.
As the old saying goes, there's no such thing as a free
lunch. Cutting taxes for the most affluent almost inevitably
results in long-run reductions in the disposable income of
working families. This lesson is confirmed by dynamic
distributional analysis.
Thank you again for the opportunity to address this
Committee. I look forward to your questions.
[The prepared statement of Mr. Furman follows:]
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Chairman RANGEL. Thank you so much.
Douglas Holtz-Eakin, Senior Fellow, The Peterson Institute,
and someone that has provided invaluable service to the
Congressional Budget Office and the Congress, welcome back.
STATEMENT OF DOUGLAS HOLTZ-EAKIN, SENIOR FELLOW, THE PETERSON
INSTITUTE, AND FORMER DIRECTOR, CONGRESSIONAL BUDGET OFFICE
Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman, Mr. McCrery and
Members of the Committee. It's a privilege to be here today.
I've submitted a relatively long statement for the record. Let
me take a few moments to make really three basic points about
assessing the status of the U.S. Tax Code.
Point number one is that it is the job of the Tax Code to
raise funds to finance spending. It exists only for that
purpose. In that regard, the Tax Code is currently doing pretty
well. For fiscal 2007, the CBO projects that the Federal
Government will raise 18.8 percent of GDP in revenues, above
the typical amount in the past 40 years. The Federal Government
will spend about 20 percent of GDP in Federal spending, a touch
below the average for the past 40 years, and the result will be
a deficit of 1.2 percent of GDP, a bit lower than the typical
performance of the Federal Government.
So, in terms of paying the bills----
Chairman RANGEL. Excuse me. Are you including defense
spending in that?
Mr. HOLTZ-EAKIN. It's the CBO projection for the unified
deficit, all revenues, all spending. So, that's for fiscal year
2007. Now we know it hasn't been doing quite that well in
recent years. Deficits have been larger, but we've seen quite
rapid revenue growth in recent years. We've seen double-digit
growth in some portions of tax receipts. Notable portions are
corporate income taxes and capital gains taxes. I don't think
it's sensible to project that we'll get double-digit growth
forever, but there doesn't appear to be any pervasive problem
in raising revenue out of this Tax Code.
Going forward, the major focus will be on the spending
side, where as is well known to this Committee, we will see
Social Security, Medicare and Medicaid rise under current
trends to a size that's comparable to the current entire
Federal Government--20 percent of GDP--if we get good news in
the health programs. If we don't, it will be larger yet.
How will this play out? One possibility is we'll borrow
money until credit markets say no and leave our kids with a
very large bill. Another possibility is we'll try to raise
taxes by 50 or 75 percent above their current levels and
cripple this economy regardless of whether you're a ``supply
sider'' or not. In either case, we will leave to the next
generation a burden that is inappropriate, and that is the most
pressing fairness issue facing this government, it's the most
pressing fairness issue facing this Committee, which has
jurisdiction over all those pieces that are the key components
of the fiscal challenge.
So, right now we're doing okay, but going forward, we must
control the spending, and that's the central fairness issue
that we face.
The second part of the review would be to look at the
ability of the Tax Code to raise revenue without additional
extra costs, and there I can't say that we're doing so well.
Everyone who looks at the regular Tax Code and then adds on the
alternative minimum tax comes to the conclusion that the U.S.
income tax is a Byzantine, complex morass that most individuals
simply cannot navigate. The President's tax panel put a price
tag on the cost of this and said that it imposes an extra $140
billion per year--a thousand dollars for every man, woman and
child--in just complying with the Tax Code. We clearly can do
better and not impose an extra burden on the families of the
United States in raising our revenue.
A second cost, typically hidden, is the cost that the Tax
Code imposes in the form of economic distortions; changing the
way markets and families would like to do their business just
for tax purposes, and a lot of financial engineering that we
hear so much about. These are big costs to an economy that
needs to grow to face the burdens of the baby boom, and that
needs to be internationally competitive. If you look at the
double tax on saving, if you look at the extra taxation on some
forms of business, you look at the differential taxation of
fringe benefits, you look at all sorts of high marginal tax
rates, particularly for low-income individuals, this is a Tax
Code that has compliance burdens and efficiency burdens that
should be reduced, and it's not doing very well on that front.
The last part is fairness. As the written testimony says,
there are lots of complications in assessing fairness. So, the
caveats are, one, we don't have an agreed-upon consensus on
what fairness means. Two, we must distinguish between who sends
in the check and who bears the economic burden of a tax, the
genuine incidence. Three, there's lots of competing measures.
I'll simply touch the high points, which is you can imagine
a neutral system being one where we tax you equal to what you
get back from the government, and you can look at the current
tax system where low-income individuals, 40 percent of which
pay no income tax, receive back benefits, so there's a
redistribution toward them. High-income individuals who pay the
vast majority of income taxes, do not receive back benefits
comparable to that, and so we have a system that is by any
measure in the large a progressive tax system that
redistributes toward those at the lower end of the income
distribution.
The second part of fairness would be do we treat equal
taxpayers equally? The answer is no. We treat people with the
same lifetime incomes who save and tax them more heavily than
those who do not. We treat renters less generously than we do
people who buy their homes. We treat people who pay equity in
their homes less generously than those who borrow. We treat
people who receive their services through state and local
governments more generously than those who do not. The list
goes on and on.
So, we have a system that is meeting our revenue needs, but
will not in the future unless we come to terms with our
spending problem. That's the primary problem on fairness. We
also have a system for any given level of revenue has severe
impacts on our ability to grow and compete and doesn't meet the
standard of fairness. We could use a much better Tax Code.
Thank you. I look forward to the chance to answer your
questions.
[The prepared statement of Mr. Holtz-Eakin follows:]
Prepared Statement of Douglas Holtz-Eakin, Senior Fellow, The Peterson
Institute, and Former Director, Congressional Budget Office
Chairman Rangel, Ranking Member McCrery, and Members of the
Committee, thank you for the opportunity to participate in this
important hearing. The topic of tax fairness raises myriad issues. In
my comments today, I will focus on only a subset of the possibilities.
1. Objectives of Tax Policy
Paying the bills. The central purpose of the Tax Code is to raise
revenue to finance Federal outlays. According to the Congressional
Budget Office (CBO), for fiscal 2007 total revenues will be nearly 19
percent of Gross Domestic Product (GDP)--above the average for the past
40 years--yet fall below total Federal spending equal to about 20
percent of GDP.\1\ The resulting unified budget deficit of 1.2 percent
of GDP lies well within the range of historical budget outcomes.
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\1\ Congressional Budget Office, The Budget and Economic Outlook:
An Update, August 2007, p. xi.
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Unfortunately, in the years to come mandatory spending programs
will grow quite rapidly.\2\ The rising fiscal pressures emanating from
spending on Social Security and health programs, if left unchecked,
will threaten the three pillars of U.S. post-war economic success.
First, the successful U.S. economic strategy has been to rely largely
on the private sector; the mirror image of this approach being a
government sector that is relatively small (granted, ``small'' is in
the eye of the beholder) and contained. Growth in spending of the
magnitude promised by current laws guarantees a much larger government.
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\2\ See Congressional Budget Office, The Long-Term Budget Outlook,
December 2005.
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Second, the small U.S. Government has been financed by taxes that
are relatively low by international standards and interfere relatively
little with economic performance. Spending increases of the type
currently projected would entail taxes higher by 50 percent or more to
unprecedented levels. Such a policy would impair economic growth and
reduce living standards for future generations.
Finally, a hallmark of the U.S. economy has been its ability to
flexibly respond to new demands and disruptive shocks. In an
environment where old-age programs--namely Social Security, Medicare
and Medicaid--potentially consume nearly every budget dollar, to
address other policy goals future politicians may resort to mandates,
regulations, and the type of economic handcuffs that guarantee lost
flexibility.
In sum, the ability of the Tax Code to meet its primary objective
is most threatened by the absence of reforms to mandatory spending
programs. This raises the specter of a generational injustice:
bequeathing to our children and grandchildren a rising burden of
taxation, a less robust economy, or both. The most pressing issue of
fairness cannot be addressed by raising taxes, but rather requires
reducing the growth of spending.
Keeping the burden of taxes low. The importance of keeping Federal
spending contained to national priorities and thus permitting taxes to
be as low as possible is straightforward: taxes directly reduce the
ability of families to pay their bills and save for the future.
However, even the best tax system impairs market incentives, imposes
obstacles for households and firms alike, and undermines economic
performance. A goal of tax policy should be to keep such interference
and waste as small as possible.\3\
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\3\ This loss is sometimes referred to as the ``efficiency cost,''
``deadweight loss,'' or ``excess burden'' of the tax system and
captures the reality that there is a loss to households above and
beyond the amount of tax revenue collected.
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In this regard, unfortunately, our Tax Code is in need of a major
overhaul. A vivid example of the type of distortion our Code presents
is provided by health insurance. At present, employer-provided
insurance is not treated as part of income so companies offer health
insurance coverage as a tax-free benefit instead of higher wages or
salaries. Employees and employers alike respond to the tax-based
incentives and change compensation packages. The result is less revenue
(and the need for higher tax rates elsewhere). The flip side of the
coin is demand for more and more generous insurance which drives up
insurance costs. In some cases, individuals go without insurance as a
result. If individuals purchase insurance themselves, they do not
receive the same tax treatment as when their employer purchases for
them, generating biases in health insurance markets. In short, a
poorly-designed Tax Code exacerbates our pressing health insurance
issues.
The provision of health insurance is just one of a multitude of
economic decisions within our $13 trillion economy. Tax-based
distortions permeate our daily economic lives. Decisions on saving,
retirement, education, investment, debt and equity finance are driven
by tax-based planning to the detriment of our ability to meet pressing
national needs. The Tax Code is a basic impediment to the United
States' ability to grow robustly and compete in global markets.
The loss in economic performance is exacerbated by the sheer cost
of complying with an overly complex Tax Code. According to the
President's Advisory Panel on Federal Tax Reform, ``If the money spent
every year on tax preparation and compliance was collected--about $140
billion each year or over $1,000 per family--it could fund a
substantial part of the Federal Government, including the Department of
Homeland Security, the Department of State, NASA, the Department of
Housing and Urban Development, the Environmental Protection Agency, the
Department of Transportation, the United States Congress, our Federal
courts, and all of the Federal Government's foreign aid.''\4\
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\4\ See the final report at http://www.taxreformpanel.gov/final-
report
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Fairness. A final objective is to raise taxes in a fair fashion.
Unfortunately, there are two major obstacles to an easy evaluation of
the success in meeting this standard. The first is figuring out who
really pays a tax.\5\ For example, in 2006 the Federal Government
raised $354 billion from the corporation income tax. However,
corporations did not ``pay'' the tax in any meaningful sense--they
merely sent in the check. In the process of meeting their tax
obligation, however, firms could have raised prices, cut back on wages,
reduced fringe benefits, slowed replacement of equipment or scaled back
expansion plans, cut dividends, or many combinations of their options
to alter their revenues and cost structures. The result is that the
corporation tax is ``paid'' by customers, workers, or investors.
Indeed, recent evidence suggests that the relatively high rate of the
U.S. corporation income is ultimately paid by workers in the form of
lower wages.\6\
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\5\ This is referred to as determining the economic incidence of a
tax.
\6\ See Kevin Hassett and Aparna Mathur, ``Taxes and Wages,'' AEI
Working Paper #128, 2006.
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A second difficulty is the absence of an ethical consensus on
distributional fairness. In the absence of such benchmark, two
guidelines prove useful. The first is to note that individuals view
market transactions as a ``fair deal'' when they get back value equal
to what they paid. By analogy, a benchmark for judging the tax system
is whether a taxpayer's liability is equal to benefits received from
the Federal budget--a neutral system. If benefits received exceed
taxes, the household is a net beneficiary of the tax system and vice
versa.
This perspective differs from two other metrics that are commonly
employed--effective tax rates and tax shares. Effective tax rates are
the ratio of taxes paid to income--roughly the share of income taken by
taxes. A drawback to evaluating fairness using effective tax rates is
that the rates may change because of movements in the denominator--
families' incomes--that have nothing to do with tax policy. Incomes are
influenced by taxes, but also are determined by skills, education,
effort, risk-taking and innovation, regulations, and other factors. Tax
shares--the fraction of the overall taxes that each individual pays--
have the drawback that they ignore the spending side of the equation.
Given that taxes are necessary only because of spending, this omission
is striking.
Viewed from this perspective, the U.S. Tax Code is highly
progressive--lower income individuals receive much more than they pay
in taxes. According to the CBO, the bottom 40 percent of the income
distribution paid no Federal income tax in 2004.\7\ Of course there are
other taxes. In particular, payroll taxes are the largest tax for a
majority of households. But examining the payroll tax is ultimately a
reminder of the need for social security reform. The progressivity of
this programs will depend upon the scale of the benefits individuals
receive in the future.
---------------------------------------------------------------------------
\7\ See Congressional Budget Office, Historical Effective Tax
Rates: 1979 to 2004, December 2006.
---------------------------------------------------------------------------
A second perspective on fairness stems from the fact that the Tax
Code assigns taxpayers with the same income, number of children, and
other factors different tax burdens. As noted above, taxes will differ
depending on whether a family purchases health insurance or receives it
as part of an employer compensation package. Two families with the same
income will pay different taxes because they reside in different
states, and some families receive state-provided services for which
they can deduct income and property taxes. A person who saves more of
their earnings in taxable accounts will pay more in taxes than a non-
saver who has the exact same earnings year by year. Indeed, some
inequality may stem from the sheer complexity of the Tax Code and the
inability of individuals to take advantage of tax benefits for which
they are eligible. These differences between otherwise similar
taxpayers are at odds with basic fairness and undermine faith in the
fairness of the Tax Code.
Summary. The most pressing tax fairness issue facing the United
States is the potential for dramatic tax increases, slower income
growth, and reduced standards of living for future generations if the
spending growth profile of the Federal Government is not reduced. All
other fairness issues pale by comparison.
At present, the Federal tax system is roughly achieving its goal
of providing financing for Federal spending. However, there is little
else to defend in the current Tax Code. It is overly complex and
burdensome, interferes too much with commerce and economic
competitiveness, and is riddled with uneven treatment. Far-reaching
reforms are merited; more modest efforts will not succeed in raising
Federal revenues in a pro-growth and fair fashion.
2. Recent Issues in Tax Policy
In recent years, there have been numerous changes in Federal tax
laws which has, in turn, spawned vigorous discussion regarding tax
policy.
Recent Trends in Tax Receipts. Table 1 shows total Federal revenues
and key components over the period 1996-2006. As the table makes clear,
Federal receipts are currently growing quite rapidly. Total receipts
have grown at 14.5 percent and 11.8 percent in fiscal 2005 and 2006,
respectively; a pace that exceeds the celebrated revenue surge of the
1990s that drove the Federal budget to balance. Individual income tax
receipts are also rising at rates above those from the earlier period,
driven in part by growth rates of capital gains receipts equal to 21
percent, 38 percent, and 23 percent in the years 2004-2006. Even more
striking has been the very rapid increase in corporation income tax
receipts, which hit a recent peak growth rate of 47 percent in 2005.
Such rapid growth cannot, of course, be sustained indefinitely when the
underlying economy is growing at 5-6 percent per year. However, the
evidence to date suggests that the current tax system is generating
adequate revenue growth.
Tax policy and economic growth. Overall GDP growth fell
dramatically in 2001 (0.8 percent) and 2002 (1.6 percent) as the
economy suffered a recession and weathered the impact of terrorist
attacks, corporate scandals, and higher energy costs. Since that time,
annual GDP growth has averaged 3 percent and solid growth in payroll
employment has resumed. Most analysts credit the 2001 Economic Growth
and Tax Relief Reconciliation Act (EGTRAA) with mitigating the extent
of the falloff in economic growth, largely because its passage very
nearly coincided with the economic downturn.
It is best, however, to view this timing as fortuitous and not as a
signal that future Congresses should attempt to engage in fiscal
``fine-tuning'' that attempts to counter the inevitable business cycles
of the future. Instead, it would be preferable for tax policy to focus
on promoting robust, long-term economic growth. What would such a Tax
Code look like?
Consumption-based taxation.\8\ A consumption tax is just what it
sounds like: a tax applied to consumption spending. However, under that
deceptively simple umbrella resides a vast array of potential variants.
Consumption taxes can be flat or contain multiple rates; can be applied
to households, firms, or both; and can be viewed as ``direct'' or
``indirect'' taxes.
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\8\ This section draws on Douglas Holtz-Eakin, ``The Case for a
Consumption Tax,'' Tax Notes, October 23, 2006.
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For purposes of my remarks today, let me focus on a few identities
that give the flavor of the issues. For a household--or the country as
a whole--all income (Y) is either consumed (C) or saved (S): Y=C+S.
This suggests two broad strategies for taxing consumption. One is to
tax consumption (C) as in a national sales tax. The alternative is to
tax it ``indirectly'' by levying the tax on ``consumed income''--income
after deducting saving or investment: (Y-S). This is the strategy taken
by a value-added tax (VAT), the Hall-Rabushka flat tax, or the ``X-
tax'', a more progressive variant of the Hall-Rabushka tax developed by
the late David Bradford.
Interest in a U.S. consumption tax is not new. Advocates have
touted the potential benefits from moving to a consumption tax for many
years. However, I wish to separate my support from some of the more
overreaching arguments. In particular, my support for a consumption-
based tax reform is not about:
1. Simplicity. Some consumption taxes--notably the original Hall-
Rabushka flat tax--have been publicized on the basis of their
``simplicity.'' Who can forget (admittedly tax economists have a
limited reservoir of thrills) the first time they saw the Hall-Rabushka
postcard tax return? Similar simplicity arguments have been made about
a national retail sales tax, where advocates tend to argue that there
is little to do except piggyback on existing state efforts.
But this really misses the point for three reasons. First, no tax
system will be that simple. For any household, the goal is to legally
minimize its tax liability. The innate craftiness of the American
populace will dictate that any tax system will acquire a growth of
rulemaking that delimits the boundaries of acceptable behavior. That
is, a certain amount of complex rule-making will be necessary. A common
complaint of income-tax defenders is that consumption tax folks compare
an ideal consumption tax with the actual income tax. This is truly
unfair and no way to decide between the two. Second, as noted above,
for many there is nothing simpler than the current income tax--they
don't pay it. As is becoming more widely appreciated, the current
income tax is not your father's income tax. Complexity of the income
tax is the curse of those who pay it. Third, postcards are obsolete.
Today your taxes are ``done''--that is computed--by tax-preparation
software and filed on-line.
2. Making taxes more or less visible. A common argument supporting
a national sales tax is that it would make more visible the cost of
government. Perhaps, but the ultimate measure of the size of government
is its spending. Once the dollars have been committed, the taxpayer
will pay one way or the other. Either taxes will be levied to match the
spending, or there will be borrowing to cover the Federal deficit. It
may be important to raise the visibility of Congressional decisions,
but putting taxes on your register receipt does not display spending.
Indeed, if a national sales tax did produce pressure to keep taxes low,
it may do nothing to address the tsunami of future Medicare spending
and lead to larger deficits.
3. Raising the national saving rate. A consumption tax would remove
the tax-bias in favor of current consumption, and many believe that
this would raise the private saving rate. If so, then good. The main
idea is to eliminate tax-based financial decisions and have households
choose based more on the economic fundamentals. However, I suspect that
the scope for dramatic changes is somewhat limited. Instead, the most
rapid improvement in the national saving rate will come from
controlling Federal spending and thus reducing government borrowing.
Instead, a consumption tax meets the following needs of the tax
system:
1. The philosophical foundation of the Tax Code. Public policies
should mean something. As I have stressed, the Tax Code exists for a
single purpose: it exists to finance the costs of public programs. The
powerful behavioral effects of taxation are real, and a tribute to the
power of market incentives as the mechanism by which taxes influence
behavior is to change prices. Since the purpose of the Tax Code is to
raise revenue, it has as its core mission reducing the resources of
some households. The central question is why choose those who consume
over those with income. Consumption is the spending that extracts
resources from the economy. In contrast, saving is economic activity
necessary to contribute to a growing economy. Recall the identity:
Y=C+S. An income tax treats identically those high-income individuals
who live frugally and plow their resources back into the economy and
those that spend every night drinking champagne in a limousine while
hopping from club to club. Taxing consumption reduces the burden on the
former, while focusing it on the latter.
2. Economic efficiency. A consumption tax would reduce the extent
to which economic activity is dictated strictly by reducing taxes (an
unproductive use of time and money). First, it broadens the tax base to
include all consumption. The essential recipe in any tax reform is to
broaden the tax base and lower tax rates. Specifically, the base would
include the consumption of employer-provided health insurance
(currently entirely untaxed) thereby correcting a major inefficiency
that feeds health spending pressures. In addition, it would eliminate
the current deduction for state and local taxes, thereby including
consumption provided by sub-Federal Governments. Thus, it would improve
the allocation of consumption spending across sectors.
A consumption tax would not distort household choices in the timing
of consumption--after all you would either pay the tax now or pay it
later. In contrast, under an income tax households pay at both times if
they choose to save and consume later. A consumption tax would equalize
the tax treatment of investments in physical capital, human capital,
and intangible capital. At present, the firm purchases of the latter
two types of investment are ``expensed'' (immediately deducted), while
physical capital expenditures are depreciated. Moreover, by eliminating
the deduction for mortgage interest, the allocation of physical capital
would be improved as business investments would compete on a level
playing field with the construction of housing.\9\
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\9\ For estimates of the long-run impact on economic growth, see
``Simulating Fundamental Tax Reform in the United States'' by David
Altig, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and
Jan Walliser, American Economic Review, 574-595.
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A desirable feature that is difficult to quantify is the impact on
entrepreneurs. Entrepreneurial forces are widely acknowledged to be
important to the success of the United States, but tax policy is rarely
formulated with an eye to their incentives. For example,
entrepreneurial ventures develop a scale and financial structure
dictated by market conditions. In contrast, the Tax Code interferes
with these incentives--extracting a double tax on equity in ``C
corporations'', subsidizing leverage, and thus distorting the choices
of business form and financing. The flat business-level tax does not
depend on financial structure--it is focused on ``real'' business
transactions--and yields the same liability regardless of legal
organization.
3. Acknowledgment of reality. Our current income tax is an exercise
in fantasy. An important part of its administration is the taxation of
the return to capital. To be successful, this requires that capital
income--interest, dividends, capital gains, rents, royalties--be
comprehensively measured and adjusted for depreciation and inflation.
There is no reason to believe that the U.S. is even moderately
successful in this effort, or that the continuing maturation of global
financial markets will make it anything but less successful in the
future. A consumption tax focuses the tax base on real economic
activity--not financial transactions. This is an important difference
in a world in which global financial markets have made if virtually
impossible to tax capital income, and an excessive regulatory and
enforcement regime has grown up around attempts to do so. Instead, the
consumption tax focuses on ``taxing at the source'' before business
income enters into financial markets and ultimately is paid to
investors.
Specifically, the X-tax (along with the VAT or flat tax) would
impose a single-rate business-level tax on a base that consisted of
total receipts minus the sum of purchases from other firms and employee
compensation. Implicit in those receipts is the contribution of
capital, which is taxed prior to distributions in the form of dividends
or interest.
4. Fairness. Because a consumption tax is neutral regarding the
timing of consumption, it does not penalize those patient households
that save their income for a greater lifestyle later in life. That is,
two households with the same lifetime income will pay the same lifetime
taxes. More generally, consumption taxes may be designed to achieve
conventional distributional goals. To begin, under the X-tax,
households are taxed on the basis of comprehensive employee
compensation. However, such a system would include a generous exemption
for a basic standard of consumption and a progressive rate structure.
A concern often raised is that taxing compensation permits high-
income individuals to ``avoid'' tax on their capital income. However,
an appropriately-designed consumption tax includes the vast majority of
such earnings in its base. In the X-tax, saving and investment is
immediately tax-deductible or expensed, but all principle and interest
is taxed in the form of revenues at the entity level. Mechanically,
this differs from an income tax only by the fact that under an income
tax the saving and investment would be depreciated and not expensed.
That is, the two approaches differ only by the timing of tax receipts
to the U.S. Treasury--less up front for the consumption tax because of
expensing, but more in later years because there is no ongoing stream
of depreciation. Accordingly, the two tax bases differ only by the
return to Treasury securities--the least risky and lowest rate of
return. All additional returns--accruing from risk, monopoly power,
luck, and other sources--are included in the tax base of both tax
systems. Since these types of capital returns are responsible for the
largest differences in incomes and consumption tax would capture these
in the base, the distributional consequences of such a consumption tax
would be in accord with U.S. tradition.
JGTRAA and pro-growth taxation. Viewed from this perspective, the
2003 Jobs and Growth Tax Relief Reconciliation Act is an important
step. Reduced taxation of corporate equity returns reduces the bias
toward debt finance, lowers the misallocation of capital in the economy
and, combined with partial expensing of some investments represents a
step toward a more efficient Tax Code. An impediment to fully realizing
the potential of this improved tax policy, however, is the fundamental
uncertainty over the future of the Tax Code. Eliminating this
uncertainty, keeping taxes low and efficient, would benefit overall
economic performance.
The Alternative Minimum Tax. The Alternative Minimum Tax (AMT) has
attracted attention in recent years because of the growing number of
taxpayers who are projected to become liable for the AMT, the fact that
the most affluent of taxpayers are longer exclusively the payers of the
AMT, and the fact that most additional taxpayers will become liable for
the AMT because the effects of inflation. Thus, in the narrow the major
tax policy issue is the failure of Congress to index the AMT.
Viewed from a broader perspective, however, the AMT raises larger
issues. To begin, although some argue that the AMT is a better tax
because it has a broader base (achieved by disallowing exemptions and
deductions) and only two relatively low statutory rates, this is
misleading. From an equity standpoint, there is a long history of
acknowledging the impact of family size on tax liability and the AMT
does not. From an economic efficiency standpoint, the key issue is that
effective marginal tax rates are not always than the regular tax's
marginal rates; sometimes, they are actually higher. A large portion of
the AMT's lower rates reflects the tax-free threshold's zero rate. Once
the AMT kicks in, the marginal rate jumps to 26 percent, well above the
regular system's 10 to 15 percent. The highest marginal rate under each
system is the same--35 percent.
The more general problem is that the very presence of the AMT is an
indictment of the basic Tax Code. It should be the case that a single
Tax Code can be designed to raise needed revenues, while meeting
sensible criteria for simplicity, fairness, and economic growth and
competitiveness. Attempts to ``fix'' the AMT by modifying tax brackets,
rates, or deductions will not address this fundamental problem. A more
desirable approach would be to eliminate the AMT entirely, but do so in
the context of a broader revamping of the Tax Code.
Tax policy and the distribution of economic well-being. While
recent U.S. GDP growth has been robust and payroll employment growth
sustained, concern has arisen that growth is not translating into
acceptable increases in standards of living for too many American
households. This has generated a further concern that pro-growth tax
policy per se is responsible. The facts, however, suggest otherwise.
The dominant source of change in the income distribution is a long-term
trend in the wage structure in the U.S., and not recent changes in tax
policy. To the extent that policymakers wish to address this issue, the
most fruitful approaches involve improving K-12 educational outcomes,
thereby equipping future workers with better skills and the ability to
be successful in college.
A large literature in labor economics documents a substantial
widening of the U.S. wage structure during the 1980s.\10\ Wage
differentials by education, by occupation, and by age and experience
group all rose substantially. The growth of wage inequality was
reinforced by changes in non-wage compensation leading to a large
increase in total compensation inequality. These wage structure changes
translated into a rise in household income inequality. The trend to
wage inequality in the 1990s was considerably slower than in the 1980s,
with the key feature being that the highest earners (the 90th
percentile of the wage and earnings distribution) continuing to grow
faster than the median, but no noticeable decline for low earners. The
more recent labor market data suggests a continuation of this
pattern.\11\
---------------------------------------------------------------------------
\10\ See, for example, Attanasio, Orazio and Steven J. Davis. 1996.
``Relative Wage Movements and the Distribution of Consumption.''
Journal of Political Economy 104 (December): 1227-62;,Autor, David H.,
Lawrence F. Katz, and Melissa S. Kearney. 2005. ``Trends in U.S. Wage
Inequality: Re-assessing the Revisionists.'' NBER Working Paper 11627,
September; Autor, David H., Frank Levy, and Richard J. Murnane. 2003.
``The Skill Content of Recent Technological Change: An Empirical
Investigation.'' Quarterly Journal of Economics 118 (November): 1279-
1333; Cutler, David M. and Lawrence F. Katz. 1991. ``Macroeconomic
Performance and the Disadvantaged.'' Brookings Papers on Economic
Activity, 1991:2, 1-74; Cutler, David M. and Lawrence F. Katz. 1992.
``Rising Inequality? Changes in the Distribution of Income and
Consumption in the 1980s.'' American Economic Review 82 (May): 546-51;
Goos, Maarten and Alan Manning. 2003. ``Lousy and Lovely Jobs: The
Rising Polarization of Work in Britain.'' Unpublished paper, Center for
Economic Performance, London School of Economics, September; Hamermesh,
Daniel S. 1999. ``Changing Inequality in Markets for Workplace
Amenities.''Quarterly Journal of Economics, 114(4), November, 1085-
1123; Karoly, Lynn and Gary Burtless. 1995. ``Demographic Change,
Rising Earnings Inequality, and the Distribution of Well-Being, 1959-
1989.'' Demography 32: 379-405; and Piketty, Thomas and Emmanuel Saez.
2003. ``Income Inequality in the United States, 1913-1998.'' Quarterly
Journal of Economics 118 (February), 1-39.
\11\ Another set of concerns relates to inadequacies in the
measurement of earnings, income, and standards of living more
generally. For example, (1) real wages have grown more slowly than real
compensation because benefits are a rising portion of total
compensation; (2) standard price indexes overstate inflation, causing
an understatement of real compensation gains; and (3) traditional
poverty measures failure to adequately reflect redistributive taxes and
transfers.
---------------------------------------------------------------------------
Low-income features of the Tax Code. In 2007, the Treasury projects
that the share of individual income taxes paid by low-income taxpayers
will fall, while the share of taxes paid by high-income taxpayers will
rise. At the same time, the share of taxes paid by the bottom 50
percent of taxpayers will fall from 3.8 percent to 3.4 percent. Since
there has not been a dramatic change in the distribution of spending,
this indicates that the impact is becoming more progressive. At the
very highest levels of income, this is especially true, as the share of
taxes paid by the top 5 percent of taxpayers is projected to rise from
55.3 percent to 56.5 percent.
As these figures indicate, a great many Americans pay no income tax
at all. In 2007, a married couple with two children will have no tax
liability until their income reaches $42,850. For those low-incomes
families near the poverty level, refundable tax credits like the child
tax credit and the earned income tax credit (EITC) provide payments
from the Treasury to those families. A single parent with one child and
$14,257 of income (i.e., the estimated 2007 poverty level for a two-
person family) will receive $3,410 back from the Federal Government in
2007.
Taxation of carried interests. Recent discussions and legislative
initiatives have raised the possibility of taxing so-called ``carried
interests'' as ordinary income instead of capital gains. By itself,
such a change would not improve the performance of the Tax Code. As
noted earlier, a fundamental unfairness of the current Tax Code is that
similar taxpayers are taxed differently. Under such a proposal,
investments in real estate (for example) would face different effective
tax rates depending upon whether they are undertaken by an individual,
through a real estate investment trust, or via a limited partnership.
This inequity would carry with it an efficiency cost as the higher tax
would discriminate against a particular organizational form--the
partnership--that was previously preferred by investors. Moreover, as
noted above the benchmark for efficient, pro-growth tax policy allows a
deduction from the tax base for all saving and investment, while taxing
at a common rate all cash flows. The proposed tax change imposes the
latter taxation, without the corresponding deduction. In short, it is a
move in the wrong direction for the Tax Code.
In the absence of broad reform, there appears to be little merit
to changing the tax treatment. As noted in a recent analysis by Michael
Knoll, taxing the cash equivalent of the carried interest will raise
modest amounts of revenue.\12\ In reaching this conclusion, he computes
the cash value of an option contract that mimics carried interest for
general partners, and calculates the additional taxes that would be
collected by taxing this cash grant as ordinary income. In his
analysis, this represents the additional payments that limited partners
would be required to offer in order to retain sufficient inducement to
attract general partnership talent. Another perspective on this
analysis, however, is to note that he employs a conventional formula
for valuation that assumes independent freedom to exercise the option
and deep, liquid markets for the underlying asset. In the context of
some investments, these likely overstate the reality and thus the value
of the option. At present, the Tax Code treats the grant of the carried
interest as of low and hard to quantify value, assumes reinvestment of
the grant, and taxes the result as a capital gain. While imperfect from
the perspective of investment and growth, it is preferable to the
proposed alternatives.
---------------------------------------------------------------------------
\12\ Michael Knoll, ``The Taxation of Private Equity Carried
Interests: Estimating the Revenue Effects of Taxing Profit Interests as
Ordinary Income,'' University of Pennsylvania, August 2007.
---------------------------------------------------------------------------
Taxation of publicly traded partnerships. A related initiative is a
proposal to subject certain publicly-traded partnerships to the
corporation income tax. As noted earlier, good tax policy imposes a
single layer of tax and achieves investment neutrality by integrating
the corporation and individual income taxes. Increasing the double-
taxation of saving and investment is a step in the wrong direction.
Doing so in a discriminatory, non-uniform fashion increases distortions
and represents unsound tax policy.
----------------------------------------------------------------------------------------------------------------
Table 1 Tax Receipts 1996-2006
-----------------------------------------------------------------------------------------------------------------
Year Individual Income Corporation Income Social Insurance Total Revenue
--------------------------------- Taxes Taxes Taxes -------------------
------------------------------------------------------------
Billions Growth Billions Growth Billions Growth Billions Growth
----------------------------------------------------------------------------------------------------------------
1996 656.4 11.2% 171.8 9.4% 509.4 5.1% 1,453.2 7.5%
----------------------------------------------------------------------------------------------------------------
1997 737.5 12.3% 182.3 6.1% 539.4 5.9% 1,579.4 8.7%
----------------------------------------------------------------------------------------------------------------
1998 828.6 12.4% 188.7 3.5% 571.8 6.0% 1,722.0 9.0%
----------------------------------------------------------------------------------------------------------------
1999 879.5 6.1% 184.7 -2.1% 611.8 7.0% 1,827.6 6.1%
----------------------------------------------------------------------------------------------------------------
2000 1,004.5 14.2% 207.3 12.2% 652.9 6.7% 2,025.5 10.8%
----------------------------------------------------------------------------------------------------------------
2001 994.3 -1.0% 151.1 -27.1% 694.0 6.3% 1,991.4 -1.7%
----------------------------------------------------------------------------------------------------------------
2002 858.3 -13.7% 148.0 -2.0% 700.8 1.0% 1,853.4 -6.9%
----------------------------------------------------------------------------------------------------------------
2003 793.7 -7.5% 131.8 -11.0% 713.0 1.7% 1,782.5 -3.8%
----------------------------------------------------------------------------------------------------------------
2004 809.0 1.9% 189.4 43.7% 733.4 2.9% 1,880.3 5.5%
----------------------------------------------------------------------------------------------------------------
2005 927.2 14.6% 278.3 47.0% 794.1 8.3% 2,153.9 14.5%
----------------------------------------------------------------------------------------------------------------
2006 1,043.9 12.6% 353.9 27.2% 837.8 5.5% 2,407.3 11.8%
----------------------------------------------------------------------------------------------------------------
Chairman RANGEL. Thank you all for your splendid testimony.
I hope that all of you would feel comfortable in submitting to
the chair which areas of the existing Tax Code you would
believe that we should focus on in order to make certain that
at the end of the day with our so-called reform measure that
more people will believe that we're doing the right thing.
It's abundantly clear that one of the main reasons why Jim
McCrery and I are in accord on taxes is that there's just no
justification for who got caught up in the AMT. But in order to
restore the lost revenues, we have to look at the entire Code.
Also to remember that we have to encourage investment, which
means that the Code, for good or for bad, has been used not
just to raise revenue, but to direct people's behavior. Some of
those things have worked, some of them have not worked, and
we're hoping that there are a lot of provisions in the Code
that people forgot why they were put in that we can take out
and raise some revenue.
Having said that, I'm going to yield to Mr. McCrery. But we
will be following through and getting some of your ideas so
that we can have more time to go through those things because
one of the things that I am persuaded by is that we have a
voluntary tax system because people believe that it's fair, or
we want them to believe that it's fair, and we have to do that,
and we've got a big job to do. Mr. McCrery.
Mr. MCCRERY. Thank you, Mr. Chairman. Before we proceed
with questioning the witnesses, Mr. Chairman, a former
colleague of ours on the Committee on Ways and Means, Jennifer
Dunn, we learned yesterday has passed away. Many of us on this
Committee today served with Jennifer Dunn and know that she was
a very valuable and respected Member of this Committee. We will
miss her, not only here in this Committee, but as a friend and
colleague. So, Mr. Chairman, in recognition of this Committee's
respect for Jennifer Dunn and in memory of her, I would ask for
just a moment of silence for the Committee before we proceed.
Chairman RANGEL. The staff has sent condolences and flowers
to the family of the deceased. She was quite a lady. She was a
tough lady, a charming lady, and a great Member of this
Committee, and she certainly will be missed, but not the great
contribution she's made. We'll have a moment of silence in
memory of her.
[Moment of silence.]
Chairman RANGEL. Thank you. Now we have a vote on the
floor. What's the situation? I think it would be better if we
take a short recess, go vote and come back and then yield to
you. Thank you.
[Recess.]
Chairman RANGEL. I will ask Congressman Neal to assume the
chair and then yield to Mr. McCrery.
Mr. NEAL [presiding]. Thank you, Mr. Chairman. The chair
now would yield to Mr. McCrery for his line of questioning.
Mr. MCCRERY. Thank you, Mr. Chairman. Thank you, witnesses,
for your excellent testimony. I just have a few questions. Dr.
Furman, I guess I'll start with you, because your testimony was
interesting but also somewhat confusing. In one instance, you
said, or at least what I heard you say, was that even with all
the tax cuts--I don't know if you said the bottom quintile, but
you said lower income earners were worse off. If in fact that's
what you said, I doubt that's what you meant in an absolute
sense, but maybe you were speaking in a relative sense in terms
of the gap between the lowest quintile and other wage earners.
Would you clarify that?
Mr. FURMAN. Yes, sir. I was actually speaking in an
absolute sense. If you look at economic models that attempt to
estimate the benefits of tax cuts for the economy, they always
make financing assumptions about how the tax cuts are paid for.
So, for example, Professor Greg Mankiw and Matthew
Weinzierl have a model in which they try to study if you cut
taxes, what would the benefit or harm to the economy be? To
make that economic model work, they assume that the tax cuts
are paid for because they cost money. They're paid for by, for
example, cutting Medicare benefits, cutting Medicaid benefits,
cutting Social Security or raising lump sum taxes. When you
factor in the financing of the tax cut and the effect on
households, 74 percent of households in my analysis, using the
tax policies in the microsimulation model, are made worse off.
That's using exactly the same models that, for example, the
Treasury Department has used to argue that tax cuts will on
average benefit the economy. Even if on average it does, when
you take into account the financing in the Treasury model
itself, most people are made worse off in absolute terms.
Mr. MCCRERY. Okay. I better understand what you were saying
now. While that may fit into your model, your model, like any
other economist's model, is full of assumptions. In your model,
you're assuming that Medicare or Social Security or some kind
of benefit will be cut because of the tax cuts. But if we can
just for the moment set aside those assumptions that haven't
happened yet, and may not happen, if you just looked at the
impact on the bottom line of the taxpayer, isn't it accurate to
say that all taxpayers benefited in terms of money in their
pocket from the Bush tax cuts, especially when combined with
transfer payments like the earned income credit? That's
essentially--it's scored even by CBO as a spending program in
part. So, when you consider those spending programs like that
in conjunction with the tax cuts, isn't it accurate to say that
everybody got some tax relief or some relief in their
pocketbook?
Mr. FURMAN. I think it's still not everybody, but it's
substantially more than what I said, that relief differed quite
a lot, was much, much larger for high-income people.
Mr. MCCRERY. No.
Mr. FURMAN. Than for low-income people. The key question is
whether that is a sustainable increase in people's incomes or
whether we're going to pay the bills and become much worse off
for it as a result. That's what these economic models are
trying to ascertain.
Mr. MCCRERY. Yeah. I don't have any quarrel with the model.
I understand how you get there. But I think you understand that
those are assumptions. We can alter those assumptions with
different policy changes. For example, we could solve the
Social Security problem in a way that maybe your model doesn't
contemplate, that would reduce benefits and also wouldn't
necessarily over the long term take more revenue. So, there are
all kinds of changes we can make in policy to alter the
assumptions in your model.
I just want to get this question out real quickly. Dr.
Burman, you talked about taking the, or repealing or revising
the AMT, and we ought to do it on a revenue-neutral basis.
Implicit at least in your remarks, or at least I inferred from
your remarks, that you would recommend letting the 2001-2003
tax cuts expire on schedule which to me brings up the question
that we don't talk about enough in this Committee, which is at
what percent of GDP would you stop in getting revenues from the
American people? Isn't that a question that we should consider
from an economic standpoint? If you let all the tax cuts
expire, if you do the AMT repeal on a revenue-neutral basis,
you're going to get up to somewhere close to 21 percent of GDP
coming into the Federal Government in revenue.
Mr. BURMAN. As Dr. Holtz-Eakin pointed out in his
testimony, the real issue is spending. If you look at the
projections going forward, starting in 2010 when the baby
boomers retire, the Federal Government's spending is set to
explode. You need to figure out how to rein in the growth of
entitlements. I think it's unlikely that you'd be able to rein
them in so much that you wouldn't require additional revenues.
So, my view is that undermining an important revenue source
before you figure out how to control the growth in spending
would be problematic. It would mean that you'd be pushing a lot
of burdens on our children and on our grandchildren.
Mr. MCCRERY. Well, I'm certainly a proponent
Mr. BURMAN. Nobody likes taxes.
Mr. MCCRERY. I'm certainly a proponent of solving the
entitlement problem in this country from a spending standpoint.
I don't think they're sustainable as they're currently
structured. But I guess I'd just like for you, maybe all three
of you, to just give us a ballpark figure of where you think if
we started getting 25 percent of GDP in revenues, would that be
damaging to the economy in a fundamental way, or would it be 30
percent, or do you care?
Mr. BURMAN. Well, in part it depends on how you raise the
revenues. The current tax system is very distortionary. There
are lots of loopholes and deductions. The basis is fairly
narrow and the rates are higher than they would have to be if
there weren't a broader tax base. The ideal thing would be if
we could broaden the base and keep marginal tax rates
relatively modest going forward like we did in 1986.
As far as what the right level of revenue is, we need as
much revenue as the government is spending over the long run.
We should try to raise it in a way that's both fair and
progressive but also does as little damage to economic growth
as possible. If you look at the projections going forward, the
spending on entitlement programs, according to CBO, is going to
be as large as total current Federal spending, and you're still
going to need defense. You're going to need courts. You're
going to need to pay for Congress. So, the right level of
revenue really depends on what you can do to spending.
Mr. MCCRERY. If the other two witnesses would just comment
briefly on my question.
Mr. FURMAN. Sure. I agree first of all it depends on how
you raise the revenue. But second of all, a key question is
timing. What we've seen in the last 6 years is actually not
really a tax cut so much as a shift in taxes. So, if you raise
taxes by a small amount today, that forestalls the need for
much larger tax increases in the future, which is why I'd
rather see us act sooner than later, and then we can have a
lower level of revenue as a share of GDP that is consistent
with funding the government that we want.
Mr. MCCRERY. Dr. Holtz-Eakin.
Mr. HOLTZ-EAKIN. Well, I won't reprise my concerns over the
spending side. If you spend it, ultimately you're going to pay
for it. You're going to borrow the money now and raises taxes
later or something of that nature. So, you've got to do the
spending.
The second two guidelines you can look at are either
history. We've not typically gone above 18 percent of GDP, and
there's a reason for that. We can't deploy the highly
inefficient Tax Code we have without having people rebel at
above that level. Or we can look at other countries where, at
least on the business side, we are now looking like a tax
unfriendly jurisdiction, and we can't allow that to happen.
So, you know, we don't live in a vacuum. We've got to be
cognizant of our international competitors, and we have to be
cognizant of the fact that the private sector feels the burden
of these taxes and responds.
So, I would be hesitant to push much higher.
Mr. MCCRERY. Thank you, Mr. Chairman.
Mr. NEAL. Thank the gentleman. The gentleman from Michigan,
Mr. Levin, will inquire.
Mr. LEVIN OF MICHIGAN. Thank you very much. You know, when
three economists testify I think the assumption is that your
being economists, it's all going to be very complex and hard to
understand I think for us here and for everybody else. But I
must say from your testimony, certain key facts, key
developments just spring forth.
Dr. Burman, you say income inequality has been rising since
the mid-eighties and now approaches levels not seen since the
Great Depression. That's a dramatic statement unchallenged so
far. Then Dr. Furman, you say this, because one of the
arguments in favor of inequality is that it spurs growth. You
essentially challenge that this inequality has been a major
generator of economic growth. You quote, you cite the Treasury
Department analysis saying--having the projection of very
modest economic gain from the tax cuts made permanent 0.04.
That's less than one--that's four one-hundredths, right, of 1
percent?
Mr. FURMAN. Right.
Mr. LEVIN OF MICHIGAN. As you can imagine, Dr. Holtz-Eakin,
we probably did look--we were going to look at your comments
when you were with us. Going back to them, one of your comments
regarding the President's tax policies, and I quote, ``taken
together, the proposals would provide a relatively small
impetus in an economy the size of the United States.'' So you
have the tax cuts, including those regarding capital gains and
dividends and the savings rate in this country has remained
essentially stagnant.
So if the motto is growth with equity, to put it rather
plainly, and I'd like all three of you to comment, there's been
almost historically high growth in inequality. It has not
sparked basically economic growth. So we've gotten the worst of
both worlds. So, comment on that. Dr. Holtz-Eakin, your
testimony seems to talk about other things and a consumption
tax and we can talk about that. But what is the thrust of the
testimony of Dr. Burman and Dr. Furman is that it's been a bad
deal for this country in terms of this nearly historic
inequality that has not been a major spark of economic growth.
So, why don't we go down the row and leave time for each of
you, if you would.
Mr. BURMAN. Thank you, Mr. Levin. It's certainly true that
at the same time that economic inequality has risen
dramatically, the economy has actually grown pretty well over
the last two decades, but it's not clear that there's any link
between the two.
I would also say that as Dr. Holtz-Eakin has pointed out,
that it's not tax policy that has caused the pre-tax inequality
per se, although it can mitigate it somewhat. I think any
economist would say that there is a link between tax policy and
the economy, but there are ways you could actually make the tax
system more progressive without entailing additional costs on
the economy. You could probably make it more progressive and
actually make the economy grow better.
Mr. LEVIN OF MICHIGAN. Dr. Furman
Mr. FURMAN. One of the numbers in my written testimony was
that there was a $664 billion shift in income from the bottom
80 percent to the top 1 percent----
Mr. LEVIN OF MICHIGAN. Dramatic.
Mr. FURMAN [continuing]. Over the last 25 years, 664
billion. When you think of something like international trade,
some people have estimated $500 billion to a trillion dollars
of benefits from international trade. When you look at numbers
like that, the benefits of trade, the magnitude of inequality,
it says that the types of policy responses that we should have
to deal with inequality, to deal with trade and globalization
should really be at the scale of those problems and those
issues. We've been going in the wrong direction for the last 6
years. We really should be going in the right direction and
quite substantially.
Mr. LEVIN OF MICHIGAN. Dr. Holtz-Eakin, you have the last
word.
Mr. HOLTZ-EAKIN. Yeah. I think Dr. Burman said it pretty
clearly, which is that we have seen rising inequality in wage
earnings in the eighties, dramatically at the top and bottom in
the nineties, much more dramatic at the top than at the bottom,
and those trends appear to continue today. They're not driven
by tax policy. This is not a tax policy issue. The dividing
line between those who get high earnings and those who do not
are driven by education, and that if you want to go find out
how to improve those outcomes, you would begin by having kids
arriving at school ready to learn and you would improve the
performance of the whole school system. That's it.
Mr. LEVIN OF MICHIGAN. I agree. You're saying tax policy
has been irrelevant to the growing income inequality?
Mr. HOLTZ-EAKIN. I think it has had very little to do with
the labor market earnings inequality that the professor's
document that I referenced in my testimony. So, you're looking
at the wrong culprit if you're looking at tax policy and labor
market outcomes.
Mr. LEVIN OF MICHIGAN. Dr. Furman.
Mr. FURMAN. One thing I looked at again in my written
testimony is if the Tax Code had stayed as progressive as it
was in the year 2000, the progressive tax system would have
offset 20 percent of the increase in inequality I talked about.
Of that 664 billion, 20 percent of that would have been offset
by the progressive Tax Code. But as a result of tax changes
from 2001 to the present, the Tax Code ended up offsetting a
much smaller portion of that increase in inequality, less than
a third as much as it would have otherwise.
So, I agree with Dr. Holtz-Eakin. I don't think taxes are
the cause of inequality. But the tax system, even if you had
just left it in place, would have solved about one-fifth of the
problem. Instead, we tampered with it, and it solved less than
10 percent of the problem.
Mr. LEVIN OF MICHIGAN. Okay. Thank you.
Mr. NEAL. I thank the gentleman. The gentleman from
California, Mr. Herger, will inquire.
Mr. HERGER. Thank you, Mr. Chairman. A question for Dr.
Holtz-Eakin. We've heard many in the majority complain that
President Bush and the tax relief of the last several years
increased the number of taxpayers on the alternative minimum
tax or AMT. I think we can all agree that negative effects of
the AMT on the unsuspecting middle class Americans and about
the need to eliminate this tax regime that was never intended
to dip into the middle class. But my question to you is if a
taxpayer did become subject to the AMT because President Bush's
tax cuts lowered their regular tax liability, would they still
receive an overall tax cut? In other words, whether or not they
paid regular income tax or AMT, am I correct in saying that the
Bush tax cuts would not increase the total income taxes of any
taxpayer?
Mr. HOLTZ-EAKIN. That's correct. So, he gave them a tax
cut. There's no question about it.
The tables at the beginning show this. I mean, they say
what fraction of the people's tax cuts got taken by the AMT?
None of those fractions were over 100 percent. No one's taxes
went up. They went down.
Mr. HERGER. So, this allegation and implication that
somehow the Bush tax reductions in which we've seen the results
of a major increase in our economy, major increase in revenues,
total revenues to the Federal Government, despite the fact that
taxes went down, the fact that somehow these in the lower
income tax bracket are paying more is just absolutely
incorrect. Is that true?
Mr. HOLTZ-EAKIN. It's incorrect. People are paying less in
total taxes, and there's no question if you look at the problem
with the AMT, the problem is not the cuts in the regular income
tax. The problem is the AMT is not a very good tax. It's not
indexed for inflation and it should have been a long time ago.
It doesn't make any sense from the point of view of a tax base.
It doesn't, you know, sort of recognize family size. It's got
very high marginal rates. This is not a tax anyone should
embrace. It's a bad tax. The real indictment is that we need it
at all. The fact that we have an AMT says that our regular tax
system makes no sense, so we're going to patch it on the side
with this alternative. Fix the Tax Code. Stop staring at the
AMT.
Mr. HERGER. Thank you. That's very helpful and incredibly
important for trying to clarify this debate. You say in your
testimony that recent evidence suggests the relatively high
U.S. corporate income tax is ultimately paid by workers in the
form of lower wages. Can you please speculate for us the
effects on raising taxes on small businesses?
Mr. HOLTZ-EAKIN. Well, there are two dimensions to that. I
mean, the first is economists have struggled for a long time to
try to pin who actually is harmed when we tax a particular type
of business activity, in this case the C corporations, the
Chapter C corporations.
You know, corporations aren't going to pay that tax.
They're either going to charge their customers higher prices,
cut payments to shareholders and cut back on investment, reduce
wages. It's going to go somewhere. Some of the recent evidence
suggests that given the global mobility of capital, that what
is really going to happen when that tax goes up is the capital
won't tolerate a lower return, so the workers are going to pay
it. So that tax is harmful on workers in the global context.
The second piece of evidence is largely domestic, and in
research I've done with multiple co-authors, the kinds of
people who are in sole proprietorships, small businesses of
different legal forms, appear to be unusually sensitive to
taxes and tax increases cause them to invest less in the firms,
cause them to grow their payrolls slower. They don't hire
people. They don't give them raises. They tend to go out of
business more quickly, if you have higher taxes.
Mr. HERGER. Doctor, I thank you very much. Again, this just
brings out the importance of the debate. The debate between the
party that's in the majority that somehow feels we're not
paying enough taxes, that taxes need to be increased, and the
part I belong to, the minority party right now that feels that
just the opposite is true. We need to be moving toward lowering
our basic taxes, and the results are clear.
Despite what conventional wisdom might predict, when we
lower taxes at a time when taxes are high, revenues actually
increase, and the opposite happens when we raise taxes.
Revenues actually decrease, and we see the economy hurt. More
importantly, we see our citizens hurt. So, I want to thank you
very much for your testimony and for your being here testifying
before our Committee today.
Thank you, Mr. Chairman.
Mr. NEAL. Thank the gentleman. The gentleman from
Washington, Mr. McDermott, is recognized to inquire.
Mr. MCDERMOTT. Thank you, Mr. Chairman. This is a country
that fundamentally believes in hard work, and you could call it
the Protestant work ethic or whatever you want to call it, but
the value of work has really been the bedrock of our society.
Today it looks like we're headed back, it seems to me, toward
the Gilded Age when hard work didn't mean very much. We're the
most productive workers in the world at this point, even
beating the Norwegians, but we're returning to an age really
when the nation's spoils seem to go to the few while the rest
of the folks work.
Now Mr. Burman's testimony is replete with data that bears
out these facts. Income inequality is approaching levels not
seen since the New Deal. Low- and middle-income families are
working longer, harder, more efficiently, but their real wages
are flat and they're falling in the face of rising energy,
housing and health care costs.
Since the year 2000, the cost of employment-based health
premiums has gone up 87 percent. Now American families today
are walking a tightrope over a snakepit really of economic
insecurity. The social safety net has been ripped, but the
corporate America seems to enjoy a real lifeline of tax
holidays. There just seems to be a lack of fairness in the
policies.
I put up this slide on the screen for people to look at. No
one disagrees with this. This is the Urban Institute,
Brookings. This is--everybody realizes that all the money is
going to the people on the far right end. The tax laws
implemented over the last 6 years have exacerbated the
challenges that globalization imposes on working families.
Aftertax income inequality is dramatically more severe because
of the tax cuts that have been put in place. It's obvious from
looking at it, and Mr. Furman's testimony really bears that
out.
Now as low- and middle-income families lose their health
care, their pensions and their homes, the affluent are bathed
in these tax cuts which were about to expire. Now the AMT nails
middle-income again and volunteers fight an endless war in
Iraq. The fortress of Wall Street really goes on almost
untouched by this, and wants to protect a tax rate of half the
rate that the ordinary people in this country are paying.
It seems to me that our real issue here is that we need to
design a tax policy and labor policy that responds to
globalization. This is a new era. This is not the Industrial
Age. This is the Globalized Age. I'd like, Mr. Furman, for you
to talk a little bit about as these tax cuts expire--the
Republicans set it up for them to expire in 2010, and I don't
think we should, as they say, get in the way of a man when he's
doing himself in. They did it. They set it up. We should let
them expire. Then let's talk today about what we should do with
things like unemployment insurance reform or universal health
care or wage insurance or continuing education. I'd like to
hear how you would spend the money which is going to come to us
as a result of the expiring tax cuts. Or maybe just get rid of
the AMT. I mean, that may be one thing. But there's some other
things, it seems to me----
Mr. FURMAN. Right.
Mr. MCDERMOTT [continuing]. That we have to do to make
equality in this society.
Mr. FURMAN. Right. Thank you for asking me that question,
and I run something called the Hamilton Project at the
Brookings Institution, and we have put out policy proposals on
every one of the issues you just mentioned, including wage
insurance, health insurance and unemployment insurance. Of
those areas, I think achieving universal health insurance is
far and away the most important goal.
You look at the tax cuts, they cost $200 billion a year.
You could do a feasible plan for universal health insurance
that costs maybe $100 billion a year, for half of the cost of
what we did for the tax cuts, if you're willing to consider
altering the tax exclusion for health insurance as the
administration did, you might even be able to do a plan that
gets health insurance for everyone at no additional cost.
Mr. MCDERMOTT. Are you talking about a universal national
health plan, or are you talking some kind of band-aid system on
the present employer-based system? What are you talking about?
Mr. FURMAN. The $100 billion number would be for something
that builds on the existing system and fills in the cracks,
providing options for people who don't have options within the
system. If you switch to a national health insurance system,
some form of single payer, the additional cost to the
government would be more than $100 billion, although then you
would have an additional savings to individuals of, you know,
five or six hundred billion dollars a year of the premiums that
they're paying for their health insurance right now.
Mr. MCDERMOTT. So, the money----
Mr. FURMAN. But I was talking about a more incremental
system. It would still cover virtually every single one of the
uninsured.
Mr. MCDERMOTT. The bottom line is, there is the money to do
universal health care coverage for all Americans inside this
present system if we do it efficiently?
Mr. FURMAN. The bottom line is that there are tradeoffs
that have to be made, and if you do more in one area, you can
do less in the other area. So, if you do tax cuts like that,
you won't be able to afford to do universal health insurance.
Mr. MCDERMOTT. Thank you, Mr. Chairman.
Mr. NEAL. I thank the gentleman. The gentleman from
Michigan, Mr. Camp, is recognized to inquire.
Mr. CAMP. Well, thank you, Mr. Chairman. Dr. Holtz-Eakin,
there's been a suggestion that income equality is rising, and
using the data they use has a certain definition of income. But
other experts define income in a different way and leave out
significant amounts of cash and noncash income the households
have.
Can you comment on what gets counted as income for purposes
of some of these studies and discussions?
Mr. HOLTZ-EAKIN. I'll comment briefly. It's a topic that's
enormous, quite frankly. But----
Mr. CAMP. It is enormous. I would agree with that.
Mr. HOLTZ-EAKIN. The key thing for the Members to know is
that there is absolutely a consensus that inequality in labor
market earnings has increased over the past two-and-a-half
decades, and there's a list of potential explanations. Much of
them revolve around education, skills and abilities, period.
Mr. CAMP. But, for example, does the definition of income
include the value of the earned income tax credit?
Mr. HOLTZ-EAKIN. So, the point I wanted to make is that's a
very narrow slice of how people actually live. You want to get
to, you know, how do people live at the end.
Mr. CAMP. What do they actually have in real life? What
resources do they have in real life?
Mr. HOLTZ-EAKIN. Earnings. Then compensation including, you
know, non-wage compensation, health insurance, things like
that. Then you want to take that and add taxes net of
transfers, or add transfers----
Mr. CAMP. Taxes they pay and other----
Mr. HOLTZ-EAKIN. The poverty statistics leave those out.
Then you want to deflate them for the cost of living, and we
have, you know, higher quality goods cheap. Then you get to a
standard of living.
Mr. CAMP. The Census Bureau figures don't do any of that,
do they?
Mr. HOLTZ-EAKIN. No.
Mr. CAMP. So, the Census Bureau doesn't include food stamps
or housing assistance?
Mr. HOLTZ-EAKIN. No.
Mr. CAMP. Medicaid spending. I think one of the
difficulties this Committee has had is coming up with a uniform
definition of poverty, because then these figures can be used
to say whatever they want. I would just agree with you that
this is an immensely complicated topic. I would ask unanimous
consent to include in the record a report by the Heritage
Foundation that expands on these and other definitions and
deficiencies in the way income is calculated and would submit
that for the record.
But I also want to comment on some of these Census Bureau
numbers that get put out there. For example, they often divide
the population up into fifths. Those don't have equal numbers
of people in them, do they? So, the top fifth has more people
than the bottom fifth.
Mr. HOLTZ-EAKIN. Depending on who does them, quite frankly.
That's why it's hard to compare them.
Mr. CAMP. I'm talking Census Bureau.
Mr. HOLTZ-EAKIN. In the census poverty numbers?
Mr. CAMP. Yes.
Mr. HOLTZ-EAKIN. The census poverty numbers, the income
distribution is over households, and you have to figure out
household sizes and things like that.
Mr. CAMP. Yeah. The quintiles are not equal in terms of
numbers of people.
Mr. HOLTZ-EAKIN. Right.
Mr. CAMP. So you obviously are not making--obviously the
comparisons, then, are not between comparable numbers of
households in these various categories, and then results in a
skewed percentage. So, I think that, without getting too far
into the weeds on that, I think that it's important just to
state that census figures ignore taxes paid and most of the
social safety net that is available to the American people both
in terms of Federal and state dollars. Is that an accurate
statement?
Mr. HOLTZ-EAKIN. Yes. The census figures are highly
incomplete. I would highlight a second problem with them, which
is that they're not counting the same people every year. The
mobility of individuals across different standards of living is
a key part of what goes on in the U.S. economy. The evidence
doesn't suggest there's been a dramatic change in economy
mobility. So, you know, the idea that somehow things are very
different than they were 20 or 30 years ago is not supported by
the data. We do have issues in giving people labor market
skills, both in advance and after their job prospects change,
that are real and genuine. But they're not addressed by those
statistics at all.
Mr. CAMP. Just in closing, I would agree. So, this leaves
us with a definition of income that's incomplete and ignores
really the efforts that are made in terms of the social safety
net and the dynamics of our society where people are mobile and
move from one income category to another over time, which would
really--which really prevents us from getting a clear picture
of what the situation in America is.
So thank you for those comments, and I yield back the
balance of my time.
Mr. NEAL. The chair would recognize the gentleman from
Georgia, Mr. Lewis, for inquiry.
Mr. LEWIS OF GEORGIA. Thank you very much Mr. Chairman. Mr.
Chairman, let me thank the witnesses for being here. Since we
have these three distinguished economists here, I'd just like
to ask a very general question, and maybe I can come back to
something in particular. We have this unbelievable involvement
abroad in a war in Iraq and Afghanistan. The only people that
have been called upon to sacrifice are young men and our young
women in uniform.
I'd like to hear your opinion about is there some way to
use the Tax Code to get other Americans to sacrifice, to pay
something for our involvement in these two military conflicts?
Is it fair? Is it right? Is this just?
Mr. BURMAN. I'll certainly comment on the fact that as far
as I know, it's unprecedented that we've launched a major war
and at the same time enacted huge tax cuts. The mentality of
the country is a lot different than it has been in the past.
Bill Gates, Sr. and Chuck Collins in their history of the
estate tax, explained it during World War I, as a
``conscription of wealth,'' and by ones to the conscription of
young men to serve in the military. Basically, it was a way of
drawing on the people who were most wealthy to help support the
effort as well so they could also share in the sacrifice.
It's kind of ironic that at the same time that we have this
war going, we've actually proposed to eliminate the estate tax,
which is supposed to disappear in 2010.
Mr. FURMAN. I guess I would agree with Dr. Burman. The last
time I was before this Committee, CBO Director Peter Orszag
read a letter that his staff had prepared him, and it was to
the effect that there has not been a single other case, with
the exception of one technical incident during the Mexican War
in 1837 I believe, in which taxes were cut in a time of war.
That's very unusual.
It's especially unusual because it's not just a time of
war. It's a time where we understand we're going to have for
homeland security and for national security higher expenses
going forward for a very long time. Even if we weren't in Iraq,
even if we weren't in Afghanistan, just our homeland security
needs are higher than what they were in the year 2000. In
response to that, you normally don't try to cut taxes, borrow
the money, and have to raises taxes substantially in the future
as a result.
Mr. HOLTZ-EAKIN. I think it's first important to note that
there is no tax or budgetary sacrifice that's going to compare
with the service of the young men and women in the armed
forces. Let's be honest about that. That means that we should
be honest about everything. That means we should, and I echo
the comments of Mr. Furman, put on the books the real costs of
fighting a war against a group of extremists who wake up each
day trying to destroy this way of life, and it's going to be a
long battle. Every dollar of expected spending in Iraq,
Afghanistan and the rest of the fronts should be budgeted, and
budgeted all the time. To pretend otherwise is bad government
fiscal policy.
At that point, the tradeoffs will have to be clear. As you
know, I believe we have overspent the Federal budget many times
going forward, so simply adding more spending is not something
this Committee has the luxury of doing. There will have to be
some cutbacks in spending and a tax policy that will not
cripple the economy put in place.
Mr. LEWIS OF GEORGIA. Thank you very much. Dr. Furman, you
have suggested that the tax treatment of retirement saving
provide a windfall for Americans who already have enough money
and are already inclined to save, while offering few options
for low- and moderate-income Americans to save for their
future.
As you look at the years since the enactment of the 2001
and 2003 tax cut and the performance of the economy, what
changes do you recommend that we make to ensure that all
taxpayers have enough money left over at the end of the day to
put into savings?
Mr. FURMAN. Mm-hmm. Let me recommend both a paper by the
Hamilton Project written by Bill Gale, Peter Orszag and John
Gruber, and also the work of the Retirement Security Project at
Brookings. A minimal step would be taking things like the
saver's credit, which were enacted, making them refundable and
more transparent so that low- and moderate-income families
could truly benefit from them in their savings.
A set of more ambitious steps would make savings easier,
more automatic, help people turn their savings into an annuity
when they retire, so that they can have a stable income in
their retirement and have more generous tax credits for low-
and moderate-income families to help them save. So, there's a
lot of steps both within the Tax Code and within pension reform
you could take that I believe would be economically beneficial
in terms of increasing national savings, and also beneficial in
terms of increasing the retirement security of working
families.
Mr. LEWIS OF GEORGIA. Thank you very much. Thank you, Mr.
Chairman.
Mr. NEAL. We thank the gentleman. The gentleman from
Pennsylvania, Mr. English, will inquire.
Mr. ENGLISH. Thank you, Mr. Chairman. Mr. Chairman, this
testimony has been stimulating and certainly there have been a
lot of surprises. For example, in Mr. Burman's testimony a
couple of minutes ago to the effect that we've never financed a
war while cutting taxes. My impression was that we had financed
the Cold war during the eighties by cutting taxes, but that's I
suppose maybe just my ideological perspective on things.
Dr. Burman, I was also surprised by my good friend Mr.
Neal's statement that the impact of the AMT was having a
surprise impact on the Bush tax cuts. Wasn't the existence of
the AMT pretty well known at the time, and weren't the
estimates prepared by the Joint Tax Committee done with full
anticipation that some taxpayers, depending on their
circumstances, might be subject to the AMT?
Isn't it true that taxpayers are receiving the full
benefits of more than $1 trillion in tax cuts as estimated by
the Joint Committee on Taxation? Maybe more importantly, isn't
the suggestion that the Bush tax cuts have tossed people into
the AMT a little misleading? Would you agree that while more
people might be paying the AMT because of the interactions with
the 2001 and 2003 tax cuts, there's not a single taxpayer who
is paying more in taxes than they would if these bills had not
been enacted?
Mr. BURMAN. It's basically true. It turns out there are a
few married people filing separate returns that actually might
pay a little bit more, but almost nobody pays more taxes
because of the interaction of the AMT and the 2001-2003 tax
cuts.
Mr. ENGLISH. Outstanding. That's extremely helpful. Now the
point you were----
[Laughter.]
Mr. ENGLISH. I'm sorry, Mr. Chairman. Do I have the floor
here? You also made an interesting point about your concern
about undermining the revenue source. This was in response to
Mr. McCrery that the tax cuts might be undermining a revenue
source that is essential to deal with long-term entitlement
challenges. I think that's an interesting argument. I think you
also conceded that perhaps spending is a big part of the key
here.
Now Dr. McDermott laid out his programmatic menu of things
that could be invested. Would it not undermine the revenue
source equally in dealing with long-term entitlement needs to
encumber those moneys with new entitlements?
Mr. BURMAN. I certainly think that would be a problem.
Somehow you need to get the entitlements under control. I think
there are probably ways that--actually, I'm sure there are
ways--you could expand health insurance coverage without
increasing overall spending. Dr. Holtz-Eakin, discussed the
problems facing small businesses. I think one of the big
problems facing small businesses right now is the way health
care is financed. Actually, if some of the costs could be taken
off the backs of small businesses, they would actually be able
to compete more effectively with foreigners.
Mr. ENGLISH. That's an excellent point. Dr. Burman, on a
separate point, and I was delighted to see that the deduction
for state and local taxes has been brought up. As the Joint Tax
Committee has shown, the inability to deduct state and local
taxes for AMT purposes is one of the primary preference items
that causes individual taxpayers to become subject to the AMT.
Some might argue that this is unfair, since those who have
already paid the state taxes might be less able to pay Federal
taxes. But isn't it also correct that the deduction for state
and local taxes acts as an implicit subsidy by low-tax states
of those living in high-tax states? Isn't it also true that
residents of many of these low-tax states are on balance
relatively less prosperous than those in high-tax states? If
so, isn't there an equity concern when those who are better off
are asking those who are worse off to help offset the cost of
more extensive state and local government services that after
all is their option?
Mr. BURMAN. I agree with that. State and local tax
deductions are actually very regressive. The largest benefits
go to very high-income people, people who are above the AMT
threshold, and it benefits the states with the largest tax
bases. If you're actually going to try to provide assistance to
the states, it would make a lot more sense to target it to the
states that need help, places like Arkansas, Louisiana, where
they get very, very little.
Mr. ENGLISH. Dr. Furman in his testimony made the point
that income inequality in America has increased nearly
continuously since 1979. Dr. Holtz-Eakin, can you identify any
time in history when a period of economic growth did not lead
to an increase in income inequality?
Mr. HOLTZ-EAKIN. I'm smart enough to know that I'm sure
that you could slice some time period to find one where that
isn't true, but by and large, markets reward--market rewards
are different. To get growth, you have to have market rewards,
and so you get differences in outcomes for the people who
follow the market and those who don't. Inequality is part and
parcel of a market economic system.
Mr. ENGLISH. I have many more questions, but I'm out of
time. Thank you, Mr. Chairman, for your indulgence.
Mr. NEAL. We thank the gentleman. Mr. Burman, we've had
some questions about how much of the Bush tax cuts some
taxpayers lose to the AMT, with some losing as much as two-
thirds.
I want to ask you about a chart in your testimony, Table 1
on page 4. It shows that some taxpayers at the highest incomes
receive an average tax cut of $230,000. Do these taxpayers lose
any of their tax cuts to AMT?
Mr. BURMAN. Sure. They lose a little bit, but if you look
at Table 3 of my testimony, the people with the highest incomes
actually lose the smallest share among people with incomes over
$50,000. The percent of the tax cut taken back for people
earning over $1 million, basically that income group in the
first table, is less than 5 percent. Families with incomes
between $100,000 and $200,000 lose more than a third.
Mr. NEAL. Mr. Furman, is that your position as well?
Mr. FURMAN. I am less of an expert on the AMT than Dr.
Burman is. In fact, everyone in the country is less of an
expert on the AMT than Dr. Burman is, but I believe that's
correct.
Mr. NEAL. Thank you. Mr. Eakin.
Mr. HOLTZ-EAKIN. Mr. Furman was talking while you were
giving your question so I didn't actually get to hear you. I
apologize.
Mr. NEAL. That's part of our strategy.
Mr. HOLTZ-EAKIN. I see. I will stipulate, however, that Len
Burman knows more about the AMT than I do.
Mr. NEAL. Sometime ago as a Member of the Budget Committee
as a designee from the Committee on Ways and Means, I had a
chance to question you in your role, your former role. Is it
still your position that the Bush tax cuts did not pay for
themselves?
Mr. HOLTZ-EAKIN. I don't think tax cuts pay for themselves,
and I don't think sensible economic evidence supports that
position. Good tax policy matters, but it's not somehow a genie
out of which you can pull money to spend. That's not the way it
works.
Mr. NEAL. Thank you. I was driving along in the car, as I
referenced earlier, a few months back, and I heard you repeat
that in an interview you were doing with Carey Gross on Public
Radio, and I thought the fact that you were willing to restate
that position first in testimony before the Budget Committee,
with the Public Radio show and today, it's very gratifying to
all of us.
Since I haven't used all of my time, I'd like to go to Mr.
Tanner for inquiry.
Mr. TANNER. Thank you very much, Mr. Chairman, and thank
all of you for being here. I don't know of any reasonably sane
person who thinks this country is on a long-term, sustainable
financial path. A lot of reasons for that, but I don't know
anyone who would argue that we can keep doing the same thing
we've been doing for the last 6 years and be an economically
viable entity known as the United States of America.
As you know, I have been talking about this accumulation of
debt, and we have been arguing vociferously for PAYGO rules
that mean something, and we've been trying to talk about the
debt accumulation that has taken place in the last 60, 70
months as part of a larger problem.
Balancing the budget is a good idea, but in and of itself,
I don't think it's all that important. But the consequences of
what we have done over the last 6 years with this new debt have
resulted in an erosion of the tax base of about $85 billion a
year. In other words, had we not embarked on this economic game
plan that induced all this new borrowing, we would have on the
same tax base about $85 billion to fix some of these problems
like AMT, health care, education and so forth.
What's even more disturbing to me is the fact that 75
percent of this new debt, 1.6 trillion in the last 60 months,
has been financed by foreign interests. Now I've talked to Dr.
Holtz-Eakin about this before. I personally believe that
countries like China are engaged in a long-term strategy to
gain financial leverage on this country for a larger
geopolitical reason, and I think I have some pretty good
evidence to point that out. When we try to talk to them now
about the currency or we try to talk to them about something
else, they're not there yet, but eventually if we keep going
down this same road, they'll be able to say United States, you
better stay out of this or we'll roll Wall Street. We have the
ability to do it.
But all of that aside, what we're here today to talk about
is trying to fix AMT specifically but the larger economic
problem. Almost every economist I've talked to agrees that
there is no way to cut spending out of domestic discretionary
spending to fill this gap. It's impossible. There's just not
enough money. You could virtually abolish the Federal
Government here in Washington as we know it, and you still
can't make ends meet if we continue down this path.
Given that, if you accept that as a fact, and if you accept
the fact that there's not currently the political will in this
country to do something about entitlement reform, we have a
short-term problem that has got to be fixed, because every year
we borrow another 100, 200, 300 billion dollars, whatever it
is, we erode the tax base the next year to the extent that we
start paying interest on whatever we borrowed this year.
Could I get your collective opinions as to what we can do?
I personally, when it comes to AMT, the short-term fix every
year is just money down the drain and it's not a rational tax
policy to fix a particular problem. I could go on, but I'll
stop there and ask--I see the yellow light come on--for your
comments on my ramblings. Thank you.
Mr. BURMAN. On the issue of AMT, the best thing would be to
clean up the tax system overall, and as part of that you could
come up with enough revenues to pay for financing the AMT. You
could repeal the state and local tax deduction. That would
raise more than enough money to do it. Those are difficult
things to do, obviously.
I put together an option sort of illustrate another
alternative that would pay for repealing the AMT and retarget
it on people who were its original intended targets, and that's
a surtax on adjusted gross income over $200,000 for couples and
$100,000 for singles, at a 4-percent rate. Now this isn't ideal
tax policy, but it would be a lot simpler than the current AMT.
People would understand it. It would actually raises taxes on
millionaires, who were the original targets, and cut the on
most other people, and it would be revenue neutral. It wouldn't
add to the deficit over time.
Mr. FURMAN. I would suggest--oh, should I answer the
question?
Mr. TANNER. Please. Answer it, yes.
Mr. FURMAN. Okay. Just very briefly, I would suggest two
steps. One is to do no harm, and that would be the PAYGO rules.
If you do that, I think you could avoid any immediate fiscal
problems that we might otherwise face. So, for example, the way
this Committee has handled S-CHIP by paying for the proposal
and showing that you can expand children's health insurance
without expanding the budget deficit.
In the long run, PAYGO, though, isn't going to solve our
problem. It's not going to get us out of the hole. It just
means we won't dig any deeper. I think both the spending side
and the revenue side are going to need to play a role into
bring us into long-run fiscal balance, with a lot of the
emphasis on health care, Medicare and a systemwide health
reform.
Mr. HOLTZ-EAKIN. I think you've got the diagnosis exactly
right. This isn't a discretionary spending problem. It's the
mandatory programs. The good news is, those are in your
jurisdiction in this Committee. The bad news is those are in
your jurisdiction in this Committee.
My concern with the advice you're getting is that if the
short-term fix is to raise taxes, however, that will always be
the short-term fix. You will never come to grips with the
entitlement programs. You cannot in any economically sensible
way tax your way out of this problem. So if you repeat the
short-term fix, you will have set course toward a cliff. I
would encourage you to not do that. It is not something that
can succeed in the long run.
Mr. NEAL. Thank you. The gentleman from Missouri, Mr.
Hulshof, is invited to inquire.
Mr. HULSHOF. Thank you, Mr. Chairman. I was an economics
major in college, did not do well in geography, and I'm not
sure, maybe someone here knows, what point on planet Earth is
exactly the opposite of Washington, D.C.? But I'm convinced
after listening to some of my colleagues that we are that far
apart on economics. That there are some of us here in
Washington and there are some others on the other side of
planet Earth as far as what to do about this economy.
I appreciate my friend, and he is my friend, from
Massachusetts, referencing the history, Chairman Mills,
creation of the AMT. I lament the fact that in 1999 the
President of the United States had the opportunity to
completely and finally eliminate the alternative minimum tax
and yet vetoed that bill. I wish we had had a bipartisan
solution back then.
Let me pick some of the points that you all have made in
the time that I have. Dr. Holtz-Eakin, it's great to have you
back. You indicated that tax policy has little impact on income
inequality. I think you had been asked that, and you would
acknowledge that again for the record, would you not?
Mr. HOLTZ-EAKIN. Yes. It's not the source of income
inequality.
Mr. HULSHOF. Can tax policy have an impact on the growth or
the contraction of our National economy?
Mr. HOLTZ-EAKIN. Absolutely.
Mr. HULSHOF. Could you give an example or two?
Mr. HOLTZ-EAKIN. Well, there's lots of economic research
that suggests taxes that target consumption and not income will
augment long-run savings investment and economic growth. The
numbers never appear very dramatic, a couple of tenths of a
percentage point growth rate per year. But remember, a couple
of tenths of a percent per year is the difference between the
United States and England. By doing that over a long period, we
rose from being not much in the way of an economic power to the
largest economy on the globe, and England went from the largest
power on the planet to something that is far less impressive.
That growth matters.
Mr. HULSHOF. Would, for instance, the reduction of the cost
of capital or savings and investment; i.e., dividends, capital
gains, would that in your view at least have a positive
economic benefit to certain sectors of the national economy?
Mr. HOLTZ-EAKIN. I would encourage the Members to read the
written testimony, which goes on at length about how you can
construct a tax system that has no tax on that return to
capital, nevertheless meets the standards of fairness,
simplicity and clarity that I think the American people demand.
Mr. HULSHOF. This is of course a simplified point of view,
but my good friend from the state of Washington said, you know
standing on the side to, as we do ourselves in, because of the
tax cuts of 2003, and I would remind my friend that the economy
was shedding 92,000 jobs per month in the 29 months before the
'03 tax cuts on capital gains and dividends. Since then, the
increase in net new jobs average about 167,000 per month.
Now it's a very simplistic view to say that there's a cause
and effect. Again, going back to those college days, full
employment was considered to be 5 percent or less, and yet CBO
says--I mean, we've had 22 straight months of unemployment at
below 5 percent. CBO says that that rate will be about 4.5
percent in this year and 4.7 percent in 2008. Again, just
different view of the world.
Let me ask you, Dr. Furman, something that Dr. Holtz-Eakin
said to Mr. Tanner in response to Mr. Tanner. We can't tax
ourselves out of a problem. Do you agree with that?
Mr. FURMAN. I absolutely agree with that. I also would
agree that we could not solve the entire problem on the
spending side. I think both need to be part of the solution.
Mr. HULSHOF. Well, let me make sure you understand. Do you
believe that we can tax ourselves out of this problem or that
we cannot tax ourselves out of this problem?
Mr. FURMAN. I think taxes can contribute to solving this
problem.
Mr. HULSHOF. So, in other words, you think that a nation
can tax itself into prosperity. You reference such back in the
1990-1993 tax increases as somehow spurring economic growth. Is
that your testimony?
Mr. FURMAN. I believe that both the 1990 and 1993 tax
increases helped the economy by reducing the budget deficit,
contributing to national savings and fostering capital
formation.
Mr. HULSHOF. So, for instance, the 1993 luxury tax, was
that a positive economic boon for, say, people that built boats
or built luxury cars? Was that luxury tax then positive in the
sense that certain sectors of the economy expanded as a result
of that higher tax?
Mr. FURMAN. I haven't studied the individual provisions.
Taken as a whole, increasing national savings can increase
capital formation and increase economic growth. Reducing our
budget deficit is one of the main tools that policymakers have
to raise national savings.
Mr. HULSHOF. Final question. Do you agree then or disagree
with the United States Treasury as they report that the top 5
percent of income earners pay a greater share of the nation's
bills after the '01 and '03 tax reductions? Do you agree with
the U.S. Treasury's report on that?
Mr. FURMAN. That is correct. Their share of income also
went up over that period and----
Mr. HULSHOF. Their share or proportion of paying the bills
here has also gone up even after the tax reductions. Do you
agree with that?
Mr. FURMAN. When your share of income goes up, your share
of taxes paid is going to go up as well.
Mr. HULSHOF. Thank you.
Mr. NEAL. We thank the gentleman. Another footnote to the
gentleman. There were two former presidents that voted for that
conference report in 1969 as well, President Ford and President
Bush, Sr. both voted for it.
The gentleman from Texas, Mr. Doggett, is invited to
inquire.
Mr. DOGGETT. Well, thank you so much for your testimony.
We've endured 12 long years in this Congress where
particularly, though not limited, but particularly in the area
of taxation, logic, fact-based analysis was viewed with
disdain, and mythology and ideology were very much on the
ascendancy. It is good to hear all three of you reconfirm the
obvious, even though it seems to be disputed by some on this
panel, that tax cuts don't pay for themselves. That theory has
been the underlying principle for the borrow-and-spend policies
that we've endured for the last 12 years, and I view it as a
form of modern alchemy.
As for no free lunches, to which Dr. Furman referred, we do
still have at least 500-plus days of an Administration that
believes in only free lunches now. The policies that we're
looking at certainly have to consider that.
It was good to hear all three of you agree as well that we
need to find more than a short-term fix for the alternative
minimum tax. Now as to that tax and its origin, which has had
some discussion, this hearing just happens to coincide with the
recent passing of Leona Helmsley, who I guess will have as part
of her legacy the richest dog in America, but she famously said
that taxes were only for the little folks. I would ask you, Dr.
Burman, as the person who's been designated as the expert on
the AMT if you agree that the original purpose of the
alternative minimum tax that even the richest Americans should
share in contributing to the cost of our security and other
necessary services of government if narrowly structured and
implemented, still remains sound public policy?
Mr. BURMAN. The idea that somebody should pay a little bit
of tax versus no taxes, that doesn't come out of any kind of
economic principle or policy. The real issue is whether people
were benefiting from tax breaks that were really unwarranted.
My view is that in fact the best response for Congress in 1969
would have been to say, look, there are these tax loopholes
that we've created, that they're taking advantage of. We should
get rid of them for everybody.
The problem with the AMT is it says, well, we're going to
trim it back a little bit so you don't embarrass us by taking
too much advantage of these defects in the tax system. The
better approach is to get rid of the loopholes across the
board, not have two separate tax systems.
Mr. DOGGETT. With reference to how we correct the AMT on a
longer term basis, as you're aware, we've had testimony from
where you're sitting from the Bush administration that they
don't like the AMT but they refuse to show us how we could
correct it over a long period of time and pay for it. I don't
believe any of our Republican colleagues on this Committee have
suggested any way to pay for correction of the AMT, though they
join all of us in saying that it needs to be corrected over a
long period of time. What would be the effect if we just
followed the administration free lunch now approach and correct
the AMT permanently or on a long-term basis and don't pay for a
penny of the correction?
Mr. BURMAN. I think that would be a very unfortunate
policy. For one thing, even though middle-class people are
falling prey to the AMT, most of the tax is paid by people with
relatively high incomes, $100,000 and over. So, eliminating the
AMT by itself would be another large tax cut on people with
pretty high incomes. It would make the tax system even less
progressive.
The other thing is that it would reduce tax revenues by
$800 billion over the next 10 years. As we've all discussed,
the revenue demands on the government are going to be
unprecedented over the next 10 years and beyond, and I think
that would be problematic.
Mr. DOGGETT. Dr. Furman, do you agree with that?
Mr. FURMAN. Yes, I agree with that.
Mr. DOGGETT. Dr. Holtz-Eakin, do you believe we can correct
the alternative minimum tax over a long period of time without
paying for it any way?
Mr. HOLTZ-EAKIN. I echo what Dr. Burman said, which is this
should be fixed in the context of the whole Tax Code. We've
seen examples of, you know, not because I like all the
particulars, but the President's Advisory Panel put out plans
that got rid of the AMT, broadened the tax base, you know were
revenue neutral, and that's the route to go.
Mr. DOGGETT. Dr. Burman, then, unless we find a way to pay
for the alternative minimum tax correction, and you referred in
your testimony to some of those, and Chairman Neal has taken a
lead on that, there's really no way that this inequity can be
corrected for the millions of American families that are either
being impacted today or will be impacted in the future. Is that
correct?
Mr. BURMAN. Well, you could just eliminate it and increase
the deficit. But if you're not willing----
Mr. DOGGETT. Well, let me say no responsible way to correct
this inequity unless we find a way to pay for it?
Mr. BURMAN. I think revenue neutral reform is definitely
the best approach.
Mr. DOGGETT. Thank you.
Mr. NEAL. Thank you. With the consent of Mr. McCrery,
because there are more Members on this side rather than this
side at the moment, we're going to do two, and Mr. Becerra is
recognized to inquire.
Mr. BECERRA. Thank you, Mr. Chairman. I thank the panel for
their testimony. Appreciate it very, very much as we try to
formulate some sound policy to address some of the concerns
that taxpayers have expressed to us over the years.
Let me try to touch on one point for 1 second. My
understanding is that we have a civilian workforce being--not
counting the military--of something approaching 150 million
Americans who are employed. Today we have an unemployment rate
hovering somewhere around 4 percent, 5 percent. There are some
7 million, close to 7 million or so Americans who are
unemployed. I make this comment only because my friend and
colleague, Mr. Hulshof, made the point that full employment has
often been described as being 5 percent, only 5 percent of
Americans unemployed. I think we have to dispense and dispose
of that type of thinking that we can call full employment 7
million Americas, more than 7 million Americans in this
economy, without work. I think that's one of the difficulties
that I think economists run into and policymakers. When we talk
about full employment, meaning when we've got 95 percent of
Americans employed, or in this case, over 7 million Americans,
that means they're out of luck, and we would totally discard
them in our consideration of our policies if we feel we're
under an economy with full employment.
I think that's one of the reasons we have these
difficulties today with regard to tax policy. When we hear
people talk about tax cuts being the savior for the economy and
for the American worker, I think all three of our witnesses,
our expert witnesses, have said that tax cuts by themselves do
not pay for their costs. If that's the case, the Bush tax cuts
don't and won't pay for themselves either. Now that we find
that it's really as a result of the Bush tax cuts that this
alternative minimum tax problem will begin to hit more and more
Americans that never thought that they would be lumped in with
Exxon Mobil and all these other very lucrative companies and
very, very wealthy Americans, it's because we have policies
that seem so out of touch here in Washington compared to what's
going on in average America. I think we do have to come up with
a more rational approach.
To me, the AMT is a symptom of our very chaotic Tax Code
that tries to address general problems, but when you actually
come down to it, the special interests get a better grip on the
policy than do average Americans, and what we end up with is
not what we thought we would conclude with it, quite honestly.
My question to the three of you, whoever would like to
answer this, is the following. If we do AMT relief, to whom
should we target it?
Mr. BURMAN. My preference would be to eliminate the AMT
altogether and make up the revenues by making the tax system
more progressive. The problem with the AMT is that it's hitting
people whom it was never intended to hit. Certainly somebody
earning $75,000 and taking the standard deduction was never the
intended target of the AMT. They didn't choose to have their
children as a tax shelter device. Even if they did, they
probably should still be applauded because they're helping with
the long-term entitlement problem.
Mr. BECERRA. So, Dr. Burman, I sense what you're saying is,
to make the Tax Code more progressive and to try to eliminate
the disparities that we see today that middle class and modest
income working families seems to be paying a greater share of
their income in taxes than do those who are becoming very
wealthy, that you would make it more progressive and therefore
tax--make sure the Tax Code reflects that the more--the higher
your income, the more you're going to pay in taxes?
Mr. BURMAN. Right. The original intent of the AMT was to
make sure the people who in current dollars would be
millionaires were paying at least some tax, and the 4 percent
surtax that I laid out would be one simple approach to do that.
It would take the AMT completely off the backs of couples
earning less than--$200,000.
Mr. BECERRA. You wouldn't AMT if you had a progressive Tax
Code because you'd always make sure that people are paying
their fair share of taxes?
Mr. BURMAN. Right. It would be nice to broaden the base and
get rid of the unwarranted loopholes. That might even allow you
to lower marginal tax rates, which would make Dr. Holtz-Eakin
and the rest of us happier.
Mr. BECERRA. Dr. Holtz-Eakin, I sense that you may want to
respond.
Mr. HOLTZ-EAKIN. I think he said something with which I
disagree. I mean, you don't always need an AMT to have a
progressive tax. You shouldn't have an AMT. The AMT is an
acknowledgement that the tax system is broken. The basic job of
constructing a Tax Code that raises the revenue in a sensible
fashion has not been accomplished. It's not that the AMT is
there to make sure that high-income people pay more taxes. It's
to make sure that they don't exploit the loopholes provided
legally in the regular tax in order to not pay taxes.
So, be clear. The goal is not to have an AMT, because that
would say, gee, we want to continue to fail at having a
sensible Tax Code. No. We do not want to have that as the goal.
How to target the AMT, I have no good guidance to give you. We
don't have a tax system that has any foundation in terms of
trying to meet objectives of fairness. It taxes high-income
people who are productive, employing people, eager to improve
the surroundings, are donating money to charity, the same as
high income people who are slugs. That makes no sense to me. So
I don't see how you ethically fix a tax system that has no
ethical foundations. I wish you luck.
Mr. BECERRA. I appreciate your answers [continuing]. Thank
you very much, Mr. Chairman. I yield back.
Mr. NEAL. Thank you. The gentleman from Kentucky, Mr.
Lewis, is recognized to inquire.
Mr. LEWIS OF KENTUCKY. The American people feel very simply
this way, I do not think they feel like they do not pay enough
taxes. I think their concern these days is how much the
government is spending. Dr. Burman, your testimony shows a
chart indicating that about 16 percent of all income is earned
by the top 1 percent. Treasury and CBO data show the share of
individual income taxes paid by the top 1 percent is about 37
percent. Does this suggest the Tax Code is progressive in
imposing greater burdens on higher income earners. That goes
without saying.
Mr. BURMAN. The Federal Tax Code overall is progressive.
Mr. LEWIS OF KENTUCKY. If 37 percent is not enough, then
how much would you like to see the top 1 percent pay? I think
that is what I am trying to get here today: what is fair?
Mr. BURMAN. It is actually not up to me to make that
decision, you as the elected Representatives have to reflect
what the people's preferences of the public are. People in
polls overall, over the last 50 years anyway, have supported
the idea of a progressive tax system where high-income people
pay a larger share of their income in tax than lower income
people. My personal view is that high-income people are doing
so well that they could probably afford to carry more of the
burden. They have gotten the largest gains from the economic
growth over the last 20 years but it is really your call.
Mr. LEWIS OF KENTUCKY. What share of taxpayers, and this is
not a question, 37 percent of all income taxes are paid across
the board by 90 percent of the lower income. The other question
is should the upper income folks take over more of that burden
or take over all of that burden?
Mr. BURMAN. Well, there is certainly an argument for having
everybody pay at least a little bit of tax. That said, low-
income people are in a situation where they really need help
from the government. One nice approach is the refundable earned
income tax credit, which can offset the income tax liability of
people who are working and cannot afford to feed and clothe
their families.
I should also point out that if you just look at the income
tax data, you get a somewhat misleading picture because most
American families pay more in payroll taxes than in income
taxes. If you look at taxes overall, payroll, excised income
and state taxes, people at every income level are paying
positive tax liability, it is relatively low at the bottom and
around 20 to 25 percent at the very top. Even at the top, at
the very top of the income distribution, people get to keep
something like three quarters of the income that they are
earning.
Mr. LEWIS OF KENTUCKY. Mr. Tanner of course I think brought
up the ultimate question, government expense is growing faster
than what eventually we can tax the American people to keep it
going, The PAY-GO rule, if we are going to spend more, we are
going to have to figure out how to come up with the money, cut
spending somewhere else or increase taxes. What is the breaking
point for the American people? Wealth is created in the private
sector, not in government. There comes a point when we kill the
goose who is laying the golden egg and, as has been said here
today, we cannot tax our way out of it but we are going to
reach a point where we cannot grow the economy to meet the
cost. So, we are going to have to come up with some good tax
policy, and we are going to have to come up with a way to
provide the necessary programs for the American people without
breaking them. So, anyway I yield back. Thank you.
Mr. NEAL. We thank the gentleman. Mr. Pomeroy is recognized
to inquire.
Mr. POMEROY. Well, I like my colleague's phrasing, I think
he has squarely put forward an economic view and ideological
view of the whole supply side economic theory that is addressed
in this month's New Republic. I would just like to quote from
an article discussing this theory: ``Supply side economics is
not merely an economic program, it is a totalistic ideology.
The core principle is that economic performance hinges almost
entirely on how much incentive investors and entrepreneurs have
to attain more wealth and that this incentive in turn hinges
almost entirely on their tax rates. Therefore, cutting taxes,
especially those of the rich who carry out the decisive
entrepreneurial role in the economy, is always a good idea.'' I
would like to ask our economists, each of whom I have great
respect for and think that you draw your conclusions based upon
the numbers, whether there is history to support this view,
that in the end our ability to grow the economy depends on
whether people invest and whether people will invest depends
upon how much their tax rate is and so that reducing the tax
rate always brings more investment? Let's start with you, Dr.
Holtz-Eakin. I have got several more questions, I guess two
more questions, so if we can do it quickly.
Mr. HOLTZ-EAKIN. First and foremost, I do not think any of
the major Ph.D.-granting economics departments uses The New
Republic to teach economics, and so I would encourage us to
look for more informed sources.
Mr. POMEROY. Actually, just to reclaim the point, I do not
quote The New Republic as an economic source, I do think this
particular article in doing an analysis on the economic basis
of the supply side economic theory offers value for our
discussion today. In that respect, is there economic data that
supports the view that a further reduction in tax always
produces more incentive to invest and therefore the more you
cut taxes, especially on the rich, it guarantees economic
growth?
Mr. HOLTZ-EAKIN. Every economist is trained that economic
growth is a supply side phenomenon in the following sense: To
grow, you must expand your capacity to produce by giving up
something today and investing in either greater physical,
intellectual----
Mr. POMEROY. No, no, in the filibuster, is that completely
related, Dr. Holtz-Eakin----
Mr. HOLTZ-EAKIN. No, no, that is actually, with all due
respect----
Mr. POMEROY [continuing]. Into the tax rate applied?
Mr. HOLTZ-EAKIN. With all due respect, if you want to
answer the question correctly, you have to frame it correctly
and so the question is how do you accumulate technology,
physical capital, human capital, skills which allow the economy
to be more productive? The answer is through incentives. Now
where do taxes fit in that? Taxes impair incentives and so you
should only use taxes to impair incentives if there are
beneficial public programs that they need to finance period.
You should not ever raise taxes----
Mr. POMEROY. You are not answering my question and you are
burning up my time, so let me ask you is the decision to invest
or not invest hyperlinked to the tax rate? Is that the
principal driving issue driving entrepreneurial investment in
our economy?
Mr. HOLTZ-EAKIN. It is inextricably linked to taxes, they
are part of the rate of return. No way to take it out.
Mr. POMEROY. Of course it is a factor, is it the principal
factor so that cutting taxes, especially those on the rich,
will always produce economic growth?
Mr. HOLTZ-EAKIN. Those are two different things.
Mr. POMEROY. Okay, you apparently have no interest in
answering the question, move to the next panelist.
Mr. FURMAN. An important determinant of national investment
is national savings and, as I have talked about before, in the
nineties we had higher tax rates, we also had higher rates of
investment, higher rates of savings, higher rates of job
growth. So, clearly the Tax Code in the nineties was compatible
with very strong economic growth and, as I said, I believe it
contributed to that strong economic growth by fostering
national savings. There is more than just taxes that matter for
economic growth. I am a supply sider, I agree with Dr. Holtz-
Eakin that it is the supply side that can create growth in the
long run but for that supply side, you need high national
savings, you need for example investments in the NIH, which
went up in the nineties and have been cut in real terms in
recent years. There are a lot of elements to a strategy for
supply side economic growth that have nothing to do with lower
taxes.
Mr. POMEROY. Pursuing the national savings issue, and, Dr.
Burman, we will give you a shot at the question, but pursuing
the national savings issue, I have distributed a chart and it
is displayed and it tracks the national savings rates. You will
see that the government savings, the bottom line goes into
surplus but sharply into deficits featuring in part the revenue
loss of the tax cuts passed under this administration. But as
you look, even though those deficits while still in deficit and
no longer a surplus, seems to be abating a little, the national
savings rate has plummeted and is actually in deficit. So, the
question then raises, Dr. Furman, has the tax cut strategy we
have embarked upon under this administration produced an
increase in national savings or has it actually potentially
contributed to a national savings problem?
Mr. FURMAN. Right, I would say almost any economist would
agree that our National savings rate is between one and 2
percentage points lower than it otherwise would have been if we
had not had the tax cuts that were passed beginning in the year
2001, without the tax cuts we would be saving one to 2
percentage points more depending----
Mr. POMEROY. With the Chairman's leave, could Dr. Burman
briefly respond to the first question, basically the Laffer
Curve question?
Mr. BURMAN. It depends, I think this is what Dr. Holtz-
Eakin was trying to say, on how you cut taxes. If you cut taxes
by broadening the tax base, holding revenues constant, most
economists would say that that would encourage savings,
investment and economic growth. If you do what we did in 2001
and 2003, borrow the money to finance the tax cuts, on the one
hand individuals might have an incentive to save more,
businesses to invest more, but the government is borrowing more
and that is draining the capital that businesses need to
finance for investment, increasing interest rates. The other
thing is looking at the savings rate, it is hard to make
personal savings move. Almost all the economic evidence
suggests that personal saving is relatively unresponsive to tax
rates. I am not saying there is no response but it is very
small. So, basically tax cuts can be good for the economy, they
could be bad for the economy. Tax increases is the same thing.
Mr. POMEROY. But if you are going to have tax cuts that are
good for the economy, they should be paid for so you do not
drive the deficit deeper. They should be broad-based and the
distribution tables we have seen of the tax cuts recently
enacted during this administration show disproportionate effect
to the wealthiest few, probably not spurring deeper investment.
They already had the money to invest. I yield back.
Mr. NEAL. We thank the gentleman. The gentle lady from
Ohio, Ms. Tubbs Jones, is recognized to inquire.
Ms. TUBBS JONES. Thank you, Mr. Chairman. I want to salute
you or celebrate you for all the work that you and the Chairman
have been doing in this area. I am pleased to have an
opportunity to participate in this discussion, particularly
about AMT. I am looking at some statistics that arise from the
11th Congressional District of Ohio and the people who are
impacted by this imposition. I am personally of the belief that
we need to do more than put a bandage on the AMT, that we need
to in fact implement it such that it is taken care of over a
period of time so that taxpayers, much like businesspeople,
have a knowledge about what is going to happen in the future
for their planning.
I in fact have two letters from my constituents, one dating
back to--originally back to 2005 in March and it comes from a
young man by the name of Tony Mastrioani, and he says, ``When
we worked together in the prosecutor's office, we prosecuted
matters deemed criminal by statute. For how it will potentially
decimate our district and others, alternative minimum tax ought
to be considered criminal. The AMT increased my Federal tax
liability by over $13,000. This increase did not result so much
from my income level but rather was directly related to the
fact that Cleveland Heights has among the highest property tax
rates in the state and the state of Ohio is among the states
with the highest income tax rate.'' It goes on to talk about
what he thinks we ought to do to fix the AMT.
Another letter from another constituent of mine by the name
of Doug Bondman says, ``I am writing to strongly encourage you
to repeal, re-write the AMT statute. As you are probably aware,
when the AMT was established, there was no provision for
inflation adjustment.'' So I am concerned that this
administration, in the course of trying to fix taxes, has
failed at any point other than say we will fix it year by year.
I am only going to give a short amount of time, answer that
question for me first, Mr. Furman, your position or your
comment with regard to what I have discussed about AMT? Burman,
I am sorry, Mr. Burman, I apologize.
Mr. BURMAN. I completely agree with you that the AMT ought
to be eliminated. I do not think it has a place in the income
tax and there are a number of options to do that in a fiscally
responsible manner and it would be great for you to do it.
Ms. TUBBS JONES. Mr. Furman.
Mr. FURMAN. I agree with that as well. I would like to say
as part of a broad tax reform, it would be wonderful to get rid
the AMT. The AMT should not be necessary. If this Committee
were able to undertake something that eliminated the AMT for
the vast majority of people that paid it but still kept it in
place for higher income people, I think that would also be a
very substantial contribution to improving tax policy in this
country.
Ms. TUBBS JONES. Mr. Holtz-Eakin, I am going to switch to
another subject matter. Did I hear you say that there was no
ethical standard in our taxing policy, is that what you said?
Mr. HOLTZ-EAKIN. When I see the U.S. income tax, I do not
see anything that looks like a coherent approach to taxation
that is based on single standards for raising revenue,
achieving economic efficiency and having some notion of
fairness.
Ms. TUBBS JONES. So, you do not really intend to use the
term ``ethical?'' You know I am chair of the Ethics Committee
so I am concerned about what you are saying the conduct of
Members of Congress as ethical, so you do not really mean that
it is not ethical?
Mr. HOLTZ-EAKIN. One can look at pieces of the Tax Code and
wonder if they have an ethical foundation that we would not be
proud of because there is no place in a good Tax Code for rifle
shot provisions that----
Ms. TUBBS JONES. Maybe you ought to define ``ethical'' for
us?
Mr. HOLTZ-EAKIN. What are you trying to achieve with the
Tax Code? What is the standard of fairness? Mine would be that
we should tax people more if they take more out of our economy.
We should tax them on that basis, not on the basis of what they
contribute. Income is a measure of what you contribute to an
economy. It is your labor, it is your capital, it is your
skills and energy. Consumption is what you take out.
Ms. TUBBS JONES. Mr. Eakin, thank you. I am running out of
time. I have one more question. Tell me in two or three words,
each of you, how you can say, if anybody says that the tax
policy does not cause inequality in this country? Tax policy
absolutely causes inequality in this country even if it is
based on the income of the people, we are looking at the fact
that the income in this country has separated, that there are
more rich people and more poor people than ever. There is this
disparity, how is it that tax policy could not have an impact?
Mr. BURMAN. The point we were making I think that it is not
likely it is a major factor in the distribution of pre-tax
income. My position is that the income tax plays an important
role in the distribution of aftertax income, that is it can
mitigate the effects of rising economic inequality. Of course,
over the last 6 years, the tax system has actually been going
in the opposite direction and becoming less progressive at the
same time that pre-tax incomes have been spreading out.
Ms. TUBBS JONES. So, you are saying it has become less
progressive and therefore it has a greater impact on the income
of folks?
Mr. BURMAN. On aftertax income, which is of course what
matters to individuals.
Ms. TUBBS JONES. One more answer and then I am done. Mr.
Furman.
Mr. FURMAN. The changes in the tax policy have not caused
the increase in inequality but had we not changed tax policy,
then the Tax Code would have solved a meaningful portion of the
inequality.
Ms. TUBBS JONES. But the fact that the way our tax policy
operates, it operates in the interest of people giving to
charity and charity impacts those at the lower income stream
because are more generous only because the Tax Code allows them
to be generous?
Mr. FURMAN. Oh, aftertax income is higher this year than it
would have been in the absence of the tax cuts enacted starting
in 2001.
Ms. TUBBS JONES. I am out of time. Thank you.
Mr. NEAL. I thank the gentle lady. The gentleman from New
York, Mr. Reynolds, is recognized to inquire.
Mr. REYNOLDS. I thank the Chairman for holding this
important hearing, which touches two critical tax policy issues
that I have been involved with for some time: the tax treatment
of carried interest and the tax relief from the AMT or, as I
like to call it, the ``stealth tax.'' I want to take a moment
to talk about a few key aspects of these two key issues, both
because they have such an enormous impact in my home state of
New York, as well as the country as a whole. Let me make three
specific points about the Levin-Rangel proposal to raise taxes
on investment partnerships by reclassifying their carried
interest as ordinary income rather than capital gains.
First, the Democrats are using Blackstone as a Trojan horse
to smuggle into law higher taxes on capital gains. Anyone who
thought the new Democratic majority might actually wait until
2010, the year the lower taxes on capital gains and dividends
are scheduled to expire, to raise taxes on investments should
be concerned. This bill is likely just the first of many
legislative assaults on the very tax incentives that have
helped create 8.3 million jobs over the past 4 years, a period
that has seen net job growth of 47 consecutive months. Indeed,
Democrats' new PAYGO rules will inevitably force them into
additional massive tax increases in order to fund their
voracious appetite for spending. While certain Wall Street fund
managers may be easy political targets, it is clear the new
majority is using Blackstone as the Trojan horse to sneak
through far broader tax increases. But the truth is that the
2003 tax cuts have worked. Mr. Chairman, notwithstanding some
of the revisionist history we will hear today that we have
already heard and will hear, particularly with the recent
turbulence we have seen in the credit markets, now is not the
time to make an economic u-turn by raising taxes, especially
when those tax hikes would discourage capital investments.
Second, this proposal would have a profound impact across
our National economy, from Wall Street to Main Street.
Proponents of the carried interest rate tax hike claim they are
only going after wealthy private equity hedge fund managers,
the Wall Street ``fat cats'' that so offend Democrats' notion
of tax fairness. However, the Levin-Rangel bill would actually
affect not just private equity and hedge funds but partnerships
across the spectrum, from small venture capital firms to local
real estate partnerships in each of our communities.
When Democrats use the phrase ``tax fairness,'' watch out,
it always seems to translate into tax increases on the middle
class. Indeed, not just investment partnerships themselves will
be affected by the Levin-Rangel proposal. Lost in all the
political rhetoric is the fact that university endowments,
charitable foundations, and public and private pension plans
are among the biggest investors in private equity and hedge
funds. For example, New York's common retirement fund, the
nation's third largest public pension fund with over one
million members, retirees and beneficiaries, have made
substantial investments in private equity and other alternative
investment vehicles. It helps bring the consequences of this
proposed tax hike into focus when we remember that grandma's
retirement security may be at stake.
Third, this proposal would hurt U.S. competitiveness in
global financial markets and further undermine New York's
position as the preeminent financial center of the world. As
the sole Republican Member on this Committee from New York, I
am particularly concerned that this legislation would make a
bad situation worse for U.S. competitiveness in international
capital markets, especially in the wake of Sarbanes-Oxley.
Though well-intentioned, Sarbanes-Oxley is now widely viewed as
having put a significant drag on our economy and having
undercut our capital market competitiveness where once New York
was unquestioned global headquarters for capital formation. For
example, billion dollar IPOs now occur far more regularly in
London and Hong Kong. Unfortunately, the damage Sarbanes-Oxley
has caused through excessive corporate regulation would only be
compounded by the Levin-Rangel carried interest proposal
through higher taxes on investment partnerships. The last thing
Congress needs to do is give investment partnerships new
reasons to explore their global options by imposing new taxes
on entrepreneurial risk taking here at home.
Let me turn briefly to AMT. The new majority talks a good
game about wanting to solve the AMT problem but history shows
that Democratic majorities created the AMT regardless of the
vote outcome in 1969, made it worse in 1993, opposed full
repeal of this unfair stealth tax in 1999. Republicans on the
other hand have consistently enacted legislation to limit AMT's
growing reach into the middle class during our years of the
majority. As author of the House Middle-Class AMT Relief bill
for 2006, the Stealth Tax Relief Act, I was pleased that
Congress was able to enact the most recent temporary patch
without raising taxes and with an overwhelming bipartisan vote
of 414 to 4. But now more than 8 months have come and gone
since that temporary relief expired, and we are still yet to
see an actual proposal from House Democrats on how to address
the AMT.
While I had originally hoped that we could have used these
past few months to make bipartisan progress on long-term AMT
solutions, the time has come to begin focusing our attention on
a realistic temporary fix for middle class America stealth tax.
Just as Senator Bachus has recommended and just as we did in
2006, we should enact that critical relief without raising
taxes somewhere else.
I thank the Chairman and yield back the balance of my time.
Mr. NEAL. We thank the gentleman. The gentleman from
Connecticut, Mr. Larson, is recognized to inquire.
Mr. LARSON. Thank you, Mr. Chairman. Mr. Chairman, let me
acknowledge your work and that of Chairman Rangel to provide 90
million Americans with direct tax relief finally. A lot of
crocodile tears on the other side of the aisle about everything
that would have, could have, should have. It has taken the
leadership of Mr. Neal and Mr. Rangel to bring this to
fruition, and I commend you both for that. I also commend our
analysts today (a) for your endurance and your willingness to
take a number of obvious important questions as it relates to
this subject matter before us. The first question I have
because it is always good discussion here on the Committee is I
believe it was Milton Friedman who famously said, ``To spend is
to tax.'' Are tax cuts simply another form of spending?
Mr. FURMAN. No, what he meant is that if you lower taxes
today at the same time that you raise spending, which is what
we have seen for the last 7 years, you are not actually
lowering the long-term tax burden, you are shifting taxes by
borrowing money today, which necessitates for any given level
of spending even higher taxes than you would otherwise have had
in the future. So his point--and I know a number of
conservative economists who have argued that the tax cuts
enacted in recent years do not need an economic definition of
tax cuts because they have been accompanied by higher debt and
will lead to higher taxes in the future.
Mr. LARSON. Well, if that logic follows through, would
refusal to extend the Bush tax cuts simply be a choice not to
spend more money to the wealthy?
Mr. FURMAN. It would be a choice to borrow less and would
mean that we would need less of a tax increase in the future
when our entitlement problems are severe.
Mr. LARSON. Do the other panelists want to comment?
Mr. HOLTZ-EAKIN. I think it is really simple, the threshold
issue is do you spend the money, so do you authorize and
appropriate money out of the Federal budget? Once you do that,
you are going to pay for it. If you choose not to raise taxes
this year, you will borrow and raise taxes to pay off that
debt. There is no way around that. His point was simply if you
commit to those resources in the public sector, you will take
them from the private sector one way or another.
Mr. BURMAN. There used to be a commercial for a muffler
company saying, ``You can pay me now or you can pay me later.''
Basically if you spend money, you have to pay for it. You can
pay for it with current taxes or future taxes or future
spending cuts.
Mr. LARSON. I believe it was the Fram Oil commercial as a
matter of fact and so the American public is paying now and
will be paying later.
With respect, Mr. Furman, in the Hamilton Project paper you
co-authored, you wrote, ``As capital moves more quickly across
borders, capital income becomes increasingly elusive of tax.''
It often seems to me that there are separate sets of rules for
different people and that this contributes greatly to income
inequality. We are very good at taxing wages, people fill out
W-2's and the employer withholds the tax and so forth. In this
age of globalization, it seems there are more and more ways of
making money and often the IRS and Congress itself cannot keep
up. So, my question is, I hope you will all join in, but are
sophisticated financial systems making it easier for
corporations to avoid paying taxes? If so, how do we make the
rules, i.e., the Tax Code, more fair to ensure that everyone
can benefit from globalization? Are we now in the 21st century
working with a Tax Code that was designed for another century?
If so, how do we remedy this?
Mr. BURMAN. I think those are probably the hardest
questions that will be facing us over the next couple of
decades. It certainly is true that globalization and technology
have made it harder to sustain a tax base. Some people would
say, well, the problem is you are trying to tax income but, as
Dr. Holtz-Eakin has pointed out, that exempting the return to
savings or exempting savings from taxing under a consumption
tax does not solve the problem, you shift it. Right now we have
to measure income. People try to hide income from the Treasury.
If we said we were only going to tax spending, then people
would make wages look like spending. The best thing is to
eliminate as many loopholes as possible, to broaden the base
and keep the rates as low as you can while maintaining
revenues. One thing we all know is that the rewards for tax
avoidance and evasion go up the higher the tax rate is, so that
puts a huge premium on having a relatively efficient tax
system.
Mr. LARSON. Mr. Furman.
Mr. FURMAN. I would say there are some places where there
are disagreements between the parties and between the different
persuasions, like the level at which you want to tax capital.
One thing we should all agree on though is that you want to tax
it in a consistent and coherent manner. So, for instance, it is
indefensible that debt-financed investment right now, corporate
investment is taxed at negative 6 percent. No one would defend
that at the same time that equity financed corporate investment
is taxed at 36 percent. So, the substantial scope for making
the tax rate that you pay on different types of activities,
corporations, partnerships, debt, equity, different forms of
investment at the business level, at the individual level,
making those more coherent. Once you are paying similar tax
rates on different types of activities, you can make those tax
rates lower, you can reduce the rewards to financial planning,
and you can do a better job of dealing with some of those
challenges in terms of technology, financialization and
globalization that have been eroding our tax base.
Mr. LARSON. I see that my time has expired. I do not know
if the Chairman----
Mr. NEAL. I thank the gentleman. The gentleman from Oregon,
Mr. Blumenauer, is recognized to inquire. There are four votes
on the House floor. We will move to Mr. Ryan next after Mr.
Blumenauer.
Mr. BLUMENAUER. Thank you very much, Mr. Chairman.
Chairman RANGEL. I really do not know whether we have time
to do this in the regular order, notwithstanding the fact that
those who have not inquired want to inquire. It would mean
bringing the panel back, and I guess that would be close to 45
minutes. However, if there are people who are scheduled to
speak that would be willing to yield and be the first ones to
come back to testify, if that is so, it would prevent us from
having to bring the panel back. So, let me informally ask,
among those who are about to inquire, any of you willing to be
the first to inquire of the second panel by yielding so that we
can dismiss this panel?
Mr. BLUMENAUER. If that is your preference, Mr. Chairman, I
am happy to relinquish----
Chairman RANGEL. Is there anyone who would have a problem
with it but that would prefer that the panel come back? There
is no way in the world for us to do this anyway. The only
question is whether or not those who want to continue would
have the panel come back. If you put up your hand and say you
want them to continue, then they will have to come back even if
it is only one. But if unanimously you are prepared to say that
you will accept the priority in terms of those of you who have
not questioned the panel, then it will make it easier for us to
go vote and then do that. As a matter of fact, I would ask that
you consider that, would you? Well, by unanimous consent, we
want to thank this panel because they have agreed to come back.
Mr. RYAN. Mr. Chairman? We still have about 5 minutes left,
can we do about 5 minutes before they leave?
Chairman RANGEL. Yes, it will be a Democrat that is up for
5 minutes, will that help you at all?
Mr. RYAN. I have got one question.
Chairman RANGEL. No you do not because you are not next.
Mr. Blumenauer has got 5 minutes.
Mr. RYAN. No, after Earl. We have what 6 minutes left on
the clock?
Mr. NEAL. There is time for Mr. Blumenauer to inquire.
Mr. RYAN. Look, it is fine, I am just saying we can run
this thing out to the end, then let's dismiss the panel. That
would be all I would suggest. Let's use up what time we have
and then dismiss the panel.
Chairman RANGEL. Okay, Mr. Blumenauer, I am asking to yield
to the gentleman, yield to you for your questions.
Mr. RYAN. Thank you.
Chairman RANGEL. I would just like to hear the question
though.
Mr. RYAN. I just had one quick question I wanted to ask.
Chairman RANGEL. I want to listen to it.
Mr. RYAN. Wonderful. I wanted to ask each of the three of
our economists, this is probably a yes or no answer, do you
believe that a lower capital gains tax rate on capital gains is
appropriate? Then I have one follow-up. Let's just start with
you, Mr. Burman, and go down the line.
Mr. BURMAN. Sorry, a lower capital gains tax rate?
Mr. RYAN. Is a lower capital gains tax rate a good thing,
is it appropriate?
Mr. BURMAN. No, I have a book on the subject.
Mr. RYAN. I realize that. Mr. Furman and Mr. Holtz-Eakin.
Mr. FURMAN. I would like to see us move toward a more
consistent way of taxing capital and business income and that
consistency is more important to me than the ultimate rate that
you end up at.
Mr. HOLTZ-EAKIN. Yes.
Mr. RYAN. Okay, Mr. Burman, because you have written most
extensively on this, you just did this very interesting op-ed
in the Washington Post about a month ago where you basically
conclude, and correct me if I get this wrong, that the whole
debate about carried interest, really if they want to get this
right from your perspective, which is not to tax carried
interest at the capital gains rate, instead of just plugging
this particular loophole so to speak, we should just get rid of
the lower preferential rate on capital gains altogether and
that if they do not do that, if they are short of that, then
smart people will get around whatever block Congress puts in
front of it, like the Rangel-Levin bill, and they will find
another way of taxing carried interest at 15 percent instead of
the higher 35-percent rate which you seem to advocate they
ought to go to, is that correct?
Mr. RYAN. I would eliminate capital gains tax rate except
in the case of corporate stock where there is an argument for
providing a credit for taxes paid at the company level. So,
putting something in the Code to prevent carried interest from
being taxed as capital gains, from your perspective the only
real way to do that is simply to eliminate the preferential tax
treatment on capital gains itself and then, as you mention, on
double taxation on corporate tax credits, is that basically
what you are saying we ought to go to?
Mr. RYAN. If you cannot fix the capital gains tax regime
overall, it would make sense actually to get rid of the tax
break and to move in the direction of the right taxes, which is
taxing these things that seem to be gains as income. So, I
would not agree with that.
Mr. RYAN. I just think it sheds light on where this
ultimate debate kind of ends up going. I thank the Chairman for
his indulgence.
Mr. NEAL. I thank the gentleman. Mr. Davis has asked that
he be allowed to use 1 minute to get to the panelists.
Mr. DAVIS. Thank you, Mr. Chairman. I just want to pose one
question and invite whichever one of you wants to take it, a
swing at it. One of the ironies to me, when the administration
sent up its budget earlier this year, there was a very
interesting contradiction. As it has done the last several
years, the administration resumed permanence of the 2001 and
2003 tax cuts and made a number of representations about their
essentialness to economic growth and job creation. At the same
time, the administration beyond a 1 year fix, presumed that the
AMT levels would continue to escalate over the next several
years. I thought that was a striking contradiction. If we are
concerned about tax rates impacting economic growth, it would
seem to me that we would be equally concerned about the AMT
levels. Do any of the three of you, perhaps you Dr. Holtz-
Eakin, want to comment on that contradiction and whether you
were struck by it as well?
Mr. HOLTZ-EAKIN. I did not read the budget carefully enough
to be struck by it but the bottom line is the Tax Code affects
growth through its incentives on----
Mr. DAVIS. Well, just speak to that point, do you see that
as a contradiction or any one of you want to speak to that?
Mr. HOLTZ-EAKIN. All marginal tax rates matter whether they
are AMT or otherwise. That is that.
Mr. RYAN. Dr. Furman.
Mr. FURMAN. I think it essentially is not a budget, does
not even meet the definition of a budget if it does not include
a set of very predictable things both on the tax side and
spending side in the future.
Mr. NEAL. I want to thank the panelists, as usual, most
informative and delighted you were here. The Chair will declare
the Committee in recess.
[Recess.]
Mr. NEAL. We will begin to receive testimony.
Mr. Shay, we would like to welcome you to open testimony
for the second panel.
Mr. SHAY. Thank you, Mr. Chairman. My name is Stephen Shay.
I am a partner at the law firm of Ropes & Gray. The views I am
expressing today are my personal views and do not represent the
views of either my clients or my law firm.
With the Chairman's permission, I would like to submit my
testimony for the record and summarize my testimony in
hopefully brief oral remarks.
Mr. NEAL. So, ordered.
STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY, LLP,
BOSTON, MASSACHUSETTS
Mr. SHAY. I will direct my testimony toward how fairness
concerns may be taken into account in U.S. tax rules relating
to the taxation of foreign business income, that is income
earned from conducting economic activity outside of the United
States. There is a joint Committee pamphlet that has a good
summary of our international tax rules so I will not cover
those.
I have previously testified that the current U.S. rules for
taxing international income, foreign income, while complex do
represent the best of all worlds for U.S. taxpayers engaged in
international activity. Taxpayers that are earning high tax
foreign business income can use excess foreign tax credits
against other low tax foreign income. The effect of this cross-
crediting is to provide an incentive to a taxpayer with excess
foreign tax credits to earn low taxed foreign income and then
to credit the high foreign tax against the U.S. tax on this low
foreign tax income. So, the current state of our credit rules
does provide an incentive to invest to earn foreign income that
is subject to lower taxes.
In addition, allowing U.S. taxation of foreign, active
foreign business income earned through a foreign corporation to
be deferred until repatriated as a dividend subject to some
anti-deferral rules encourages investment in lower tax foreign
countries. Over a long enough period, the difference between
the foreign effective rate and the U.S. effective rate can be
quite valuable in an even appropriate--I'm sorry, even approach
exemption. In practice, the current U.S. system of worldwide
taxation with elective deferral of U.S. tax on foreign
corporate business income while complex can be managed to
achieve very low effective rates of tax on foreign income.
Indeed, the overall effect can be more generous than an
exemption system for taxing foreign income.
There is no o priori reason for taking foreign income,
which is subject to these benefits, and excluding it from a
fairness analysis as we would the taxation of other income in
the U.S. system. In other words, there are some special
considerations with respect to international income but at the
end of the day, it is part of the overall U.S. tax system and
should be evaluated under the same criteria that we evaluate
the taxation of other forms of income.
If the U.S. taxation of foreign business income is lower
than on domestic business income, U.S. persons who do not earn
the foreign business income will be subject to heavier taxation
solely because of where their business or activity is located.
This violates the ability to pay norm and can be justified only
if there is an identifiable benefit to individual U.S. citizens
and residents.
In my testimony, I have explained why I think a limited
foreign tax credit that does eliminate double taxation is
justifiable even though on its face it is inconsistent with an
ability to pay criterion. I go into that in the testimony.
But I do conclude that our current rules do permit
excessive crediting of foreign taxes and to some extent that is
illustrated by the fact that if you go to an exemption system,
we actually would, it is estimated we would raise revenue and
that is a result of the fact that under our current system we
can cross credit foreign taxes to a point that you get more of
a benefit than you would if you just exempted foreign income
altogether.
In my testimony, just outlining at a very high level some
thoughts for how one might address the current rules. I
respectfully submit that reducing the scope for deferral and
more closely aligning the foreign tax credit rules to the
purpose of avoiding double taxation should be supported on the
grounds of fairness as well as sufficiency.
I want to make a note about inter-company transfer pricing.
A taxpayer's ability to control inter-company pricing is a
fundamental attribute of international taxation. The necessary
flexibility of tax rules relating to transfer pricing, that is
to allow taxpayers to carry on their businesses, is a critical
factor in assessing a structure of those rules. In order to
restrict transfer pricing abuse, the focus must be on reducing
the effective tax rate differential between earning the foreign
income and the U.S. income and that is the thrust of the
direction of the changes I would support, as I have said, on
both fairness and efficiency grounds.
The current foreign tax--I'm sorry, reducing the scope for
deferrals would be a key element and improving the foreign tax
credit by repeal of the sales source rules and rationalization
of source rules for taxing income from intangibles would
contribute in this regard.
The changes that I describe in my testimony would move
toward equalizing the taxation of foreign and domestic business
income and the results, I submit, would be a fairer tax system.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Shay follows:]
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Mr. NEAL. We thank the gentleman. Mr. Leon Metzger, former
vice Chairman and chief administration officer of Paloma
Partners Management Company, we welcome your testimony.
Mr. Metzger.
STATEMENT OF LEON M. METZGER, ADJUNCT FACULTY, COLUMBIA, NEW
YORK, AND YALE UNIVERSITIES
Mr. METZGER. Mr. Chairman, Mr. Ranking Member, and
distinguished Members of the Committee, I applaud your efforts
to conduct a hearing on fairness and equity in the Internal
Revenue Code. I am here to explain why some hedge funds are
organized offshore. Investors in hedge funds can be classified
as U.S. taxable, U.S. tax-exempt, and foreign. In a master
feeder arrangement, the fund advisor manages only one pool of
trading capital, the ``master'' fund, which is either an
onshore or offshore limited partnership, or an offshore
corporation that ``checks the box'' to be treated as a
partnership for U.S. tax purposes. The master fund's capital is
supplied by two or more feeder funds. Taxable investors invest
in one ``feeder'' fund, a flow-through entity, while U.S. tax-
exempt and foreign investors invest in the other one, an
offshore corporation.
Usually, hedge funds compensate their advisers in two ways:
a management fee, frequently 2 percent of capital under
management, and incentive compensation, typically 20 percent of
the profits. In my experience, most hedge fund income of U.S.
taxable investors is taxed at ordinary rates because, one,
funds tend to trade rapidly in and out of positions, which
generate short-term capital gains or losses; two, all capital
gains and losses deriving from short sales are treated as
short-term; three, gains or losses from section 1256 regulated
futures contracts, no matter how long the positions are open,
are treated as 60 percent long-term and 40 percent short-term
capital; and, fourth, many funds elect section 475 mark-to-
market ordinary-income treatment.
Hedge fund advisers to offshore corporate feeder entities
often defer their management fee and incentive compensation for
periods as long as 10 years when they expect that the benefit
of deferral will exceed the benefit of being taxed partially at
preferential rates. Therefore, hedge fund advisers that can
elect to defer their income instead of receiving a carried
interest often do so.
How does deferral work? The offshore corporation accrues
the compensation for the advisor but does not pay it. Each
year, the notional value grows or contracts at the same rate as
the performance of the fund. Assuming an adviser uses the cash
method of accounting, the adviser does not record any taxable
income until the compensation is paid.
Why do U.S. tax-exempt investors invest offshore? These
investors would be subject to tax on their share of earnings
from unrelated--if they invested in a flow-through entity.
Typically, the income they receive when they redeem their
shares is not considered unrelated debt--financed income
because these blocker corporations prevent the debts from being
attributed to tax-exempt investors. These offshore corporations
are located in either no- or low-tax jurisdictions. In general,
the only U.S. tax paid by these corporations is the U.S.
withholding tax on dividends received. Often, derivative
financial instruments are used to avoid the dividend
withholding tax.
There has been talk about possibly taxing U.S. tax-exempt
investors on their indirect share of unrelated debt-financed
income even if they invest through offshore corporations. If
the purpose of such a law is to raise revenues to offset the
elimination of the alternative minimum tax, it is worth noting
that many of the beneficiaries of pension plans that invest in
hedge funds are middle-class taxpayers. What they save in AMT,
they might give back in reduced pension benefits, if such a law
were enacted.
Foreign investors invest through offshore blocker
corporations to maintain confidentiality and to avoid the U.S.
regulatory environment applicable to U.S. taxable investors.
These corporations also allow foreign investors to avoid direct
liability from the fund's ``effectively connected income,'' if
any.
My written statement addresses other important issues.
Thank you for inviting me to testify. I would be happy to
answer any questions you may have.
[The prepared statement of Mr. Metzger follows:]
Prepared Statement of Leon M. Metzger, Former Vice Chairman and Chief
Administration Officer of Paloma Partners Management Company
Mr. Chairman, Mr. Ranking Member, and Distinguished Members of the
Committee:
I applaud your efforts to conduct a hearing on fairness and equity
in the Internal Revenue Code (Code). I am here to explain why some
investment funds are organized offshore.\1\
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\1\ By way of background, I teach hedge-fund management courses at
Columbia, New York, and Yale Universities. An expert witness,
arbitrator, and consultant on financial-services matters, I was
associated with a hedge fund management company for 18 years, most
recently as its vice chairman and chief administrative officer. My
opinions do not necessarily reflect those of any institution with which
I have been or currently am affiliated. I do not hold myself out to be
a tax expert.
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Investors in hedge funds, which are private investment vehicles,
can be classified as U.S. taxable; U.S.-tax-exempt; and foreign. Each
has a different goal. For example, taxable investors prefer long-term
capital gains (LTCGs) and qualified dividends to short-term capital
gains and ordinary income, flow-through\2\ status of their investment
vehicles, and the flexibility to invest in certain derivative financial
instruments that would minimize their current tax liabilities. U.S.
tax-exempt investors might want to avoid investing in flow-through
entities that generate unrelated debt-financed income (UDFI).\3\
Foreign investors might want to avoid investing in an entity that
generates income that is effectively connected with a U.S. trade or
business. U.S. tax-exempt and foreign investors want the investment
entity to minimize the amount of U.S. withholding taxes, and all three
types want to avoid incurring costs that pay for a transaction that
benefits the other type but not itself.\4\
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\2\ Flow-through entities in this context either can be general or
limited partnerships; limited liability companies (LLCs), which are
treated as partnerships for tax purposes; S corporations; and certain
trusts. For purposes of this discussion, when I use the term, ``flow
through,'' I am referring to either partnerships or LLCs.
\3\ UDFI is considered unrelated business taxable income (UBTI) to
otherwise tax-exempt investors.
\4\ For example, a notional principal contract (e.g., swap) may
achieve an inferior pre-tax economic result compared to a direct
investment, but, post-tax, it may generate a superior result for
taxable investors notwithstanding the financing cost involved. For an
investor who does not pay taxes, the financing cost of the contract
represents an economic cost without any offsetting gain.
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Most hedge funds use one of two structures to satisfy the
investors. In a side-by-side arrangement,\5\ the fund adviser\6\
manages two or more pools of trading capital, one in the U.S. for
taxable investors, and the others offshore for U.S.-tax-exempt and
foreign investors, often by splitting tickets\7\ between or among the
pools.
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\5\ A side-by-side structure could look like this:
\6\ For this testimony, the term, ``adviser,'' includes advisers,
LLC managers, and general partners.
\7\ Splitting tickets is the process where the adviser enters one
trade on behalf of two or more clients, and subsequently allocates the
trade between or among those clients.
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In a master-feeder arrangement,\8\ the fund adviser manages only
one pool of trading capital, the ``master'' fund, which is either an
onshore or offshore limited partnership, or an offshore corporation
that ``checks the box'' to be treated as a partnership for U.S. tax
purposes. The master fund's capital is supplied by two or more
``feeder'' funds. Taxable investors invest in one feeder fund, also a
flow-through entity, while the U.S.-tax-exempt and foreign investors
invest in the other one, an offshore corporation.
---------------------------------------------------------------------------
\8\ A master-feeder structure could look like this:
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Usually, hedge funds compensate their advisers in two ways: a
management fee, frequently 2 percent of capital under management; and
incentive compensation, typically 20 percent of the realized profits,
which is structured either as another fee, if paid by an offshore
corporation, or as a special allocation of partnership profits, also
known as a ``carried interest,'' if paid by a flow-through entity. If
the feeder is a flow-through entity, often the management fee and
incentive compensation are paid to separate entities for state or local
tax reasons. Usually, the offshore corporation pays just the adviser.
In the early days of master-feeder arrangements, the master funds
were more often located onshore. More recently, the trend is for master
funds to be located offshore.
In my experience, if one looks at the total pool of taxable income
generated by all hedge funds, most of that income is not taxed at
preferential rates. Reasons for this range from the fact that such
funds tend to trade rapidly in and out of positions, which generates
short-term capital gains and losses, to the rule that all capital gains
and losses deriving from short sales, no matter how long the short
sales are held open, are treated as short-term. Furthermore, gains or
losses from section 1256 regulated futures contracts, no matter how
long the positions are open, are treated as 60 percent long-term and 40
percent short-term capital. Last, many funds elect section 475 mark-to-
market ordinary-income treatment. Hence, the preferential-rate income
from the carried interest may be less than what many might have you
believe.
Hedge fund advisers to offshore corporate-feeder entities often
defer their management fee and incentive compensation for periods as
long as ten years when they expect that the benefit of deferral will
exceed the benefit of being taxed partially at preferential rates. For
example, if a fund earns 10 percent pre-tax, of which 65 percent of its
income is derived from preferential-rate income, the adviser will earn
more, after tax, if he or she elects a ten-year deferral rather than
accepting a carried interest. On the other hand, at a 20 percent pre-
tax growth rate, almost 90 percent of a fund's income would need to be
derived from preferential-rate income to make the manager prefer a
carried interest to a ten-year deferral.\9\
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\9\ This table illustrates scenarios under a ten-year deferral:
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How does the deferral work? The offshore corporation accrues the
compensation to the adviser but does not pay it. Each year, the
notional value grows or contracts, as the case may be, at the same rate
as the performance of the fund. Assuming an adviser uses the cash
method of accounting, the adviser does not include any income until it
is paid. Advisers who opt for deferral take real economic risk because
if the fund loses money, their eventual compensation will be reduced
pro rata. Deferred compensation is subject to the claims of the general
creditors of the offshore corporation.
Hedge fund advisers to onshore flow-through entities might also
structure their management fee as a carried interest.\10\ If the fund
loses money and the management fee is paid in the form of a carried
interest, however, the manager might need to borrow money to fund
operations. Hence, these managers might take real economic risk to
reduce their taxes. The incentive compensation in this case typically
is an allocation of partnership profits.\11\
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\10\ Fund Managers' Taxes May Rise as Senate Targets Fees
Stratagem, By Ryan J. Donmoyer, Bloomberg News, June 19, 2007, http://
www.bloomberg.com/apps/news?pid=20601070&refer= home&sid=aYdxW3YnhjK4
\11\ In a U.S. corporation or partnership, there is a disincentive
to deferral insofar as the employers will receive a current deduction
if the compensation is paid currently. In a domestic situation, there
is thus a tension between employees, who want to defer their
compensation, and employers that wish to take a current deduction. When
a hedge fund is formed with an offshore corporate feeder, there is no
countervailing force working to ensure that the deduction is taken into
account as soon as possible (unless it is a flow-through entity or a
corporation that elects to check the box to be treated as a partnership
for U.S. tax purposes). This lack of an incentive is one reason why
hedge fund managers are able to defer their compensation for a
significant portion of time.
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Why do U.S.-tax-exempt investors invest offshore? These investors
would be subject to tax on their share of earnings from UDFI if they
invested in a flow-through entity. Typically, the income they receive
from a corporation when they redeem their shares is not considered UDFI
because the corporate ``blockers'' prevent the debt from being
attributed to the tax-exempt investors. And, the offshore corporations
are located in either no- or low-tax jurisdictions. In general, the
only tax paid by these corporations is the U.S. withholding tax on
dividends received. Often, the adviser is able to use derivative
financial instruments to avoid the dividend withholding tax.\12\
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\12\ IRS Probes Tax Goal of Derivatives, by Anita Raghavan, The
Wall Street Journal, July 19, 2007, page C1.
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While it may seem like an artificial device to allow a U.S.-tax-
exempt investor to avoid UBTI simply by investing through a blocker
corporation, it is questionable if UDFI from investments in hedge funds
that trade securities\13\ was ever the type of UBTI Congress had in
mind when it enacted in 1950 and expanded the definition of UBTI in
1969 to cover abusive sale-leaseback transactions in which certain
organizations rented their tax-exempt status for a fee.\14\ Recently,
there has been talk about possibly taxing the U.S.-tax-exempt investors
on their indirect share of UDFI even if they invest through offshore
corporations. If the purpose of such a law is to raise revenues to
offset the elimination of the Alternative Minimum Tax, it is worth
noting that many of the beneficiaries of pension plans, which invest in
hedge funds, are middle-class taxpayers. What they save in AMT they may
give back in reduced pension benefits.\15\ While an overhaul of UDFI,
section 514 of the Code, could lead to renewed abusive transactions, by
allowing U.S.-tax-exempt investors to continue to rely on blocker
corporations, Congress need not repeal section 514.
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\13\ Admittedly, the term, ``hedge fund,'' is a self-designated
moniker and certain of those funds engage in commercial activities that
would not necessarily be considered trading in securities.
\14\ Statement Regarding Unrelated Debt Financed Income and
``Blocker Corporations,'' June 27, 2007, Council on Foundations, http:/
/www.cof.org/files/Documents/Government/HedgeFundJune2007.pdf.
\15\ I thank my NYU students, who called my attention to this
point.
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Foreign investors invest through offshore blocker corporations to
maintain confidentiality and to avoid the U.S. regulatory environment
applicable to U.S. taxable investors. The blocker corporation also
allows foreign investors to avoid direct liability from the fund's
``effectively connected income,''\16\ if any.
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\16\ In general, active business income other than trading in
stocks, securities, and commodities.
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If the master fund were an offshore corporation rather than a
partnership, why might the adviser receive its compensation at the
feeder-fund level rather than at the master-fund level? If deferral
were so much better than receiving preferential-rate income, would it
not make more sense if the master fund elected to defer the income? The
answer is that because the master fund checks the box to be treated as
a partnership, the investors in the U.S. feeder would not be entitled
to a tax deduction for the adviser's deferred fees until they were
paid, which would mean that their taxable income would exceed their
economic income, which is usually an undesirable result.
Why might a master fund be domiciled offshore? First, the
regulatory burden might be simpler there. Second, the administrative
burden of withholding taxes is removed from the fund, which eliminates
its risk of being subject to penalties for under withholding. Third, in
certain jurisdictions, the fund may be able to achieve a higher degree
of leverage than what U.S. regulators might allow. Last, there may be a
sourcing (and thus withholding) benefit with regard to certain notional
principal contracts.
Why might a master be domiciled onshore? First, the adviser might
prefer to use Delaware law. Second, while the fund has the
administrative burden of dealing with withholding taxes, it can hold,
for a longer period, the cash that would otherwise be needed to be
withheld, and earn income on such cash.
What are some of the advantages of the master-feeder arrangement
compared to side-by-side funds? First, the adviser does not need to
split tickets to generate similar returns between the funds. Second, if
an investor withdraws from or contributes to a fund, the positions sold
to meet the redemption or the asset purchased with the new funds will
be spread pro rata among all investors, which enables the investors to
earn similar returns, without requiring the adviser to re-balance the
portfolios. Third, a larger pool of capital may ease credit terms, as
there is more collateral.
What are some of the disadvantages of the master-feeder arrangement
compared to side-by-side funds? First, the fund may lose the ability to
invest in, say, a U.S. broker-dealer, which has customers, or a lending
business because that might generate effectively connected income,
which foreign investors want to avoid. Second, the adviser has the same
fiduciary responsibility to all investors and cannot favor one class
over another. Therefore, for example, the master may have to turn down
the opportunity to invest in a derivative financial instrument that
could convert ordinary income into LTCGs because the cost to finance
such an investment would be borne by all investors, including those
that do not stand to benefit from the tax savings. In such instances, a
feeder fund might make an investment that another feeder cannot.
CONCLUDING COMMENTS
In this section, I will address other issues.
Carried interest is not a recently discovered nefarious tax
loophole. Advisers to hedge funds and other industries have used it for
many years.
I do not believe that hedge-fund and private-equity advisers should
be subject to one set of tax rules, while others, who provide similar
services, are subject to different rules, whether more lenient or
strict. Singling out specific industries for special adverse tax
legislation by enacting, e.g., a ``hedge-fund adviser's windfall
profits tax'' would be poor public policy. I agree with H.R. 2834, in
this respect, that a carried interest is no different whether the
investment vehicle holds real estate, oil and gas, venture capital, or
stocks, bonds, and derivative financial instruments.
Some have argued that if all carried interest were taxed at
ordinary rates, it might lead to fund managers' increasing their
compensation beyond the typical ``2 and 20'' arrangement, which would
reduce the returns of investors like pension plans and endowments.
There is no requirement for advisers to charge ``2 and 20.'' Indeed, it
has been reported that one can find managers who charge ``3 and 50,''
``5 and 44,'' and ``4 and 23.'' And, some charge less than ``2 and
20.'' The adviser's compensation typically is determined by the market.
Advisers that have exceptional performance records or that have
convinced investors that the prospects of exceptional performance are
excellent, may try to charge more than ``2 and 20.'' In contrast,
advisers that have less-stellar performance records will encounter
resistance from investors if they try to charge higher fees. Fees will
increase if advisers try to raise them and the investors acquiesce.
If Congress decides to tax all income from carried interests as
ordinary, some funds might try to replace a ``2 and 20'' structure with
some variation of a higher management fee and partially non-recourse
loan from the investors economically similar to a 20 percent carried
interest. Effectively, the adviser would retain economics and tax
consequences similar to the 20 percent carried interest on the positive
side, but now would be exposed to any negative performance\17\ and
would incur interest expense, which might be offset by the higher
management fee. If the economics for investors were potentially
impaired by this type of arrangement, such deal could be implemented
only if investment demand for those funds were relatively inelastic.
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\17\ Should, for example, the fund implode, the adviser might have
cancellation-of-indebtedness (COD) income from the loan and capital
loss from the decline of its share of the fund, which would not
necessarily offset because of the difference in character between those
types of income. On the other hand, if, because of such an implosion,
the adviser becomes insolvent, section 108 of the Code may exclude the
COD income while simultaneously reducing the basis of the adviser's
interest in the fund.
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Does the U.S. economy truly benefit from preferential-income
rates\18\ and is ``realization,'' rather than change in market value,
the appropriate aspect for determining when income should be taxable to
certain persons? If we retain the status quo, taxpayers will continue
to arrange their affairs so that they can achieve the best character,
timing, and source.
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\18\ Market liquidity and price discovery might not change
significantly if preferential rates were eliminated. Paul Krugman, an
economic professor at Princeton University, says, ``[There's] very
little evidence that taxing capital gains as ordinary income would
actually hurt the economy.'' The New York Times, July 13, 2007, page
A19. The majority of trades that are executed on the New York Stock
Exchange are on behalf of public institutional investors, which do not
benefit from preferential rates (see, e.g., http://www.calstrs.com/
Investments/NYSEBoard112003.pdf). Alan S. Blinder, an economics
professor at Princeton University and former vice chairman of the
Federal Reserve, says, ``[The] evidence--[that lower taxes on capital
gains boost investment] is iffy at best, and there are better ways to
spur investment, like, say, the investment tax credit.'' He adds, ``The
tax preference for capital gains undermines capitalism--a system in
which capitalists, not the state, are supposed to make the investment
decisions.'' The New York Times, Sunday Business, July 29, 2007, page
4.
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Thank you for inviting me to share my views with you. I would be
happy to answer any questions you may have.
This analysis does not consider the effect of any state and local
taxes, e.g. New York City's Unincorporated Business Tax, which would
make a deferral less desirable, as would a shorter period.
Mr. NEAL. Thank you, Mr. Metzger. Janne Gallagher, who is
vice president and general counsel of the Council on
Foundations, we welcome your testimony.
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STATEMENT OF JANNE G. GALLAGHER, VICE PRESIDENT AND GENERAL
COUNSEL, COUNCIL ON FOUNDATIONS
Ms. GALLAGHER. Thank you. I want to acknowledge Professor
Schmalbeck's assistance in helping us puzzle through these
complicated issues.
The Council on Foundations is a membership organization of
grant-making institutions. Our mission is promoting and
enhancing responsible and effective philanthropy worldwide. My
statement today could be summarized in two simple points:
First, foundations seek diversified investment portfolios in
order to maximize their ability to serve the common good.
Second, we encourage any legislation that will remove the
barriers to direct investment by foundations in U.S. hedge
funds.
Before offering some background on why many foundation
investments and hedge funds are in corporate entities located
outside the United States, let me stress that the Council on
Foundations does not advocate the use of offshore blockers nor
do we have a position on whether Congress should restrict such
use.
Foundations investing through offshore blockers are
sophisticated investors. They include hedge funds among their
investments to diversify their portfolios, improve their yields
and enhance the preservation of their capital in down markets.
Based on surveys of our members, hedge funds were a small but
significant portion of investment portfolios, averaging about
8.4 percent for private foundations and about 7.5 percent for
community foundations.
Foundations invest in hedge funds to produce a stream of
revenue that provides support to communities in the United
States and around the world. I do not know of any foundation
that wants to invest in offshore blocker corporations. The
current law is such that foundations that elect to invest in
hedge funds would not be prudent stewards of their assets if
they did not use these corporations to block the application of
a tax that we believe Congress never intended to apply to this
form of investment.
We believe Congress should consider changing current law to
permit foundations to invest directly in U.S. hedge funds
without incurring adverse tax consequences. If the section 514
debt-financed property rules did not apply to hedge fund
investments, tax-exempts would be able to invest directly in
U.S. hedge funds and the use of offshore blockers would end.
We believe these changes can be accomplished without
creating new opportunities for abuse, and your next witness has
some recommendations in that regard.
Foundations that invest in offshore blocker corporations do
so in order to avoid exposure to unrelated debt-financed income
tax liabilities under section 514. Most hedge funds make use of
borrowed funds in some of their investment strategies but
because they are generally organized as limited partnerships,
the flow through characteristics of the partnership entity
results in any debt incurred by the hedge funds being imputed
to their charitable organization investors.
To address this problem, hedge funds have created foreign
corporations in low tax jurisdictions and under a series of
private letter rulings from the Internal Revenue Service, the
dividends those corporations distribute to their charitable
shareholders are free of any debt-financed taint.
Congress enacted the debt-financed property rules primarily
to prevent transactions that use the charitable organization to
convert ordinary business income into gains that could be taxed
at lower rates as capital or quasi-capital gains.
Unfortunately, section 514 does not distinguish between
legitimate and illegitimate uses of debt. Further, debt today
plays a much more important role in investment portfolios than
it did back in 1969.
Finally, a number of post-1969 changes to the tax law
generally make the transactions at which section 514 was aimed
uneconomical or pointless, most significantly, the fact that
corporations no longer enjoy a rate preference on their capital
gain income.
In closing, we urge Congress to review the continued needs
of the debt-financed property rules in light of other changes
to the Tax Code and the distorting effect those rules have on
investments by tax-exempt organizations. A further reason to
look at section 514 is to address the disparity in the current
exemption that is afforded to pension funds and universities
but not to other charitable organizations if they invest in
debt-financed real property. There is no apparent policy reason
for this distinction, as joint Committee explanation notes, and
we believe that section 514 without an exemption for other
kinds of charitable entities unfairly disadvantages efforts by
foundations to manage and diversify their portfolios through
the inclusion of investments in real property. We ask that you
consider making that exception available to all charitable
organizations. Thank you very much.
[The prepared statement of Ms. Gallagher follows:]
Prepared Statement of Janne G. Gallagher,
Vice President and General Counsel, Council on Foundations
Thank you. Accompanying me is Richard Schmalbeck, Professor of Law,
Duke University. Professor Schmalbeck is the primary author of the
Council's June 27 White Paper, ``Statement on Unrelated Business Income
and Blocker Corporations.' We have submitted a copy of the paper as
part of the record of this hearing.
The Council on Foundations (COF) is a membership organization of
more than 2,000 grantmaking foundations and giving programs worldwide.
For more than 55 years, the Council has served the public good by
promoting and enhancing responsible and effective philanthropy. My
statement today could be summarized in two simple points:
Foundations seek a diversified investment portfolio to
enhance their returns and their ability to serve the common good.
We encourage any legislation that will remove the
barriers to direct investment by foundations in U.S. hedge funds.
Let me provide some background on why many foundation investments
in hedge funds are in corporate entities located outside the United
States. But, I want to stress at the outset that the Council on
Foundations does not advocate the use of offshore blockers, as these
entities are commonly called, nor do we have a position on whether
Congress should restrict such use.
Foundations investing through offshore blockers are sophisticated
investors that include hedge funds in their investment portfolios to
diversify their portfolios, improve their yields and enhance the
preservation of their capital in down markets. They invest in hedge
funds as part of an overall investment strategy that is designed to
produce a stream of revenue that provides support to communities in the
United States and around the world. I don't know of any foundation that
wants to invest in offshore blocker corporations, but current law is
such that foundations that elect to invest in hedge funds would not be
prudent stewards of their assets if they did not use these corporations
to block the application of a tax that we believe Congress never
intended to apply to this form of investment. The Council believes the
solution is to change current law to permit foundations to invest
directly in U.S. hedge funds without incurring adverse tax
consequences. If the section 514 debt-financed property rules did not
apply to hedge fund investments, tax-exempts would be able to invest
directly in U.S. hedge funds and the use of offshore blockers would
end. We believe these changes can be accomplished without creating new
opportunities for abuse.
Many tax-exempt organizations, including universities, foundations,
and pension funds, include hedge funds in their investment portfolios.
According to Council surveys, community foundations invested an average
7.5 percent of assets in hedge funds in 2006, while private foundations
allocated 8.4 percent to hedge funds in 2005. From an investment
viewpoint, these strategies have been successful, producing returns
that have generally exceeded overall market performance measures in
both rising and falling markets. They are not, of course, without risk,
as recent events have demonstrated, and the Council has taken steps to
educate our members about factors to consider in making investments in
hedge funds. For example, our just-published report, 2006 Investment
Performance and Practices of Community Foundations, includes a five-
page article, ``The Dimensions of Investment Risk--Hedge Funds and Non-
Market Risk,'' by a highly-respected investment consultant.
Tax-exempt organizations face a problem, however, in structuring
their investments in hedge funds in ways that do not create exposure to
unrelated debt-financed income tax liabilities under section 514 of the
Internal Revenue Code. Hedge funds make use of borrowed funds in some
of their investment strategies, especially those involving arbitrage.
Because hedge funds are usually organized as limited partnerships,
rather than as corporations, that borrowing is imputed to their
partners, including any charitable organizations that may be limited
partners. If a hedge fund were organized as a corporation, it could
freely use debt in pursuit of its investment strategies, and still pay
dividends to charitable stockholders that would not be characterized as
unrelated debt-financed income. However, operating through a corporate
structure would generate income tax liabilities at the entity level
that are otherwise completely avoidable and that would be unacceptable
to the fund's non-exempt investors.
To address this problem, hedge funds have created foreign
corporations in low-tax jurisdictions. These corporations, in turn,
invest in limited partnership hedge funds--typically in funds organized
and operated within the U.S. The foreign corporations under these
arrangements pay little corporate income tax in the countries in which
they are incorporated (because of the very low rate structures
generally prevailing in those countries). However under a series of
private letter rulings from the Internal Revenue Service, the dividends
they distribute to their charitable shareholders are free of any debt-
financed income taint.
Congress enacted the debt-financed property rules primarily to
prevent transactions that used a charitable organization to convert
ordinary business income into gains that could be taxed at lower rates
as capital (or quasi-capital) gains. Unfortunately, section 514 does
not distinguish the legitimate use of debt from sham transactions.
Investment portfolios maintained by taxable individuals and entities
often make judicious use of debt to enhance returns in ways that cannot
be described as abusive of any tax rules and which does not present the
abuse section 514 was designed to prevent. Further, a number of post-
1969 changes to the tax law that have nothing to do with charitable
organizations would generally make the transactions at which section
514 was aimed either uneconomic or pointless today. The most
significant among these is the fact that corporations no longer enjoy
rate preferences on capital gain income, which obviates any attempt to
convert ordinary business income into capital gain in most cases. There
may be a few special circumstances to which the unrelated debt-financed
property rules should still apply, but hedge fund investments are not
among them.
The primary purposes of the unrelated business income tax, and of
the debt-financed property rules, are to protect the integrity of the
corporate income tax, and to preserve a level playing field in cases
where nonprofit organizations and profit-seeking firms compete.
However, in cases where a nonprofit organization merely makes an
investment, but does not actively conduct a business, Congress has
provided exemption for the passive investment income received by the
organization from the unrelated business income tax. This exemption
extends both to income that was subject to tax at the corporate level
(dividends), but also to income (rents, royalties, capital gains) upon
which no corporate tax was paid. The income of hedge funds is not
ordinarily exposed to corporate-level taxation, due to the widely
accepted structuring of such funds as limited partnerships. Individual
investors in such funds are and should be liable for taxes on the
income of the funds; but since charitable entities are normally not
liable for taxes on income from their investments, they should not be
taxed on investment income generated by hedge funds. The use of blocker
corporations effectively achieves this result, but the use of blockers
would not be necessary if the tax were not construed as applying to
theses investments.
The issue of the use of offshore blocker corporations in hedge fund
investments illustrates the need for Congress to review the continued
need for the debt-financed property rules in light of other changes to
the Tax Code and the distorting effect of the rules on investments by
tax-exempt organizations. An additional reason for undertaking such a
review is to address the disparity in the current exemption for
investments in debt-financed real property, which excludes only
investments made by universities and by pension plans and not those by
other tax-exempt organizations including foundations. There is no
apparent policy reason for this distinction, which unfairly
disadvantages efforts by foundations to manage and diversify their
portfolios through the inclusion of investments in real property. We
ask you also to consider making this exemption available to all
charitable organizations if you undertake a reform of section 514.
Mr. NEAL. Thank you, Ms. Gallagher.
Suzanne Ross McDowell is a partner at Steptoe & Johnson. Ms.
McDowell, we welcome your testimony.
STATEMENT OF SUZANNE ROSS MCDOWELL, PARTNER, STEPTOE & JOHNSON,
LLP
Ms. MCDOWELL. Thank you. Mr. Chairman, Ranking Member Mr.
McCrery and Members of the Committee, thank you for inviting me
to appear today. My practice focuses on the law of tax-exempt
organizations. In the eighties, I served in the Office of Tax
Policy at the Treasury Department where I was responsible for
issues relating to tax-exempt organizations, including issues
relating to debt-financed income property. Since leaving
Treasury, I have written papers and given presentations on the
debt-financed income rules. My testimony will focus on these
rules. It represents my views, not those of my firm, any
client, or any other organization.
Let me begin with a brief overview of current law. For over
50 years, congressional policy has been to exclude most types
of investment income from the unrelated business income tax.
However, if the investment income is derived from property that
was acquired with debt, the income is taxed under the debt-
financed income rules. Thus, the debt-financed income rules are
an exception to the general congressional policy of exempting
investment income of tax-exempt organization from tax.
The original purpose of the debt-financed income rules,
however, was not so broad. Rather, when enacted in 1969, these
rules were intended to foreclose abusive sale leaseback
transactions. These transactions permitted businesses to sell
property to tax-exempt organizations in transactions that
converted ordinary income to capital gains and allowed the tax-
exempt purchasers to buy the property over time while investing
little or none of their own capital. No one suggests that it
was not a good idea to put an end to such transactions.
The unrelated debt-financed income rules can be avoided on
securities and financial products by investing through foreign
corporations referred to as ``blocker entities,'' as Mr.
Metzger described.
At first blush, blocker entities may look like a loophole
that should be shut down. However, blocker entities are
frequently used to avoid the application of unrelated debt-
financed income rules to legitimate, non-abusive transactions
that were not the intended target of the rules. Thus, before
taking action on blocker entities, it makes sense to take a
look at the policy and impact of the unrelated debt-financed
income rules.
These rules tax all debt-financed investments of tax-exempt
organizations even though they were enacted for the narrower
purpose of foreclosing abusive sale leaseback transactions. The
current breadth of application of these rules would be
justified only if all leveraged investments of tax-exempt
investors should be discouraged. The purpose of leverage is to
increase the investor's return on investments. The tradeoff for
the increased return is taking on greater risk. The increased
risk of an individual investment, however, can be reduced
through diversification in the investor's portfolio.
Furthermore, investments that do not use debt or leverage may
be as risky or riskier than leveraged investments. Thus, taxing
all debt-financed income is not an effective way to protect
tax-exempt investors from risks if, indeed, that is the
purpose. Moreover, the level of risk permissible for tax-exempt
organizations is already addressed by various other laws at
both the Federal and state level. These laws, which are
explained in more detail in my written statement, permit the
prudent use of debt financing.
As more fully described in my written statement, an
additional problem with the debt-financed income rules is that
they have been applied in a rigid manner that makes formalistic
distinctions between debt and leverage. The result is that the
rules tax transactions which involve straightforward borrowing
in the traditional sense while permitting investors who use
leverage in more sophisticated transactions to escape tax.
Finally, blocker entities are not the only way to avoid the
debt-financed income rules. These rules can also be avoided by
investing in mutual funds or REITs and through certain
contractual arrangements.
I urge the Committee to significantly restrict the
application of the debt-financed income rules. Under current
law, there is an exception for real estate transactions if the
transactions meet certain requirements which are designed or
intended to prevent abuse. The exception is currently available
only to pension funds and universities. This exception and its
requirements should be used as the model for a broader
exception to the debt-financed income rules applicable to all
types of debt-financed property and available to all tax-exempt
organizations. My written testimony expands on this suggestion.
If Congress amends the unrelated debt-financed income rules
as suggested, tax-exempt investors would no longer be forced to
invest offshore and use blocker entities to avoid unrelated
debt-financed income rules on legitimate investments. Further,
the current disparate treatment between direct borrowing and
leverage and between different types of tax-exempt investors
would be eliminated.
Thank you again, and I would be pleased to answer any
questions you may have.
[The prepared statement of Ms. McDowell follows:]
Prepared Statement of Suzanne Ross McDowell, Partner, Steptoe & Johnson
LLP
Mr. Chairman and Members of the Committee:
My name is Suzanne Ross McDowell. I am a partner in the law firm
Steptoe & Johnson llp in Washington, D.C. My practice focuses on the
law of tax-exempt organizations with particular emphasis on tax,
corporate governance, and commercial transactions. From 1983 to 1987, I
served in the Office of Tax Policy at the U.S. Department of Treasury
and was responsible for issues relating to tax-exempt organizations,
including issues related to the debt-financed income rules. Since
leaving the Treasury Department, I have written academic papers and
given presentations on the debt-financed income rules and numerous
other topics relevant to tax-exempt organizations.\1\
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\1\ Taxing Leverage Investments of Charitable Organizations: What
is the Rationale?, 39 Case W. Res. L. Rev. 705 (1988); Taxation of
Unrelated Debt-Financed Income, 34 Exempt Org. Tax Rev. 197 (2001).
---------------------------------------------------------------------------
My testimony today will focus specifically on the unrelated debt-
financed income rules. These rules impose a tax on investment income of
an exempt organization that would otherwise be tax-exempt solely
because the exempt organization uses debt to acquire the property that
produces the income.\2\ To avoid the tax imposed by the debt-financed
income rules, exempt organizations often use so-called blocker entities
to acquire investments. Generally speaking, a blocker entity is a
corporate entity formed in a low-tax jurisdiction that is interposed
between an investment and the exempt organization. The corporation
``blocks'' the attribution of any debt to the exempt organization, and
thus enables the exempt organization to avoid the application of the
debt-financed income rules. My testimony will cover the history and
purpose of the rules, the types of transactions they discourage, and
the policy concerns that should be considered by Congress in the course
of its evaluation.
---------------------------------------------------------------------------
\2\ IRC Sec. 512(b)(4); 514(a)(1).
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Legislative History and Current Law
Tax-Exempt Status of ``Passive Income.'' Since 1950, tax-exempt
organizations have been subject to the unrelated business income tax
(``UBIT'') on income from businesses that are not related to their
exempt functions. When Congress enacted the UBIT, it excluded certain
types of investment income--commonly referred to as ``passive
income''--from the tax. Specifically, dividends, interest, royalties,
annuities, most rents, and capital gains and losses were not subject to
UBIT.\3\ In the years since the enactment of the UBIT, exceptions have
been added for payments with respect to securities loans,\4\ loan
commitment fees,\5\ and income from the lapse or termination of
options.\6\ According to the legislative history, Congress excluded
these types of income from UBIT because it did not think they posed
serious competition for taxable businesses and because such income had
long been recognized as a proper source of revenue for educational and
charitable organizations.\7\
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\3\ IRC Sec. Sec. 512(b)(1), (2), (3), (5).
\4\ IRC Sec. 512(b)(1), (a)(5).
\5\ IRC Sec. 512(b)(1).
\6\ IRC Sec. 512(b)(5).
\7\ H.R. Rep. No. 2319, 81st Cong., 2d Sess. 38-40 (1950); S. Rep.
No. 2375, 81st Cong., 2d Sess. 30-31, (1950).
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Unrelated Debt-Financed Income Rules. The exclusion for ``passive
income'' does not apply to the extent that such income is derived from
debt-financed property.\8\ In other words, income earned by an exempt
organization from debt-financed property is subject to tax. Property is
treated as debt-financed if indebtedness is incurred before or after
the acquisition or improvement of the property that would not have been
incurred but for such acquisition or improvement.\9\ The portion of
income that is subject to tax is the fraction equal to the average
acquisition indebtedness for the year over the average adjusted basis
of the property for the year.\10\
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\8\ Section 514 applies to all debt-financed property but contains
several exceptions which have the collective effect of generally
limiting its application to investment income.
\9\ IRC Sec. 514(c)(1).
\10\ IRC Sec. 514(a)(1).
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The debt-financed income rules were passed in 1969 to foreclose
abusive sale-leaseback transactions. In such transactions, a charitable
organization would acquire property (usually real estate) from a
taxable business, often borrowing to finance the entire purchase price.
As a condition of the sale, the exempt organization would lease the
property back to the seller on a long-term basis. The exempt
organization would repay the loan, plus interest, with the lease
payments or ``rental payments'' received from the seller-lessee. The
exempt organization would receive both (i) the difference between the
``rental payments'' and the sale price and (ii) outright title to the
property, all without investing or risking much, if any, of its own
funds. The seller would obtain capital gain treatment for the sale
price received and large deductions against taxable income for the
``rental payments'' made, all while continuing to operate its business
using the property in the same manner as before.\11\
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\11\ S. Rep. No. 552, 91st Cong., 1st Sess. 62-63, reprinted in
1969 U.S.C.C.A.N. 2027, 2091-92; H.R. Rep. No. 413, 91st Cong., 1st
Sess. 44-46, reprinted in 1969 U.S.C.C.A.N. 1645, 1690-91.
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Application of Unrelated Debt-Financed Income Rules to Securities
and Financial Products. The debt-financed income rules have been
challenging to apply to securities and other financial products.
Neither the Internal Revenue Code (the ``Code'') nor the Treasury
regulations thereunder define ``indebtedness'' for purposes of the
debt-financed income rules. Consequently, in determining whether a
particular transaction creates indebtedness and therefore is subject to
tax, the Internal Revenue Service and the courts have looked to common
law definitions of indebtedness and definitions in other parts of the
Code. The result has been that the rules have been applied in a
formalistic manner. Generally, when a tax-exempt investor borrows funds
and has a clear obligation to repay the funds, the debt-financed income
rules have been applied. Thus, securities purchased on margin have been
held to be debt-financed property.\12\ A pension plan that used a
certificate of deposit (``CD'') with a low interest rate as collateral
to borrow funds to acquire a new CD with a higher interest rate, was
subject to UBIT on the new CD because it was purchased with borrowed
funds.\13\ In this case, the pension fund was not seeking to leverage
its investment. Rather, it didn't want to redeem the low-interest CD
before its maturity date because it would have incurred penalties, but
it wanted to reap the benefits of an increase in interest rates.
Similarly, the withdrawal of the accumulated cash value of life
insurance policies for the purpose of investing the funds in property
with a higher rate of return creates acquisition indebtedness and
therefore is unrelated debt-financed income when such withdrawals are
used to purchase securities.\14\
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\12\ See, e.g., Elliott Knitwear Profit Sharing Plan v. Comm'r, 614
F.2d 347 (3d Cir. 1980), Alabama Central Credit Union v. United States,
646 F. Supp. 1199 (N.D. Ala. 1986); Ocean Cove Corporation Retirement
Plan v. United States, 657 F. Supp. 776 (S.D. Fla. 1987); Henry E. &
Nancy Horton Bartels Trust for the Benefit of the University of New
Haven v. United States, 209 F.3d 147, 156 (2d Cir. 2000).
\13\ See Kern County Electrical Pension Fund v. Comm'r, 96 T.C. 845
(1991).
\14\ Mose & Garrison Siskind Memorial Foundation Foundation v.
United States, 790 F.2d 480 (6th Cir. 1986).
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In contrast to the above examples, many transactions that do not
involve debt in the traditional sense but do involve leverage are not
subject to the debt-financed property rules. In many cases, because the
transactions were not clear cases of borrowing, the IRS relied on
Congressional intent to exclude investment income from tax in reaching
its conclusion that the debt-financed income rules do not apply. Thus,
securities lending transactions,\15\ short sales of stock,\16\
commodities futures contracts,\17\ securities arbitrage
transactions[18] and notional principal contracts\19\ are not treated
as debt-financed property and are not subject to UBIT.
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\15\ Rev. Rul. 78-88, 1978-1 CB 163.
\16\ Rev. Rul. 95-8, 1995-1 CB 107. See also PLR 9637053 (Sept. 13,
1996); PLR 9703027 (Jan. 17, 1997).
\17\ Gen. Couns. Mem. 39620 (April 3, 1987).
\18\ Gen. Couns. Mem. 39615 (March 23, 1987).
\19\ Treas. Reg. Sec. 1.512(b)-1(a)(1).
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Limited Exception for Real Estate. Income earned from real estate
is excluded from the unrelated debt-financed income rules under a
limited exception, but only if certain conditions are satisfied. \20\
Additionally, the exception only applies to real property acquired by
pension trusts, schools, colleges and universities. To qualify for the
exception, the real estate transaction must not have certain
characteristics of the sale-leaseback transactions that were the target
of the rules when first enacted. Thus, for example, the transaction
cannot involve (i) seller financing; (ii) indebtedness determined by
reference to income from the property; or (iii) a lease back to the
seller.\21\ Additionally, in the case of real estate investments made
by partnerships, the exception is limited to transactions that do not
permit tax-exempt partners to transfer tax benefits to taxable
partners.\22\ Certain of these rules that limit the exception for real
estate partnerships, most notably the so-called ``Fractions Rule,'' are
exceedingly complex and difficult to apply in practice.\23\
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\20\ IRC Sec. 514(c)(9).
\21\ IRC Sec. 514(c)(9)(B)(i)-(v).
\22\ IRC Sec. 514(c)(9)(B)(i)-(v).
\23\ IRC Sec. 514(c)(9)(E).
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``Blocker Entities.'' The unrelated debt-financed income rules can
be avoided on securities and financial products by investing through
foreign corporations referred to as ``blocker entities.'' A blocker
entity is a foreign corporation usually established in a low tax
jurisdiction. The tax-exempt investor invests in the foreign
corporation and the foreign corporation in turn invests in a hedge fund
or other similar debt-financed investment. Income from the hedge fund
or other investment is distributed to the foreign corporation, which
pays little or no tax on the income as a result of the jurisdiction in
which it is established. The foreign corporation in turn pays the
income to the tax-exempt investor as a dividend. Because dividends are
not subject to UBIT, the income from the hedge fund is not taxable to
the tax-exempt investor and the debt-financed income rules are avoided.
Most hedge funds are partnerships and, in the absence of the blocker
entity, debt-financed income would be passed through to the tax-exempt
investor as debt-financed income and would be subject to tax.\24\ The
Service has issued private letter rulings upholding the treatment of
income received from a foreign corporation used as a blocker entity as
a dividend that is not subject to UBIT.\25\
---------------------------------------------------------------------------
\24\ IRC Sec. 512(c).
\25\ Priv. Ltr. Rul. 199952086 (Sept. 30, 1999).
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Discussion
At first blush, blocker entities may appear to be a ``loophole''
that should be shut down. However, blocker entities are frequently used
to avoid the application of the unrelated debt-financed income rules to
transactions that were never intended to be within the scope of the
rules. Thus, before taking action on blocker entities, Congress should
re-evaluate the policy and impact of the unrelated debt-financed income
rules.\26\
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\26\ In the 1980s, blocker entities were used to avoid UBIT on
offshore captive insurance companies. See Priv. Ltr. Rul. 8819034 (Feb.
10, 1988). In response, Congress added Section 512(b)(17)(A) to the
Code, providing that foreign source income from offshore captive
insurance companies is taxable. Small Business Job Protection Act of
1996, Pub. L. 104-188, section 1603(a). Those cases, however, involved
the operation of an active unrelated business--an activity that the
UBIT is clearly intended to tax.
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The unrelated debt-financed property rules tax all debt-financed
investments of tax-exempt organizations, although they were enacted to
foreclose abusive sale leaseback transactions. The current breadth of
application is justified only if all leveraged investments of tax-
exempt investors should be discouraged. The purpose of leverage is to
increase the investor's return on investment. The trade-off for the
increased return is taking on greater risk.\27\ The increased risk of
an individual investment, however, can be reduced through
diversification in the investor's portfolio. Furthermore, investments
that do not use leverage may be as risky or riskier than leveraged
investments. Thus, taxing all debt-financed income is not an effective
way to protect tax-exempt investors from risk.
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\27\ For example, if an investor buys $100,000 worth of stock and
the value of the stock increases by 10 percent in one year, the
investor has earned $10,000. If this same investor borrowed another
$100,000 at 8-percent interest and invested $200,000 in the same stock,
it would earn $20,000 on the stock and, after paying $8,000 in interest
on its debt, would net $12,000, an increase in its rate of return from
10 percent to 12 percent. Of course, if the $200,000 in stock did not
earn at least $8,000 to cover the interest payment, the investor would
have a loss. Thus, the leveraged investment is riskier because the
return on the investment must be at least 4 percent for the investor to
avoid a loss.
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Moreover, the level of risk assumed by tax-exempt organizations is
already addressed by various other laws that create legal standards for
permissible investments of tax-exempt organizations. At the Federal
level, investments of private foundations are subject to the
jeopardizing investment rules of Code section 4944 and pension funds
are subject to the fiduciary standards of ERISA.\28\ At the state
level, directors of nonprofit corporations must adhere to the common
law duties of care and loyalty. Additionally, most states have adopted
the Uniform Management of Institutional Funds Act (UMIFA), which
provides uniform rules governing the investment of endowment funds held
by charitable institutions.\29\ UMIFA was approved by the National
Conference of Commissioners on Uniform States Laws (NCCUSL) in 1972,
and established a standard of business care and prudence in the context
of the operation of a charitable institution. Prior to UMIFA, each
investment of a charitable institution was evaluated separately, an
approach that led directors of charities to feel compelled to limit
investments to fixed income investments dividend-paying stocks. UMIFA
changed the law to permit an approach that is more in line with modern
portfolio management theories, looking at the portfolio as a whole
rather than investment by investment.\30\ In 2006, the NCCUSL further
modernized the standards applicable to charitable institution fund
management and approved a revision of UMIFA entitled the Uniform
Prudent Management of Institutional Funds Act (UPMIFA).\31\ UPMIFA
expanded the application of UMIFA to charitable trusts and incorporated
the more modern standards of the Uniform Prudent Investor Act passed by
NCCUSL in 1994. UPMIFA provides that, ``[m]anagement and investment
decisions about an individual asset must be made not in isolation but
rather in the context of the institutional fund's portfolio of
investments as a whole and as a part of an overall investment strategy
having risk and return objectives reasonably suited to the fund and to
the institution.'' \32\
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\28\ Employee Retirement Income Security Act, Section 404 29 U.S.C.
1104.
\29\ According to the NCCUSL, UMIFA has been adopted in 47 states.
\30\ When originally passed, UMIFA did not apply to charitable
trusts. In 1992, the Restatement (Third) of Trusts adopted standards
similar to UMIFA and reformulated the Prudent Man Rule to provide that
borrowing is permissible if the tactic is ``employed selectively and
cautiously.'' See Restatement (Third) of Trusts (The Prudent Investor
Rule), Sec. 227 (1992). Two years later, the NCCSL approved the Uniform
Prudent Investor Act and incorporated the principles of the Restatement
and principles of modern portfolio management. As described above,
these standards were further incorporated into UPMIFA in 2006.
\31\ According to NCCUSL, UPMIFA has already been adopted by 13
states.
\32\ UPMIFA Sec. 3(e)(2).
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In summary, debt financing increases the risk of an individual
transaction, but that is not a reason to discourage all debt financing
without regard to the level of risk and return of a charitable
institution's investments as a whole, as the debt-financed income rules
do. Moreover, the debt-financed income rules are unnecessary for this
purpose because other laws govern investment standards with a more
nuanced and aggregate approach that is consistent with modern
investment theory.
An additional problem with the debt-financed income rules is that
they have been applied in a rigid manner that makes formalistic
distinctions between debt and leverage. As described above, the result
is that the rules tax transactions which involve direct borrowing while
permitting investors who use leverage in more sophisticated
transactions to escape tax.
Recommendations
Rather than focusing on the use of blocker entities to avoid the
unrelated debt-financed income rules, I urge Congress to evaluate the
operation of the debt-financed income rules and to significantly
restrict the application of these rules. Under current law, there is an
exception for real estate transactions of pension funds and
universities if the transactions meet certain requirements. This
exception, and its requirements, should be used as the model for a
broader exception applicable to all types of debt-financed property and
available to all tax-exempt organizations.
First, the exception should not be limited to pension funds and
universities. While some argument may exist that pension trusts are
uniquely focused solely on investments and are therefore distinct from
other exempt organizations, a similar argument cannot be made to
distinguish colleges and universities from other tax-exempt
organizations. Therefore, exceptions to the debt-financed income rules
should apply to all tax-exempt organizations.
Further, the exception should not be limited to real estate. As
discussed above, the current debt-financed income rules apply to many
legitimate investment transactions that are not abusive and were not
the intended target of the rules. The current real estate exception
includes requirements that (i) the indebtedness be for a fixed amount;
(ii) the seller not provide financing; and (iii) the lender not have
the use of the property. These requirements should be retained as a
condition to a new broader exception that applies to all debt-financed
property.
Finally, the current real estate exception includes restrictions
applicable to investments made through partnerships which are intended
to prevent the transfer of tax benefits from tax-exempt partners to
taxable partners. These restrictions are tailored to real estate
transactions and do not lend themselves to application to investments
in other property such as securities and other financial products.
Although I am not aware of hedge funds and other investment
partnerships being used to transfer tax benefits from tax-exempt
partners to taxable partners, nevertheless, Congress should give the
Treasury authority to promulgate regulations in the future if necessary
to foreclose such transfers in non-real estate partnerships.
Conclusion
If Congress amends the unrelated debt-financed rules as suggested,
tax-exempt investors will no longer be forced to invest offshore and
use blocker entities to avoid the unrelated debt-financed income rules
on legitimate investments. Further, the current disparate treatment
between direct borrowing and leverage, and between different types of
tax-exempt investors, will be eliminated.
I would be pleased to answer any questions you may have.
Mr. NEAL. Thank you, Ms. McDowell.
Our next panelist is Mr. Daniel Shapiro, a partner with Schulte,
Roth & Zabel. Welcome, Mr. Shapiro.
STATEMENT OF DANIEL S. SHAPIRO, PARTNER, SCHULTE, ROTH & ZABEL,
LLP, LONDON, ENGLAND
Mr. SHAPIRO. Thank you, Chairman Rangel, Ranking Member
McCrery and Members of the Committee. I am Daniel Shapiro. I am
a founding partner of the New York City law firm of Schulte,
Roth & Zabel, and I am resident in that firm's London office.
I have provided tax advice to private investment funds for
over 30 years. I appear today on behalf of the Managed Funds
Association, whose members include professionals in hedge
funds, funds of funds, and managed future funds.
In accordance with the Committee's request, MFA's prepared
statement for the record and my summary remarks today focus
principally on how hedge funds are structured, and in
particular, as others have discussed, why U.S.-based hedge fund
managers establish foreign funds outside of the United States
and why U.S. tax-exempt organizations invest in those foreign
funds.
Hedge funds sponsored by U.S. managers play an important
role in the U.S. capital markets and make positive
contributions to the U.S. economy. The ability of U.S. managers
to compete globally for talented personnel for investment
opportunities and for investors is influenced by many factors,
including the U.S. tax system. Hedge funds are structured in
accordance with established principles of Federal tax law and
the structures promote congressional tax and economic policies.
This includes the funds that U.S.-based managers establish
outside the United States in order to compete with non-U.S.
managers for passive investors from all over the world.
For more than 40 years, Congress has structured the Tax
Code to encourage passive foreign investments in the U.S. by
non-U.S. investors. Among other things, Congress has exempted
most forms of interest payments made to foreign investors from
U.S. withholding tax and it has likewise exempted their capital
gains from U.S. taxes generally. Despite this advantageous
treatment, for a variety of reasons, some of which have been
mentioned, rather than investing as partners in U.S. hedge
funds partnerships, most foreign investors strongly prefer to
use foreign corporate hedge funds as a vehicle for their U.S.
hedge fund investments. U.S. hedge fund managers would be
competitively disadvantaged if they did not offer such foreign
corporate structures to foreign investors.
As also has been discussed previously by two of the
panelists, pension funds, university endowments, certain other
tax-exempt organizations, such as foundations, also invest in
foreign hedge funds sponsored by U.S. managers. They make their
hedge fund investments into foreign hedge funds, as has been
said, to avoid the application to that investment income of the
technical unrelated business income tax provision. These
provisions, sometimes referred to as UBIT, subject income of
tax-exempt entities, generated through debt financing, to a 35
percent Federal tax. As has been mentioned, the UBIT rules
would apply if a tax-exempt organization invested in a hedge
fund in the U.S. structure as a limited partnership would use
as leverage. But by investing in a foreign corporate hedge fund
and not in a transparent U.S. partnership, the tax-exempt
organization is not deemed to be using debt financing because
the leverage used by the foreign corporate fund does not pass
through the tax-exempt shareholder.
As mentioned, the conclusion that investments in foreign
corporate funds by U.S. tax-exempt organizations does not
trigger the adverse UBIT tax result has been specifically
confirmed by a number of recent IRS rulings, as well as
implicitly by Congress in connection with 1996 tax legislation.
Moreover, from a tax policy point of view, as has been
mentioned before, there appears to be very little basis for
imposing UBIT on passive investment income received by a tax
organization where it has no liability for the leverage used by
the foreign fund, has no control over the funds investments or
the extensive leverage, and does not incur any indebtedness to
acquire or carry the investments where they would be taxed if
they did. As this Committee knows, many tax-exempt
organizations, especially universities, starting with Harvard
and Yale, have been able to achieve substantial growth in their
endowments by investing significant percentages of their assets
in foreign hedge funds. If universities and other exempt
entities, such as pension funds, which are increasing their
allocations to foreign hedge funds and fund to funds, were
subject to UBIT on such investments, their rate of return would
be substantially diminished.
As noted, and I will not talk about this much because it
was not our precise purpose, some managers defer the receipt of
fees they receive from offshore funds. What I would just point
out is that many foreign investors frequently expect these
deferral elections to be made so that there is a resulting
deferral which buttresses the alignment of interest between the
U.S. manager and the foreign investor. The onerous tax rules,
which you may be aware of, applicable to a U.S. taxpayer
investing directly into one of his foreign funds, effectively
prevent a manager from investing directly in the fund. So
deferral of fees by U.S. managers, which allow those fees to
continue to be invested during the deferral period only, along
side the foreign investors do ultimately get taxed at the top
income tax rate of 35 percent when they are received by the
managers at the end of the deferral period, and they are
subject to the comprehensive tax regulatory regime enacted by
Congress in 2004 to govern deferred compensation arrangements.
MFA is aware that this Committee is considering various
other tax policy issues, some related to carried interest, the
application of the publicly-traded partnership rules, to public
offerings, MFA has significant reservations regarding some of
these proposals and would welcome the opportunity to present
its views on these issues to the Committee in greater detail as
the legislative process moves forward.
Thank you.
[The prepared statement of Mr. Shapiro follows:]
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Mr. NEAL. Thank you, Mr. Shapiro. By an unanimous consent
agreement just prior to moving over to the House floor, the
Chair will recognize Mr. Blumenauer and then Mr. Cantor.
Mr. BLUMENAUER. Thank you, Mr. Chairman. We are in the
midst, as you know, of a series of fascinating panels here
helping us to understand some very complex interrelationships
dealing with issues of hedge funds, how we are treating
investment income, dealing with the alternative minimum tax and
in particular what we are going to do with the alternative
minimum tax as it has broader applications to people. But there
is a thread of tax equity and revenue stability that goes
through this. I was just curious if I could to start, Mr.
Shapiro, with you, you are referencing, for instance, maybe it
is not directly on point but it is in the back of people's
minds about ways that compensation can be deferred, rolled over
time, and you were talking about the alignment of interest that
some feel is desirable, makes sense to me, hedge fund managers,
the people that are participating in it, is there any reason
why this alignment of interest for a sub-set of hedge fund
managers is any different than an alignment of interest that
people may have for other valued employees in other business
enterprises? Are they somehow special or are there other
broader applications that would obtain from the alignment of
interest?
Mr. SHAPIRO. Well, there are--if I understand your
question, there are deferred compensation arrangements of
various kinds that apply.
Mr. BLUMENAUER. There are but they are limited in nature
and not every employee has the employee to have this broad
deferral, and I am just wondering if there is something special
about hedge fund managers that would not be applied to other
key and valued employees, such as if we are going to do this,
that we should apply it more broadly?
Mr. SHAPIRO. Well, I think that various key employees are
offered deferred compensation arrangements, some of them are
offered those by U.S. corporations that induce their employees
to stay with them by creating deferred fee arrangements. If you
are talking about how far and how wide should those deferred
fee arrangements be applied, I think that it depends on each
corporation's view of how valuable their employees are and
whether they want to make those arrangements.
Mr. BLUMENAUER. But they are not unique among other
millions of valued employees who are employed by other
entities.
Mr. SHAPIRO. No, I agree. I think that this arrangement,
that the hedge funds have established with offshore funds
happens because of the structure of the way their fees are paid
from the offshore funds. I think that it is one of the kinds of
deferred arrangements, all of which are now subject to very
serious regulatory rules about how those deferrals have to be
elected at the beginning of the year and how the deferral
arrangements have to be structured to meet various tax
requirements.
Mr. BLUMENAUER. One of the things the Committee is
wrestling with is to avoid the application of the alternative
minimum tax to some 27 million American taxpaying families next
year, which virtually everybody says was never intended to be
the purpose. One of the reasons 27 million families are
subjected to it is because we are now treating as a tax
loophole that needs to be closed things like paying for your
child's education, saving for your future, paying your state
and local property taxes, these are tax preference items that
get added back in in the computation. So, we are looking at
ways to fix it. Is there any reason why we should not add back
to the alternative minimum tax some of the tax preferences and
benefits that accrue to hedge fund managers that mean that most
of them are not subjected to the alternative minimum tax, is
that a legitimate--is there any reason we should not consider
adding back those tax preferences as opposed to somebody paying
their local property taxes or claiming a child income tax
credit?
Mr. SHAPIRO. Look, I think if the effort is being made to
deal with AMT, there are a lot of ways to get at it and one is
to increase tax rates, the other is to change the way the AMT
works to increase the amount that people have to earn before
they are subject to the AMT.
Mr. BLUMENAUER. No, I am referring specifically if today
the child tax credit is a preference that gets added back, if
paying your local property taxes is added back, isn't it
reasonable that we should consider adding back some of the
unique tax benefits that flow to hedge fund managers that in
many cases they are not paying the alternative tax?
Mr. SHAPIRO. But there are a variety of tax benefits that
many kinds of investors and employees and managers have. I
think it is all on the table for consideration. I do not have a
particular view as to which one you should, but I think as this
Committee thinks about how to deal with AMT, I assume
everything is up for grabs and I assume that issue could be
considered by you, yes.
Mr. BLUMENAUER. Well, I appreciate, Mr. Chairman, your
courtesy, and I do appreciate the testimony here helping us
round out a bigger, broader picture and more nuanced because we
certainly do not want to get into an area of unintended
consequences. I found this very helpful. Thank you.
Mr. NEAL. Thank the gentleman. The gentleman from Virginia,
Mr. Cantor is recognized to inquire.
Mr. CANTOR. I think the Chairman, and I want to thank the
panelists too for their indulgence and for being here all day
waiting for us to return from the floor.
Mr. Chairman, I first of all would like to in my opinion
set the record straight from some of the comments that were
made earlier, particularly by the gentleman from Texas, when he
indicated that there was no willingness on the part of the
Republicans to try and address the AMT problem and would note
that every year since at least I was here since 2001 there has
been an attempt to hold harmless, if you will, or apply a
patch. I do not think it is fair to say that we were not
willing, I think we are all here trying to address that.
Really, I think none of us would be here if we had not seen the
veto by President Clinton in 1999 of the AMT fix.
Be that as it may, we now find ourselves on a hunt for more
revenues somehow since we in this body have a very poor track
record of cutting spending and trying to reset the economic or
fiscal model due to our entitlement scenario, we find ourselves
in hunt of more revenue to address the AMT situation. In my
opinion, we saw the Bachus-Grassley bill focus the publicly
traded partnerships and want to somehow penalize them for the
profits that they were experiencing and their investors were
experiencing.
Next, Mr. Chairman, you along with our colleague from
Michigan put in a bill, which in my opinion not only targets
one of the most innovative sectors of our economy that has
really performed a function of being an agent for change,
creating jobs and opportunity, but also now may very well apply
to the mom and pop partnership millions of Americans that are
putting their capital at risk everyday to create opportunity
for their families and communities.
So, my question, Mr. Chairman, with all of that, we have
seen the partnership structure, we have seen the favored
treatment of capital gains produce an incredible increase in
investment and productivity in this economy. My question for
Mr. Shapiro and then to Ms. Gallagher and Ms. McDowell, if we
were to, as some would want, not me included, raise or change
the character of the income on carried interest so affect the
return that the fund managers have, would that necessarily, in
my opinion, translate into a change in the two and 20 formula
that most of the private equity funds have? Then would we see
the nonprofit and the retirement funds also be negatively
impacted by that increase in taxes? Mr. Shapiro.
Mr. SHAPIRO. I think sitting here it is very hard to
predict whether private equity or hedge fund managers, general
partners, if they were faced with higher taxation would believe
that the response should be increasing the two and 20, which is
not always what is charged but it has sort of become the mantra
for what most managers get in either side of the private equity
hedge funds. It is simply too hard for me to predict that. I
think that at some point there is a level of resistance on the
part of investors, and I think that tax-exempt institutions in
particular who have a lot of leverage to use, to use the often-
cited word today, would probably not be happy paying
significantly higher fees so the result might well be, even
though the managers would say, ``Well, look, we are paying much
higher taxes, we need to generate more fees,'' that that cost
would really be picked up by the managers and by the general
partners of private equity funds.
Mr. CANTOR. So, is it in your opinion fair to say though
that the level of investment would continue and disregard--
given the players in the investment partnerships as well as the
partners themselves, disregard the increased cost?
Mr. SHAPIRO. Well, look, I think that the hedge fund and
private equity areas, as you have said, have been incredibly
good to this country and the creativity and the growth of many
of the industries in this country have been fueled by the
activity of the best and brightest who tend to go into the
private equity and hedge fund world. I think they will continue
to go in that world as long as there are incentives for them to
do it. One of the incentives is they get people to invest in
their funds. Another incentive is that they have the potential
to get more favored tax treatment if they run their funds
effectively and they can generate long-term capital gains. So,
I think that the industries would be hurt, I do not think they
would be put out of business by changes in the tax law.
Mr. CANTOR. I would then, Mr. Chairman, if I could turn to
Ms. Gallagher and/or Ms. McDowell to address some of the
articles, there was an editorial in Pension and Investments
which talked about the harm to retirees if the tax structure
and the nature of the income to managers was increased on
private equity funds?
Ms. GALLAGHER. First, I would like to be clear that the
Council does not have any position on carried interest. We are
here strictly to discuss the section 514 unrelated debt-
financed property problem. Changes, any changes that effect
return on investment are clearly going to be weighed by the
investor. As Mr. Shapiro indicates, I think there would be some
question as to how the managers would react and whether they
would absorb those increased costs out of their compensation
rather than pass them along to investors. No one is compelled
to invest in hedge funds, so I think certainly what the return
is predicted to be is the factor in what you are going to do.
Ms. MCDOWELL. I am not really an expert in how managers
react and so I can only guess, but I would echo what Ms.
Gallagher has said. As far as tax-exempt investors are
concerned, they are going to manage their money in order to get
the best return they can consistent with prudence and their
fiduciary duties to manage the investments of charities. The
hedge funds are attractive because they have had such high
rates of return. If the managers begin to take a larger cut
which reduces the return, then of course tax-exempt investors,
just like others, would lose interest in these funds.
Mr. NEAL. I thank you. The gentleman from New Jersey, Mr.
Pascrell, will inquire.
Mr. PASCRELL. Thank you, Mr. Chairman. In a full-day
hearing to really I believe dissect what fortunes for the
fortunate really means, and regardless of what subject we are
talking about here today, I find it fairly incredible that, Mr.
Chairman, before I ask my question, that I have heard people's
talk today about the AMT tax and that tax will become the tax
system by 2016 if we do not do anything about that. It will
totally become the tax system. The second thing that I have
concluded today is that there is no doubt in my mind that the
AMT is a mask to the true cost of the tax cuts of 2001 and
2003. I have heard no counter-argument to that. That more than
60 percent of the cost of the AMT represents the deferred cost
of 2001 and 2003 tax cuts. So, we are here to give relief to
the middle class because they have been had. On the average,
the individual who received a $5,000 tax cut had to return
approximately $3,000 of it at what cost? We know there has been
a shift of who is being taxed over the last 30 years. We use to
tax income more than assets. Now we tax assets more than
income. What is the result of that, Mr. Shay, in your mind and
in your thoughts today, is what I said accurate or inaccurate
and what are the consequences if so?
Mr. SHAY. I am not sure I fully understand what you mean by
taxing assets more than income. My topic was really the topic
of international taxation but tying it back to that, clearly
the Committee has to grapple with how to address the issues of
the AMT and frankly much bigger issues down the road than the
AMT because of the sort of structural imbalance that we have
fiscally between the commitments that have been made and are
being made and the revenue base that is going to need to be
relied on to meet those commitments.
Mr. PASCRELL. Would anyone on the panel like to respond to
that first question that I laid on the table. I know we are
talking about the off shoring, and I know we are not discussing
directly the AMT, would anyone like to respond to my question
about the difference of taxing assets compared to income and
who suffers from that or who gains from that and who is in a
better position? Okay, let me ask the next question then. How
much money is protected when one invests offshore? Always bound
to be a compelling question. I would like to put this question
to the entire panel. Earlier this year, the New York Times
published an article entitled, ``Managers Use Hedge Funds as
Big IRAs.'' According to this article, ``Many Americans
squirrel away as much as they can into retirement investment
accounts like 401(k)s and IRAs that allow them to compound
their earnings tax free. The accounts also reduce what they owe
when tax day rolls around. For the average person, however, the
government strictly limits the contributions to about $20,000 a
year. Then there are people who work at hedge funds. A lot of
the hedge fund managers earning astronomical paychecks, making
headlines these days are able to postpone paying taxes on much
of that income for 10 years or more.'' My question is this,
does anyone think that it is fair that hedge fund managers are
able to defer paying taxes on a larger portion of their
compensation than ordinary Americans? Who would like to take a
crack at that question? Mr. Metzger.
Mr. METZGER. Many ordinary American taxpayers defer on
their income. For example, if someone buys a piece of land for
$100, which appreciates in value to $250 and the person takes a
mortgage out on it for $200, that appreciation is not being
taxed even though the person who made that investment is able
to take the cash out. Or, for example, you have someone who
buys stock for $100, which appreciates to $200, then that
person posts that security as collateral to buy other stock. Or
you have ordinary Americans who defer their year-end bonuses
past December 31st but get paid before March 15th of the next
year. So, you do have deferral all across the board. You may
have hedge fund managers deferring, as well as ordinary
Americans. The issue is whether or not we want to tax economic
gain when there is no cash offsetting it.
Mr. PASCRELL. What are your thoughts?
Mr. METZGER. I am not an expert--well, let me say that I
believe that when taxpayers cash out their economic gain,
perhaps they should be realization events. So, for example, if
you hold section 1256 regulated futures contracts, they have to
be marked to market. Whether or not you sell those contracts by
the end of the year, you pay taxes on the unrealized gains or
losses. You have section 475, which is mandatory for dealers,
they have to mark to market their positions whether they sell
them or not. So, to some extent, the Tax Code already addresses
some of these instances where unrealized income is taxed.
Mr. PASCRELL. Thank you.
Mr. NEAL. Thank you, thank the gentleman. The gentleman
from Illinois, Mr. Emanuel, is recognized to inquire.
Mr. EMANUEL. Thank you, Mr. Chairman. I am in the same line
of questions as it leads to the issue of deferral compensation.
First I have legislation on this and I come from this view,
working with and knowing a number of individuals, one is there
is nobody cheating the system. This is an opportunity to do it.
It is perfectly legal. What is different is nobody we
represent, whether it is IRAs or 401(k) deferrals, actually can
structure a way to pay for their kids' college education and
have it in an offshore fund. There is a difference for what a
family is allowed for their IRA and for their 401(k) than
certain people--not just the size of a dollar but one issue is
they are allowed to do it.
The second is can you structure--the first question is
actually is it fair for them to do something that others
cannot? Second, can you structure in the Tax Code a way that
allows I think the universities and pensions and other entities
to invest in onshore entities so that would not be the only way
they could do their compensation? My instincts tell me, and I
have talked to a number of experts, is the answer to that is
yes. I think the managers of the hedge of funds have a
legitimate concern that they would lose that money to
international hedge fund competitors, so what we should do is
structure a way that they can onshore raise the capital for
their funds from the universities, from the endowments, from
the pensions so they can invest here but also then pay
compensation here.
Last, although a lot of them use the technique, that is the
hedge funds, to retain talented employees and have them
invested in the fund, there are other ways to do retention
compensation that does not basically have a big gaping hole in
my view in the equity of the Tax Code. So I want to get to I
think the fundamental question because I think a lot of them
have legitimate concerns, that is those who run the hedge
funds, can you structure the law in a way, and, Mr. Metzger, I
want to follow-up then with you since you answered the first
time, that the universities, the pensions, the endowments, et
cetera, can invest in funds that are based here in the United
States and do not have to be offshore from a tax purposes?
Mr. METZGER. Sure, if Congress makes some changes to
section 514, the incentive that the tax-exempt investors have
to invest offshore could disappear, particularly in the area of
funds that employ leverage. If Congress says that the leverage
used by hedge funds is not considered unrelated debt-financed
income, then tax-exempt investors should lose their motivation
to invest offshore. But bear in mind--you have not asked me
this question but I just want to throw this in--if in fact,
Congress were to treat all income from carried interests as
ordinary income, some hedge fund advisers might not accept tax-
exempt money in the onshore funds. They may force them to
invest offshore because they will want to take advantage of the
deferral.
Mr. EMANUEL. Your answer, how would you resolve that
problem? You do not want to put anybody at a competitive
disadvantage but you want to deal with--because one of the
fundamentals, besides revenue here, you have to have fairness
in the system. If a family I represent on the northwest side of
the City of Chicago feels like all they can put aside for
401(k) or IRA is up to about $20,000 but other people have $145
million of deferred income, there is a sense that not that
somebody earned more but somebody is getting a break that they
cannot get and never can. You fundamentally put a crack in the
Tax Code in the sense it is not a level playing field, that is
not a good thing not just for revenue raising, just a sense
that we are all in this together and that we have the same
rules that apply across the board. So, I understand that you
are saying it may force some of the funds to only raise
capital.
Mr. METZGER. I am saying that if they have the opportunity
to take tax-exempt money, they might rather take it in the
offshore. That is assuming that all carried interest is taxed
as ordinary.
Mr. EMANUEL. That is assuming that.
Mr. METZGER. That is assuming.
Mr. EMANUEL. Okay. Second, do you have any--and this is
open to anybody, does anybody have any sense of how much
revenue there is here? I have seen all the articles of the top
10, top 25 hedge fund managers, et cetera, how much from a
revenue side if we dealt with this offshore issue in deferral,
how much revenue would it be as it relates on the tax side,
does anybody have a guesstimate? No? Okay. I yield back, Mr.
Chairman.
Mr. NEAL. That was a chance for them to improve their name
recognition within the industry. The Chair would recognize Mr.
McCrery to inquire.
Mr. MCCRERY. Thank you, Mr. Chairman. Mr. Shay, I was very
interested in your testimony as it regards what I consider to
be proposals to simplify the corporate Tax Code in this
country, the international Tax Code if you will. In your
testimony, I did not hear you say it orally, but in your
testimony, your written testimony, you talk about doing these
changes with deferral and so forth in the context of lowering
the overall corporate tax rate in this country. That to me is a
very attractive proposal, which I think is necessary if we are
going to stay competitive in terms of attracting capital for
corporate investment and allowing our domestic corporations to
compete globally. Have you thought about where there could be a
corporate rate, assuming we keep the corporate income tax,
where we should put the corporate rate in order to do away with
deferral? In other words, is there a line at which corporations
in this country would say, gee, we wouldn't mind doing away
with deferral assuming a reasonable foreign tax credit regime
if our corporate rate were ``X''?
Mr. SHAY. Let me be clear that as an initial matter, the
changes I would propose, I would propose without--independently
of reducing the corporate rate, if one were concerned about the
effect of those changes on the competitiveness of U.S.
companies and wanted to devote the revenue of those changes
instead of to the AMT to that issue, there has been some work
on what a fairly broad amount of these changes would do and
where you could bring the rate down to. I am not remembering it
off the top of my head but it is I think still north of 30, the
top corporate rate now is 35 percent, my recollection it is
still somewhat north of 30 percent. Others can correct me on
that. There is actually a paper on that that is cited in
materials that goes into that issue. Sorry?
Mr. MCCRERY. Is what you are saying that the money that we
would recoup from doing away with deferral, if applied to the
corporate rate would get it down to the low thirties or
something like that, is that what you are saying?
Mr. SHAY. I really want to be very cautious. I am trying to
remember whether the paper I was looking at included other
changes as well but certainly----
Mr. MCCRERY. That is not what I am suggesting. I am not
suggesting simply taking the revenue that we would recoup by
doing away with deferral and applying it to the corporate rate,
what I am suggesting is that we find a corporate rate, and I am
thinking much lower than 30 percent, at which domestic
corporations, those who do business overseas, who have overseas
operations, who now use deferral in order to be competitive, a
rate at which they would say, ``We do not need deferral
anymore. If you are going to have the rate at this level, we do
not need deferral, we can compete.'' That is my point. I just
wondered if you had looked at that from a competitiveness
standpoint and obviously you have not?
Mr. SHAY. No, I would defer that to some of the economists.
There have been some studies I can actually direct your staff
to where the answer to that would be.
Mr. MCCRERY. That would be great. Thank you. Mr. Shapiro,
thank you and welcome. Did you come from London to be here?
Mr. SHAPIRO. Came last night and leaving tonight.
Mr. MCCRERY. Oh, my goodness, well, we really appreciate
your making a quick trip to assist us here. There was some
questioning from Mr. Cantor and maybe one or two others about
how fund managers would react if their tax rates went up and
all of you said, ``Well, gee, we do not know how fund managers
would react.'' Let me ask it a different way: If fund managers
in this country were to react to the increase in their taxes to
35 percent from 15 percent for the carried interest by saying
to their potential investors, ``Well, you now need to pay us
two and 30,'' is it plausible that some of those investors
might say, ``I can get two and 20 in London, I think I will
take my money to London''?
Mr. SHAPIRO. I am not sure an investor would take his money
to London for that reason. I will say that the reason I am in
London is because having been in this business for a long time,
we recognize that London has become very competitive in the
world of hedge funds and private equity funds. Taxes is only a
part of that. I think that the difference in rates, I think
investors, managers will not move just for a difference in
rates but managers are mobile. We see increasingly U.S.
managers functioning in London, albeit they all pay U.S. taxes
and they have British taxes to pay and they get a credit
against their U.S. taxes for the UK taxes, but it is not a good
thing necessarily for the U.S. that highly skilled U.S.
managers, both private equity and especially hedge fund
managers, are functioning in London today and paying most of
their taxes to the UK with a credit against their U.S. tax
because even though in theory they owe U.S. tax, they get a
full credit for the tax so that one of the things I think this
Committee needs to be mindful of as you develop these proposals
as it relates to managers is not to drive managers to think
about moving to places like London and indeed managers are
thinking of moving to Switzerland and other countries, Monaco,
where the tax rates are significantly lower. Now if you are a
U.S. manager and you are a U.S. citizen, you are not going to
be changing your tax bracket as a result of that. So, taxes is
just one of the factors I think that would come into play.
Mr. MCCRERY. You talked more about what managers would do,
again I asked what the money would do, might the money be
invested--in other words, if a group of managers here said,
``We are going to charge you more because we are having to pay
a higher tax rate,'' might the money go to London or somewhere
else where they would say, ``We are only going to charge 20
percent''?
Mr. SHAPIRO. My honest view is that the institutional
investors, who are by far the biggest and growing in scope in
terms of where both private equity and hedge funds are raising
their money, they are going to be investing their money not
based on the fees that are being charged but based on the
results. We all know that there are managers----
Mr. MCCRERY. Well, I know that but let's assume all other
things being equal, Mr. Shapiro----
Mr. SHAPIRO. Right.
Mr. MCCRERY [continuing]. If Carlyle here, considers to be
just as good as you guys----
Mr. SHAPIRO. Right.
Mr. MCCRERY [continuing]. Everything else is equal, you are
going to charge them 20 percent carried interest, Carlyle has
to charge them 25 percent because of a higher tax rate, where
are they going to put their money?
Mr. SHAPIRO. I think at the margin it can make a
significant difference. I think institutions--if the managers
feel they have to raise their rates to be able to pay higher
taxes, institutions will begin to resist that and look to
places where the rates are not quite as high.
Mr. MCCRERY. Thank you.
Mr. NEAL. Thank the gentleman. The gentleman from Maryland,
Mr. Van Hollen, will inquire.
Mr. VAN HOLLEN. Thank you, Mr. Chairman. I had a few
questions for Ms. Gallagher and Ms. McDowell to follow-up on
your testimony. Ms. Gallagher, you said in your testimony if
the section 514 of the debt-financed property rules did not
apply to the hedge fund investments, the tax-exempts would be
able to invest directly in U.S. hedge funds and use of the
offshore blockers would end, and that you believe that that can
be accomplished without creating new opportunities for abuse,
the kind of sham transactions. I gather, Ms. McDowell, from
reading your testimony that you share that view. If you could
each just give some idea if you know what the magnitude of
dollars we are talking about is in terms of the amount that
would now be invested onshore instead of offshore? Number two,
if you could just elaborate a little, Ms. McDowell, on your
proposals on how to structure that to make sure that we do not
allow sham transactions but accomplish the goal of putting
these investments back onshore but without allowing abuses? So,
I would appreciate any further elaboration that each of you
have on that topic?
Ms. GALLAGHER. I am sorry, Mr. Van Hollen, I really do not
know the answer to your question as to the magnitude of the
dollars involved. It is substantial. I do want to stress though
that while we are using offshore blockers, the ultimate
investment is being made by the hedge funds themselves that are
still here in the United States largely. I can try to see if we
have that information for our membership, and I would be happy
to supply it to you.
Mr. VAN HOLLEN. Okay.
Ms. MCDOWELL. Mr. Van Hollen, in my testimony I made
reference to an exception that is in current law for debt-
financed real estate investments made by pension funds and by
colleges and universities, and I suggested that that exception
might serve as a model for an expanded exception that would
apply to all types of debt-financed property and be available
to all types of tax-exempt organizations.
The real estate exception has two types of restrictions.
One set of restrictions appies to all debt-financed real estate
transactions, and is directed at the sale leaseback type of
transaction that was the target of the debt-financed income
rules. So, for example, these restrictions prohibit seller
financing, they prohibit contingent debt, they prohibit a
leaseback of the property, all the types of things that were
found in what is referred to as the Clay Brown transaction for
the Supreme Court case that upheld that type of transaction.
There is a second set of rules that deal with real estate
investments made through partnerships. The potential abuse in
partnerships is different than the sale leaseback--well, in
some ways it is the same but the primary focus for partnerships
is that they create an opportunity for tax-exempt partners to
transfer tax benefits to taxable partners because being tax
exempt, the tax-exempt partners are neutral about whether they
receive income or losses for tax purposes. The rules in the
Code today I must say are horrendously complex. The rule
referred to as the ``fractions rule'' has been said to
complicate even the most straightforward transactions. I am not
suggesting that that rule be applied to non-real estate
transactions. It is very much tailored to real estate. What I
suggested is that Congress give Treasury regulatory authority
so that if there are abuses of this sort, Treasury could then
promulgate regulations. As far as I am aware, hedge funds are
not used for the purpose of transferring tax benefits from tax-
exempt investors to taxable investors but my understanding is
based on a couple of inquiries, not on a thorough study. So,
that is something that I think the Committee would want to be
aware of as a potential issue.
Mr. VAN HOLLEN. Okay, thank you very much.
Mr. SHAPIRO. May I just add a potential analogy that might
encourage you to follow this line because I think that the idea
of--and this is not MFA talking, this is a personal view as a
lawyer in this industry, the idea of allowing tax-exempts to
invest their money in debts and securities where they are not
controlling the leverage, it is done by a separate manager----
Mr. VAN HOLLEN. Right.
Mr. SHAPIRO [continuing]. Reminds me of what happened with
regard to the rule that I referred to before. In 1966, this
Congress said, ``We want foreign investors through the Foreign
Investors Tax Act to invest without taxation in the United
States.'' However, they said then that the principal office of
the foreign investor, if it was a corporation, had to be
offshore and that led to a whole industry of administrators and
directors and accountants and everybody doing things in the
Cayman Islands and the Netherlands. About 12 or 13 years ago,
someone finally woke up and said, ``This is ridiculous. We do
not want to charge these people taxes. We want them all to
invest in the United States.'' So, the rule which was changed,
no need to have a principal office offshore. Indeed, we are
encouraging you to have your employees, your administrators,
your directors, all of your administration in addition to the
management go on in the United States. There has been no abuse
at all, and there has been a huge move of administrators and
business to the United States away from the Caribbean Islands.
I think there is some analogy here, as you said, and you could
define it tightly so that it did not involve tax-exempt
entities going out and doing their own leverage but if you said
to the tax-exempt entities, ``We want you to invest. We just as
soon be having you invest here in the United States with
managers so you do not have to go offshore.'' I do not think if
it was done correctly that there would be a huge abuse and it
would follow the very good precedent of eliminating the
principal office rule, which was there primarily to protect
revenue, but I think everybody recognized that it was not
necessary.
Mr. VAN HOLLEN. Thank you. Thank you all. Thank you, Mr.
Chairman.
Mr. NEAL. I thank the gentleman. The gentleman from New
York, Mr. Crowley, is recognized to inquire.
Mr. CROWLEY. I thank my friend from Massachusetts for
yielding the time. Let me just make a couple of comments before
I ask my question and that is some of my colleagues on the
other side have made reference to the fact that--or at least
one colleague has made reference to the fact that in his
opinion that this is a ``stealth tax,'' the AMT, that somehow
making one, like myself, to believe we did not see this coming.
The truth be known, we have seen this coming for quite some
time, and I would just remind my colleagues on this side of the
aisle, for at least the previous 6 years, prior to the
beginning of this year, they have controlled both the House,
the Senate and the White House and really took very few steps I
think to correct the problem of the AMT. Although we can all
throw stones back and forth again at each other in each party,
over the years since the assumption of the AMT, I think it is
important to make that note, that at best there has been
neglect and we have not done enough over the last 6 years. In
my opinion, we have actually contributed, this Congress and
this administration have contributed in creating even a greater
problem to what I think are irresponsible tax cuts for some of
the wealthiest in this country.
Having said that, let me just move, and if the Committee
will just abide my moving from this issue for just a moment and
focusing on another issue of grave concern I think to the
nation as well as pertains to the subprime mortgage industry in
the United States. I would specifically direct my question to
Mr. Metzger and Mr. Shapiro. As hedge fund operators or
managers, did either of your entities purchase mortgage-backed
securities or collateralized debt obligations or other
mortgage-related securities?
Mr. SHAPIRO. I am sure some of the hedge funds that we
represent did, yes.
Mr. CROWLEY. Mr. Metzger.
Mr. METZGER. I do not know the answer to your question. I
can say that I left the hedge fund 18 months ago so I do not
know what has been in the portfolio the last 18 months.
Mr. CROWLEY. Well, I imagine prior to 18 months ago, there
was some involvement----
Mr. METZGER. I do not know the answer but it is reasonable
to assume that there were.
Mr. CROWLEY. There probably were. You can answer in an
assumed fashion if you like as well, Mr. Metzger.
[Laughter.]
Mr. CROWLEY. I will get a more pointed and direct answer
from Mr. Shapiro. Do you feel as though your entity received
the appropriate information that there were appropriate avenues
for knowing what was entailed in those CDOs?
Mr. SHAPIRO. This is a complicated question that I did not
prepare to answer.
Mr. CROWLEY. I understand. I am also not here to put you on
the spot.
Mr. SHAPIRO. Not on behalf of a MFA, it is just a reaction,
I think there were mistakes made all along the way in the
subprime area by the investment bankers, by the mortgage
bankers who did the loans, by the rating agencies, by almost
everybody and obviously Congress is going to think about what
it can do to help prevent that problem from happening in the
future. A lot of very smart people missed signs that a few very
smart people saw. What could be done better, I think that
everybody who has been affected by this is going to take steps
to now be sure that the investors and the people who package
these loans and the people who borrow money who probably should
not have been borrowing on the same terms are all on notice
with much more transparency about the transactions and much
more thought given to the risks of the whole securitization
effort. It does not mean in my view that securitization is a
bad thing. Quite the contrary, it is a wonderful new technique
for financing transactions and I think it assists the economy
and the banks because other sources of funds are there but a
lot of questions have to be asked about how carefully it has to
be put together.
Mr. CROWLEY. So, it is really a question of transparency as
far as you are concerned?
Mr. SHAPIRO. Well, I think transparency is very important
and maybe more due diligence and also an understanding that in
these transactions, if there is a small part of a
securitization that can be tainted because it is not secure, it
can affect the whole transaction.
Mr. CROWLEY. Are you suggesting that bank securities and
credit rating agencies need more regulation?
Mr. SHAPIRO. I am not suggesting that, I think that that is
probably something inevitably that one Committee or another is
going to look at. I do not think necessarily regulation as
opposed to self-review of their procedures is the answer. I
really do not know the answer.
Mr. CROWLEY. Self-review of their procedures is how we got
into this predicament I think in the first place.
Mr. SHAPIRO. Well, that is something that I think--that I
am sure you will be talking about.
Mr. CROWLEY. Mr. Metzger.
Mr. METZGER. With regard to credit risk, my understanding
is that many of the funds marked--not to market but--to rating
those investments and since they were rated triple A, they were
marked at par.
Mr. CROWLEY. Clearly had deficiencies in terms of triple A,
they were triple D probably or components thereof?
Mr. METZGER. I do not know what was in the portfolios but I
assume that with regard to credit risk if the funds are relying
on marking to rating, if the rating was incorrect, the
valuation was incorrect.
Mr. CROWLEY. Thank you. I yield back. Thank you.
Mr. NEAL. I thank the gentleman. The gentleman from
Alabama, Mr. Davis, is recognized to inquire.
Mr. DAVIS. Thank you, Mr. Chairman. Mr. Metzger or Mr.
Shapiro, let me go back to the line of questions that Mr.
Emanuel and Mr. Pascrell pursued earlier. Both of them were
asking you about the underlying inequities or equities with
respect to the deferred compensation for hedge fund managers,
and I think both of you made a similar point. Both of you
indicated that deferred compensation is a fairly regular
feature in at least some aspects of our economy, particularly
for high-end wage earners. I want to make sure you got the
point that they made in response, and I suppose everyone else
in the room got this point. Yes, it is true that deferred
compensation is a feature of our economy, the point that they
were making is that there is a very limited number of
individuals for whom deferred compensation is the heart of how
they get paid. That would be a very narrow class of people, a
very limited class of people making very large incomes. To put
this in perspective, I certainly would not be bold enough to
ask either of you your incomes, that is between you and the
IRS, but can you give--either one of you give me some sense of
the average amounts of money that hedge fund managers make in a
particular year just from your anecdotal experience, what kinds
of compensation are we talking about, what kinds of income are
we talking about, either of you?
Mr. SHAPIRO. Do you want me to start? These are not figures
that one has to go too far to find because it has become common
lore in tons of magazines how much hedge fund managers make.
Mr. DAVIS. But would you give me just some of those
numbers?
Mr. SHAPIRO. Millions of dollars.
Mr. DAVIS. What is the largest hedge fund income level that
you all are aware of just from your anecdotal experience, what
is the highest amount of money you have heard of anybody making
as a hedge fund manager?
Mr. METZGER. There was an article, it was a front page
article in the New York Times a couple of months back that
quoted from--I do not recall which--hedge fund publication that
listed the top 20 or 25 paid managers, that information is in
the public domain. I do not recall it at this point.
Mr. DAVIS. Well, I understand that but both of you were
involved in the industry, would one of you care to give me just
some numbers that you saw on that list just so we can put it in
perspective? Are both of you telling me you cannot give me a
single number the hedge fund managers make?
Mr. SHAPIRO. I think that there probably were a few
managers who made well over $500 million.
Mr. DAVIS. Okay, a few who made well over $500 million. A
substantial number who made over $100 million from your
perspective, from what you know of the industry? You are both
nodding your heads, you are nodding your head, yes, Mr.
Metzger.
Mr. METZGER. Yes.
Mr. DAVIS. You would agree, Mr. Shapiro?
Mr. SHAPIRO. Last year, yes.
Mr. DAVIS. Alright, now, since my time is limited, let me
tell you why I make this point. You know about the PAYGO rules
that this institution passed, you know it is a response to
years of spiraling deficits and spiraling debt. In effect,
every new expenditure we make under these rules, we have to now
behave as most American families do, either we have to raise
new revenue or cut spending in some place. So, we have to make
a constant set of political and moral choices about how to pay
for things, just as most families do. We could have no doubt a
very interesting, if somewhat esoteric, economic argument about
the relative benefits of deferred compensation for hedge fund
managers or the relative incentive or dis-incentivizing
consequences or particular tax treatment but ultimately this
Congress has to decide if we are going to fix AMT, how do we do
it, and we have to make a decision what are the most equitable
set of pay-for's that we could bring to the table. The point
that I think you hear from some of my colleagues on this side
of the aisle is that if we have to engage in the very important
work of providing tax relief from any middle income Americans,
frankly it makes sense for the pay-for to aim at individuals
who are making massive amounts of money, who frankly will not
really miss the difference. If we have to choose, well, we are
going to change the tax structure from 15 percent to 35 percent
for someone making $100 million per hedge fund, well, that may
be much more defensible to the people we represent. By
contrast, a few years ago, the old majority in Congress was
trying to figure out a way to pay for the cost of Katrina
reconstruction and they made a very interesting decision, to go
to 13 million families on Medicaid and say for the first time,
you have got to do a co-pay if you take your kid to a doctor.
By definition, those families were making between $28,000 and
$40,000 a year--between $14,000, I am sorry, and $40,000 a
year, so that is the framework for this argument, that some of
us on this side of the aisle believe if government has to
demand extra revenue from anyone, that you logically do it from
people who may be in the $100 to $500 million range. That is
what this debate is really about.
I yield back.
Mr. NEAL. Thank the gentleman. The gentleman from
California, Mr. Thompson, is recognized for inquiry.
Mr. THOMPSON. Thank you, Mr. Chairman. If I could just
follow on Mr. Davis' line of questioning, maybe Mr. Shay you
could tell me, as are trying to figure out how to achieve
international tax reform and recognizing the fairness and
equity issue, as Mr. Davis pointed out, are there a set of
principles or recommendations that you would make as to what we
should--how we should go about considering international tax
reform, are there things that we should or should not try and
do?
Mr. SHAY. Well, as I outline in my testimony, the current
rules have a series of exceptions or incentives that in essence
encourage investment outside of the United States in lower tax
jurisdictions. The one unique issue about international
taxation is it does involve other countries, it is not all
within one economy. Taking that into account, I still think
that there is a substantial scope to restrict some of those
benefits for foreign investment as to cut back on them to raise
revenue without adversely affecting the ability of us to
compete in the world. They basically include restricting the
current scope for deferral of U.S. taxation on U.S. persons'
foreign income earned through foreign corporations. While I am
a real believer in the foreign tax credit to the point of
eliminating double taxation so we do not discourage
international investment, our rules now go further than that
and actually encourage foreign investments, so I would also
support changes to the foreign tax credit really through the
source rules--this is starting to get technical--that would not
result in there being more foreign tax credits say than there
would be even if we exempted foreign income, which comes back
to the point I made in my testimony. I think that is responsive
to your question, sir.
Mr. THOMPSON. Thank you very much. Ms. Gallagher, would
tax-exempt investors invest in onshore hedge funds rather than
offshore hedge funds if the debt-financed income rules did not
apply to the hedge fund investments?
Ms. GALLAGHER. Yes, sir, the only reason that people go
offshore is to avoid the application of the section 514 rules.
Mr. THOMPSON. So, it is just a straight tax avoidance
issue?
Ms. GALLAGHER. Again, as we said earlier, we do not think
the section 514 rules were intended to cover this kind of
investment, by using offshore blockers, foundations and other
tax-exempt entities are able to avoid the application of that
tax and the Internal Revenue Service has issued several rulings
acknowledging that that is the case.
Mr. THOMPSON. Thank you.
Ms. GALLAGHER. But if you take away the rules, then you
take away the reason to go offshore.
Mr. THOMPSON. Thank you.
Mr. SHAPIRO. May I add something?
Mr. THOMPSON. Yes, sir. You are going to need to speak
directly in the microphone. It is very hard to hear on this end
of the dais.
Mr. SHAPIRO. You are not hearing me? Okay. If tax-exempt
entities invested in the U.S. partnerships and did not have the
debt-financed income rules, they would actually be ahead of the
game in this respect: when they go offshore, which they do
legitimately to avoid what we all think is not the right
application of the debt-financed income rules, the offshore
entities they invest in are subject to 30 percent withholding
tax on all the dividends those offshore entities earn whereas
if they were invested in a partnership here, they would have
zero tax to pay. They would not have the 30 percent withholding
tax. So, tax-exempt entities are actually hurt by having to go
offshore to avoid the debt-financed income problem by being in
entities that are subject to 30 percent withholding tax on
dividends. So, it would be an advantage to tax-exempt entities
to bring them back onshore rather than forcing them to stay
offshore.
Mr. THOMPSON. Somebody is shaking their head, are you in
agreement with this? Ms. Gallagher.
Ms. GALLAGHER. I am sorry, I was shaking my head at the
gentleman behind me.
Mr. THOMPSON. It is not hard to confuse me.
Ms. GALLAGHER. It is my understanding that the offshore
hedge funds are largely structured to avoid the dividend
withholding but I am being told I am wrong about that.
Mr. THOMPSON. Could we somehow get some clarification on
that, Mr. Chairman?
Mr. METZGER. I was also shaking my head in agreement with
Mr. Shapiro.
Mr. THOMPSON. Thank you. I yield back, Mr. Chairman.
Mr. NEAL. I thank the gentleman. All Members of the
Committee now have had an opportunity to inquire of at least
one panel so now we are going to return to the regular order,
and I would remind Members of the Committee that we still have
two more panels to go. By way of discussion with Mr. McCrery,
we would hope that Members of the Committee might consider 3
minutes of inquiry time rather than five. We will now move to
other side. Mr. English, the gentleman from Pennsylvania, will
inquire.
Mr. ENGLISH. Thank you, Mr. Chairman. Mr. Metzger, in your
testimony, you state that proposals to raise revenue to pay for
an AMT reform bill by imposing taxes on pension funds invested
offshore will hurt many of the very people the AMT is supposed
to help. Can you extrapolate on that for us?
Mr. METZGER. Yes, on May 16, 2007, the New York Times
reported that Congress is considering closing the ``Loophole''
that allows tax-exempt investors to avoid paying taxes on their
hedge funds investments. Students at NYU have suggested that if
you tax the tax-exempt investors that make offshore
investments, many of the beneficiaries of those pension plans
are middle-class taxpayers. So, if Congress tries to pay for
the AMT by taxing tax-exempts, effectively you are taking money
out of one pocket and putting it in the other pocket.
Mr. ENGLISH. Following up on that, Mr. Metzger, would you
explain for us what you meant in your written statement when
you said, and I quote: ``Singling out specific industries for
special adverse tax legislation would be poor public policy''?
Mr. METZGER. I think if there is an issue such as deferral,
you ought to tax everyone's deferral. If there is an issue such
as carried interest, you should not be singling out industries.
In terms of public policy, the best way to solve a problem is
not to enact what I will call a ``windfall profits tax'' but
deal with the economic issues, deal with the policy issue.
Mr. ENGLISH. So, in other words, equity issues when dealing
in the real world of international tax policy are sometimes a
little complicated. On that point, Mr. Shay, I noticed that you
made a number of points about fairness in your testimony. I
take it you strongly support the current U.S. system of
territoriality in the taxation of foreign income, is that a
fair summary?
Mr. SHAY. Actually, sir, the U.S. currently does not impose
territoriality in the way it is conventionally thought of.
Mr. ENGLISH. That is correct.
Mr. SHAY. I am not a supporter of territoriality.
Mr. ENGLISH. You are not. Are you familiar with the
Homeland Re-investment Act that Congress passed a couple of
years ago that created a 1 year window for repatriation of
foreign earnings into the U.S.?
Mr. SHAY. I am very familiar with it.
Mr. ENGLISH. Are you familiar with how much money was
brought back that would have otherwise been stranded offshore
by that Act?
Mr. SHAY. I do not have a specific number.
Mr. ENGLISH. Does $350 billion sound about right?
Mr. SHAY. It is somewhere in that range, that is correct.
Mr. ENGLISH. That money would have never made it into the
United States otherwise, would you concur with that?
Mr. SHAY. No, but I do think----
Mr. ENGLISH. You do not?
Mr. SHAY. Some of the money would have come back but it is
fair to say that that accelerated the repatriation of money but
the question really is did that have--that legislation was
billed as having an economic impact.
Mr. ENGLISH. You deny that?
Mr. SHAY. What is not clear to me at all is the ultimate
economic effect of money going from one pocket of the
corporation to the other pocket of the corporation.
Mr. ENGLISH. Well, I am out of time, Mr. Chairman, but I
would be delighted to share with Mr. Shay some of the studies
that have shown the economic growth that has sprung from that.
I thank you very much.
Mr. NEAL. I thank the gentleman. The Chair recognizes the
gentleman from Michigan, Mr. Levin, to inquire.
Mr. LEVIN OF MICHIGAN. Thank you and thanks to all of you.
This has been a really useful hearing. They are long but
necessary, and I think very helpful. On the UBIT issue, I think
the testimony has been very succinct and a number of us have
asked questions about it. We have been working on this issue
for some time relating to the tax-exempt entities in the UBIT
rules and there is legislation now ready to be introduced I
hope today that would address this issue. So, you have
reinforced I think the need for there to be such legislation,
and I would urge all of my colleagues to look at this
legislation and see if they would like to join in.
Secondly, I think it has been useful regarding retirement
systems, and there is a letter that was sent out yesterday from
the National Conference on Public Employment Retirement Systems
and it says the following, and I would like, Mr. Chairman, for
it to be entered into the record, this letter.
Mr. NEAL. Without objection.
[The provided material follows:]
[GRAPHIC] [TIFF OMITTED] 43307A.053
[GRAPHIC] [TIFF OMITTED] 43307A.054
Mr. LEVIN OF MICHIGAN. It states: ``While some of our
members feel that the bills,'' they are talking about the
carried interest bills, ``could affect the public planned
community, the majority of our members do not share that
opinion.'' I think Mr. Cantor was here when that was raised.
Thirdly, I would like to say to you, Mr. Shapiro, we
welcome your candor. You spoke, and I hope Mr. Cantor will hear
this now or later, you were asked a series of questions and you
gave a series of answers that the person who asked the question
I think did not find particularly felicitous. But I hope that
as we go forth on these issues, that we will ask questions and
will listen to the answers. That is why we are having these
hearings, to have an intelligent, open discussion about this
issue, including the carried interest issue. I do think that
your response was not what some wanted to hear, and I do not
want to over-characterize it, it was very direct, but that is
what we need to hear. We need to get straight answers to these
important questions, and this panel I think has been especially
helpful.
I finish with this, the question Mr. English asked about
this repatriation, I would like to see the studies that show
that this elimination of taxes in the multi-, multi-billions
really paid off in terms of new jobs in this country because I
think the evidence is overwhelming that that was not true and
that the provision that there be a job creation result was
something that was hard to trace and to the extent it has, it
turned out to be incorrect.
But, again, I want to thank you for your straightforward
testimony. We are ready on this UBIT bill and I hope to have it
introduced today, and I ask all of you to join in if you would
like to. Thank you.
Mr. NEAL. The Chair is going to move away from the previous
commitment only because the gentle lady from Nevada has not had
an opportunity to inquire. She has asked that she be allowed to
offer her first inquiry. The Chair recognizes the gentle lady
from Nevada.
Ms. BERKLEY. ``Nevada'' but thank you.
[Laughter.]
Mr. NEAL. I am from Massachusetts.
Mr. LEVIN OF MICHIGAN. How do you pronounce Massachusetts?
Ms. BERKLEY. How do I? Las Vegas. Thank you very much for
being here. This has been most informative. I am new to the
Committee and there is not a day that goes by, particularly
today, that I did not wish I paid better attention to my tax
professor in law school, it would have made my life a whole lot
easier now. You have a wealth of information, and I am
delighted that you are sharing it with us. The one thing I have
that you do not is a vote, and somehow I am going to have to
vote when all of this over on how we are going to have the
requisite amount of revenue that we need for the needs that my
constituents tell me that they are in need of.
A couple of years ago, about 3,100 of the people that live
in Las Vegas that I represent paid the AMT and in the
neighboring congressional district, there were about 6,300 that
were subject to the AMT. The next year, they do not know this
yet, but there is going to be 30,000 people that are going to
be subject to the AMT in my congressional district and in the
neighboring congressional district, approximately 55,000.
Now, I do not think the question is--I do not have a
voracious appetite to tax anybody and I ask my constituents
when they come and see me and when they come to Washington to
talk to their Member of Congress and they sit in my office, if
it is the people representing the police departments, they want
additional funding to hire more police or to get better
communication systems. If it is the firefighters, they want
more equipment to be able to fight the fires in the western
United States. Parents that come to me want to make sure that
their kids keep getting a good education. My seniors that come
and visit me, AARP and all the others, want to make sure their
Social Security is going to be here when they retire and their
Medicare is going to be there and transportation issues. We do
not want to have another disaster like we had with the bridge
in Minnesota, and for a district like mine, where we are laying
as much concrete and pavement as we can to accommodate the
5,000 new residents I have a month coming into my congressional
district, the costs of keeping up with that are extraordinary.
So, in the earlier panel, the first panel, they told us
that their best advice is to get rid of the AMT, just get rid
of it and that is going to cost us over $600 billion over the
next 10 years. I have to come up with a way because of the
PAYGO rules to offset that. If you were sitting here instead of
there, and I had paid better attention in law school so I would
be sitting where you are, what would you recommend that we do?
Where do we get that revenue if we are going to do the AMT fix
for people that never should have been ensnared in the AMT in
the first place? Anybody? Thank you, Mr. Metzger.
Mr. METZGER. I believe that Dr. Burman stated in the last
panel that he felt that he did not see much benefit to
preferential long-term capital-gains rates. That is a starting
point.
Ms. BERKLEY. How much revenue would that bring in?
Mr. METZGER. How much revenue would be brought in? I do not
know.
Ms. BERKLEY. Me neither.
Mr. METZGER. I do not know because I believe a lot of the
trading tax-exempt today, a lot of trading done is actually
done by institutional investors that are tax-exempt so actually
I do not know how much would be raised but that is at least a
place at which to look.
Ms. BERKLEY. Mr. Shapiro.
Mr. SHAPIRO. I do not know, I really think that frankly we
are sympathetic to the dilemma, I think most of us are because
we are U.S. citizens and we want to see equity and fairness. I
think rather than targeting any one industry or one loophole or
one issue that people have identified, that one would go back
and see whether the rate reductions that took place some years
ago should be re-visited to see if a small rate reduction
across the board can raise enough of the revenue to meet the
$600 million or whatever the number is.
Ms. BERKLEY. Billion.
Mr. SHAPIRO. I do not have the answer.
Ms. BERKLEY. Thank you. Thank you, Mr. Chairman.
Mr. NEAL. I thank the gentle lady. The gentleman from
Washington, Mr. McDermott, is recognized to inquire.
Mr. MCDERMOTT. Thank you, Mr. Chairman. I want to ask a
question for a bricklayer in my district who is used to being
paid wages at the end of the month and being taxed under the
IRS. Mr. Metzger, you state that hedge fund managers will
likely defer compensation when they manage offshore funds and
receive carried interest when they manage onshore funds. Now,
it seems to me that is very often managing the same pool of
money, and I would like you to explain to my constituents
because I am going to have to, why is one payment, carried
interest, taxed at capital gains rates, 15 percent, and the
other is taxed--the deferred management fees are taxed as
ordinary income, what justification is there for that? Why
should my taxpayer have to pay the higher rates and a manager
can play these games and get this break?
Mr. METZGER. That is an excellent question and before I
address it, I just want to correct the record in that a carried
interest is not taxed necessarily at 15 percent.
Mr. MCDERMOTT. What is it taxed at?
Mr. METZGER. It depends on the source of income. As I said
in my testimony, a lot of the income, in fact in my experience,
the majority of the income, is taxed at ordinary rates. Carried
interest means that the adviser, or hedge fund manager, shares
in all the tax attributes. So, for example, if only 35 percent
of the taxable income is preferential-rate income, a 15-percent
tax would apply to the 35 percent but the remaining 65 percent
of income would be taxed at ordinary rates at 35 percent. In my
experience, most of the hedge fund income is not preferential.
So, I just wanted to----
Mr. MCDERMOTT. So, are you saying this problem does not
exist, that it is a fair system, there is really nothing here
to be looked at?
Mr. METZGER. No, no, I am going to get to your question in
a moment.
Mr. MCDERMOTT. Okay.
Mr. METZGER. I just wanted to make sure that you did not
have this idea that all of the carried interest in hedge funds
was taxed at 15 percent. Now that might be different from
private equity but that is not my area of expertise.
But in terms of your question, what I think you are saying
is the hedge fund adviser does the trading at the master-fund
level and receives his or her compensation at the feeder level,
and I think what you are saying is that the managers can
choose, let's say I want to treat it as service income, so I
will say if I receive it at the offshore level, it is a service
income. If I receive it at the onshore level, no, that is a
carried interest. I think that is your question. I do not think
you will like my answer, however there is a difference and that
liquidity--if a manager wants liquidity, the manager will
choose to take compensation as a carried interest. If the
manager says, ``I do not need the money for 5 years or 10
years,'' the manager will choose deferral. That said, the tax
law, the Tax Code permits taxpayers to, if you will, choose how
they structure their compensation arrangements.
Mr. MCDERMOTT. But how can it be fair if my bricklayer can
only put $20,000 into his IRA and these managers you are
talking about can put a half a billion dollars into essentially
an unofficial IRA that is holding out there until some day they
decide to bring it back in, what is the fairness in that? Why
do you not let me put all I can put in as a bricklayer?
Mr. METZGER. Again, that is what the Tax Code allows and
they are following the Tax Code. If your question is should the
Tax Code be changed, if that is what your question is, my
answer is all types of deferred income should be treated the
same way. You should attack the issue instead of attacking
particular industries. Today the hedge fund industry is
successful, if we had this hearing 10 years ago, you would not
have been talking about hedge fund managers. Five years from
now it may be a different industry. Instead of singling out
industries, which is a quick fix, why do we not just attack the
issue of deferrals entirely?
Mr. MCDERMOTT. Thank you. Thank you, Mr. Chairman.
Mr. NEAL. I would like to yield for a moment to the
Republican leader, Mr. McCrery, for an unanimous consent
request.
Mr. MCCRERY. Thank you, Mr. Chairman. A few minutes ago,
our colleague from Michigan, Mr. Levin, introduced for the
record a letter from the National Conference on Public Employee
Retirement Systems. That letter was a follow-up to an earlier
letter, dated August 24, 2007, from the same National
Conference of Public Employee Retirement Systems, and I would
like to submit for the record that August 24th letter so that
both of these can be read together.
Mr. LEVIN OF MICHIGAN. Reserving the right to object, I do
not at all, I just urge that everybody read in that letter we
argue that the bills could potentially have a negative impact
on public pension plans, the position we took is not the view
of NCPERS' full membership and that the majority do not agree
with the letter that was sent earlier. I am glad to have both
in.
Mr. MCCRERY. I think it would do Members well to read both
letters. They can judge for themselves the merit of each
letter.
Mr. LEVIN OF MICHIGAN. No, no, I fully agree. I hope they
will read both of them. I withdraw my reservation.
Mr. NEAL. Just before the Chair recognizes the gentleman
from Georgia, maybe all the members might want to think about
the possibility of doing what we did between the first and
second panels where we allowed members of the first panel who
had not been able to participate in inquiry to become first in
line for questioning the next panel, just a thought as we move
to Mr. Lewis.--The gentleman from Georgia is recognized to
inquire.
Mr. LEWIS OF GEORGIA. Thank you very much, Mr. Chairman.
Let me thank the members of the panel for being here today. I
know it's been very long for you, like it's been long for many
of us. But we live in a complex world, unbelievable world.
We live in a country with a sophisticated economy, and so
some people believe, therefore, we should have a complicated
and sophisticated tax pool. So, I want to ask you, would you
agree that the international tax rule on hedge fund investment
off-shore are unnecessarily complicated and the effect of
making the Code less fair?
If one of you could make only one change to our
international tax law, what would it be? What would it be?
Anybody.
Mr. SHAPIRO. I haven't thought about it before and this is
my personal view, but we talked before and I made the
suggestion that trying to simplify the rules to allow this huge
and wonderful, important tax exempt community that represents
such great missions to invest their money in U.S. funds without
being subject to tax to me would simplify a significant amount
of the planning that goes into hedge funds.
So, I think that suggestion was made over here and I think
it would be a very interesting idea for you to pursue. It would
be consistent with some very smart decisions made by this
congress going back to 1966. Let's encourage foreign
investment, and then 20 years later, let's get rid of any rules
that require them to have sort of artificial, off-shore
offices. Let's encourage the money to be managed here on a
favored tax basis. I think that would be one of a number of
steps that you could take to simplify the tax law as it applies
to hedge funds.
Mr. LEWIS OF GEORGIA. Thank you. Other volunteers?
Mr. SHAY. Mr. Lewis, I mentioned a couple of proposals in
my testimony, but the one that would probably have the greatest
simplifying effect would be to not have deferral of taxation on
foreign corporate earnings in terms of reducing some of the
complexity that's in the Code.
Mr. LEWIS OF GEORGIA. Yes?
Ms. MCDOWELL. Mr. Lewis, this does not go to international
tax overall. That's not my area of expertise. My area of
expertise is tax exempt organizations. However, I think that
enlarging the exception to the debt-financed income rules so
that most debt-financed transactions could go forward without
regard to those rules would greatly simplify investments for
charitable enterprises.
Mr. LEWIS OF GEORGIA. Thank you very much. Thank you, Mr.
Chairman. I yield back. My time is up.
Mr. NEAL. I thank the gentleman. I believe the gentleman
from California, Mr. Becerra, would like to inquire.
Mr. BECERRA. Yes, Mr. Chairman. Thank you very much, and I
thank the panel for their patience as we go through all the
questioning, but we do appreciate your comments.
Ms. McDowell, let me ask a quick question. You just
mentioned that you thought we should perhaps examine the debt
finance income rule so that we could make it perhaps a fairer
process for a lot of our not-for-profit entities that are going
offshore.
What if we were to say that we want to provide an equal
playing field by saying that we'll apply the UBIT tax to
offshore investments versus not apply the UBIT tax to onshore
investments?
Ms. MCDOWELL. Well, in my judgment we're talking here about
one part of the UBIT tax. We're talking about the part that
applies to debt-financed investments. I don't see a reason to
discourage debt-financed investments across the board. The
current rules were enacted in 1969 to respond to a very
specific abusive transaction, a sale lease back transaction.
They've done that successfully, and I think that there are
rules that are in the Code now that deal with real estate
transactions that would continue to do that.
Mr. BECERRA. I sense what you're saying. I think there's a
threat of reasoning in what you're saying. You're saying that
if we actually expanded the debt finance rule under the UBIT
tax to offshore investments, what you'd in essence do is kill
those debt-financed investments.
Ms. MCDOWELL. Right, and I don't think there's anything
wrong with many of them.
Mr. BECERRA. Okay, great. I appreciate that answer. Let me
ask Mr. Metzger. I think you've been asked this question
somewhat, but I want to make sure I'm clear on this. I'm a fund
manager, and I'm making investments onshore. I suspect my
investors are expecting me to do certain things to invest that
money wisely to create a good return. I am now a fund manager
for an investment that's offshore. I expect that those same
investors, whether they are now corporate shareholders or
whether they were limited partners in the onshore investment,
are expecting the same type of wise investment and similarly
high returns.
Correct?
Mr. METZGER. Yes.
Mr. BECERRA. Does one fund manager behave differently from
the other fund manager if it's an onshore or offshore
investment?
Mr. METZGER. Now, you're talking about two side-by-side
investments, or are you talking about the classic, master-
feeder arrangement?
Mr. BECERRA. It's two different individuals. Do they try to
behave similarly whether it's an onshore or offshore investment
and to try to extract as much return for that investment as
possible?
Mr. METZGER. If I understand your question correctly,
you're asking me, if you have, for example, onshore investors,
and offshore investors, do they have different interests. The
answer is yes. So, for example, the onshore investor prefers to
receive preferential-rate dividend income. The offshore
investor prefers that fund does not receive dividend income
that is subject to withheld tax.
Mr. BECERRA. No, I understand that.
Mr. METZGER. So, therefore the manager of the offshore fund
might try to use derivative financial instruments to avoid
paying the tax. So, there might be slightly different trades.
Mr. BECERRA. Let me try to approach it a little
differently, because I understand what you've said, and I agree
with you. I know my time has expired so I want to try to close
on this.
Say I have investors here onshore who wish to invest. I
want to then calculate how to make the best investment based on
their circumstance, tax-wise and otherwise. I am now approached
by some folks who want to keep the money offshore. I then have
to make those calculations based on their circumstances.
If I've done a great job of investing in my history in my
career, is there any reason why an investor would not want to
approach me simply because of the investment being offshore or
onshore?
Mr. METZGER. Oh, if you're saying would a U.S. investor
perhaps not want to invest in an offshore fund?
Mr. BECERRA. No.
Mr. METZGER. I'm not following the question.
Mr. BECERRA. Me, the individual; me the fund manager; I'm
asking about the individual. I'm being judged on my
capabilities to invest the moneys, whether it's an offshore or
onshore investment. Correct?
Mr. METZGER. Yes.
Mr. BECERRA. Okay. I know there are different types of
investments you would make based on an offshore, onshore
investment. But if I'm a good fund manager, I'm capable of
making investments for an onshore fund or an offshore based
fund.
Mr. METZGER. Yes.
Mr. BECERRA. So, based on that then the final question is
and similar to the question that was asked earlier, is there a
reason to distinguish how we categorize the compensation
received by me as a fund manager, simply because in one
instance I'm making investment decisions for an onshore fund.
In another situation I'm making decisions for an offshore based
fund.
Mr. METZGER. So the distinction is that for the investment
in the onshore fund is, the advisers your compensation is more
liquid, and the Internal Revenue Code tells you how to treat
that income.
If the investment is in the offshore fund and the advisor
chooses not to receive it in a liquid form, the adviser follows
the Internal Revenue Code. Economically, the activity is the
same. Economically the income is the same. But because the Code
allows the adviser to classify one as liquid and the other as
illiquid, they have different tax treatments.
Mr. BECERRA. I'll decipher what you've just said in terms
of liquid versus not and trying to navigate the tax, what
you're saying is you're going to try to find the best way to
get your compensation at the lowest tax rate.
Mr. METZGER. Yes.
Mr. BECERRA. Thank you.
Mr. NEIL. I thank the gentleman.
The gentleman from Texas, Mr. Doggett, is recognized.
Mr. DOGGETT. Thank you very much.
I appreciate the testimony of each of you, but because of
the very serious perversions of our international tax system
that Mr. Shay has described today in his writings that we're
blessed by this Committee in previous years, I'd like to focus
specifically on that aspect and ask my questions to you, Mr.
Shay.
First, I think it's important, as you voice your opinions,
to make clear to my colleagues and to those who are listening,
the expertise and background you bring to this issue. As I
understand it, your career is based on advising multinational
corporations on how they can legally minimize their taxes.
Before that, you served as international tax counsel at the
Treasury Department in the Reagan Administration. Is that
correct?
Mr. SHAY. That's correct. My practice in recent years is
probably being in addition to multinationals a lot more
investment funds, because that's where the market has gone.
Mr. DOGGETT. Okay. If I understand your testimony, if I
have a multinational in the United States that does business
here and does business abroad, that multinational can deduct
from its U.S. income for what it generated here in the United
States. All the expenses that it can fairly, reasonably
attribute to its foreign operations, and it can do that now.
But with reference to income generated abroad, it may never be
taxed on that, but certainly not until it repatriates or brings
that income back to the United States.
Mr. SHAY. It is correct that you can take a current
deduction say for interest and foreign corporate stock that
earns foreign income that's not currently taxed.
That's correct.
Mr. DOGGETT. We'll take your expenses now but pay later on
your income from abroad, and that deferral system is what much
of your writing has been about. When you combine that with
other inequities and what is really a swiss cheese
international holes in the international tax system, like
transfer pricing abuse, like a pharmaceutical company assigning
a valuable patent to a subsidiary in a low tax jurisdiction,
what you end up with is a significant distortion of investment
decisions growing out of the tax system itself that a
reasonable company would make.
Mr. SHAY. I think it's correct to say I think the current
rules do encourage tax moving and shifting of particularly
intangible assets. As I think you're suggesting, under current
law, it is done legally. I mean, this is not something that's
prohibited.
Mr. DOGGETT. When you testified to us last year, you were
with a couple of fellows who said, you know, the best thing for
us to do on international tax is let's not have any tax at all.
Let's go to zero through what they call the territorial system
on foreign source income. You don't agree with that approach.
Mr. SHAY. That's correct as reflected in my testimony.
Mr. DOGGETT. But we have learned that if you did that,
given the way the current international tax system is
perverted, that if we cut it to zero and let them stop this
deferral of the expenses, that we'd actually generate tens of
billions of dollars of income, of revenue.
Mr. SHAY. The revenue estimate that is associated with
exemption, which is substantial, is partly attributed to
expenses. It's also attributable to the fact that you would no
longer be able to credit foreign taxes against export sales
income.
Mr. DOGGETT. I should have clarified that, because you also
pointed out in your paper that we essentially end up picking up
effectively some of the foreign tax burden. Our taxpayers are
lost to the Treasury here. Of course we actually, as you note
in your paper in your testimony, we've actually experimented
with doing away with taxes or almost doing away with taxes in
the so-called American Jobs Act that this Committee so
blissfully approved a few years ago.
Some of us would really call it the Export American Jobs
Act. But under that, some of these corporations that had
manipulated the tax system actually got a tax amnesty where
they were able to bring back these earnings and pay at most
five and a quarter percent on those earnings. Weren't they?
Mr. SHAY. That's correct.
Mr. DOGGETT. You refer to that in footnote 16 of your paper
as being a farce and cite two others who found it to be a farce
like an article called ``The Great American Jobs Act Caper.''
Mr. SHAY. I think I was citing a paper, which referred to
it as a farce. I think the farce that was intended was that it
was presented, I think, as an economic stimulus measure, where
I think I'd be delighted to see the studies that Mr. English
has raised. It's very hard to see what the economic consequence
was that was more than essentially financial shifting.
Mr. DOGGETT. Well, thank you. We can't export at greater
length today, but what we had were some companies that brought
back these earnings at essentially zero tax. When they consider
the foreign tax credit the same day almost that they were
cutting American jobs, and a situation where a company like Eli
Lilly in 2004 paid an effective tax rate of 1 percent on its
worldwide income, not considering this repatriated earnings.
But I just contrast that with a community pharmacy down in
Buda, Texas. It's incorporated and paying 35 percent. I think
that's some of the inequity that this Committee has permitted
in the past that we must remedy.
Thank you very much.
Mr. NEAL. We thank the gentleman.
The gentlelady from Ohio is recognized to inquire, and I
believe that we will then move to the next panel.
Ms. TUBBS-JONES. To my colleagues and friends out there;
unfortunately, I've got to go back to Ohio to a funeral. So,
all I want to say is I think that all of you need to help us
come up with some policy that will be fair on behalf of all the
taxpayers there; those at the bottom of the rung of the ladder
and the upper end of the ladder.
There's got to be a little more equity to all the
foundations out there. You know I'm not chairing the
philanthropic caucus. I mean, we're looking for, me and my
colleague are looking for opportunities to take a closer look
at how you're able to raise funds for the non-profits that
you're doing and the work that you're doing.
To the next panel, all the best. I hope my colleagues don't
beat you up too bad and I'll see you next time around when we
hit this issue.
Mr. Chairman, thanks for the opportunity to be here, and I
appreciate it.
Mr. NEAL. We thank the gentlelady, and I want to thank the
panelists for your patience, and certainly your sound
reasoning.
Everybody offered a very good perspective, and I thought
that in particular you took a very complicated matter and
explained it in a manner that we could all understand.
Thank you, very, very much.
Mr. LEVIN OF MICHIGAN [presiding]. We'll now start with the
third panel. We very much appreciate your patience. We're
getting your names appropriately placed.
All right, Mr. McCrery, I think will begin. I believe it
was suggested that we were going to have two sets of panels and
that the third and fourth would come here after lunch at two
o'clock. It's now four o'clock, and I think a lot of us had
lunch.
But we very much appreciate your patience, and so let us
introduce all of you together. Then if you go in the same
order, first, and I think most of you are doctors, PhDs, Peter
Orszag, who is Director of CBO.
Welcome Gene Steuerle, who also has been here many times.
We welcome you back.
Actually, next to you, if we're going to go in that order,
is Jack Levin, who is a partner in Kirkland & Ellis in Chicago.
Then Darryll Jones, who is a professor of law at Stetson
University College of Law in Florida.
Next, Victor Fleischer, who is associate professor of law
at Illinois College of Law in Champaign, Illinois.
Last, but as we often say not least, Mark Gergen, a
professor of law, the University of Texas Law School, Austin.
Now, as you know, many of you have been here before. Your
testimony will be placed in the record. We have the 5-minute
rule. You can be assured the full testimony will be fully
distributed and aired. This is just the beginning of our
consideration of these issues and so everybody is not here all
the time. I think you can be assured, because of the tradition
and nature of this Committee, your testimony will receive the
fullest consideration.
So, we'll start first with Peter Orszag, and then if we
might simply go down the row, thank you.
STATEMENT OF PETER R. ORSZAG, DIRECTOR, CONGRESSIONAL BUDGET
OFFICE
Mr. ORSZAG. Thank you. Thank you very much, Mr. Levin, Mr.
McCrery, other Members of the Committee. Thank you for having
me this afternoon.
As you know, a growing amount of financial intermediation
is occurring through private equity and hedge funds, which are
typically organized as partnerships or limited liability
companies and now have at least $2 Trillion under management.
These organizational forms are growing rapidly for many
reasons, but among the reasons is their tax treatment.
In particular, such partnerships do not pay a separate
corporate income tax. Instead, they pass all income and losses
through to the partners. The manner in which that income is
taxed is the central focus of my written testimony. The
partnerships have two types of partners, limited partners who
contribute capital and general partners who manage the
partnership's investments and may contribute a modest amount of
capital themselves.
The general partners typically receive two types of
compensation: a management fee that is tied to some percentage
of assets under management and a carried interest tied to some
percentage of profits generated by those assets. For example,
if a fund had $1 Billion under management and the typical 2
percent management fee, management fees would amount to $20
Million a year and that amount would not depend on the
performance of the underlying investments.
That $20 Million management fee is taxed as ordinary income
to the general partner since it reflects compensation for
services provided. If the fund also generated $150 Million in
profits, the general partner with a 20 percent carried interest
would receive another $30 Million. That is 20 percent of the
$150 Million in profits. In practice, at least within private
equity buyout firms, carried interest often applies only after
a hurdle rate of return is achieved. That would change the
calculations but not the underlying analytical issues involved.
Taxation on this carried interest is deferred until the
profits are realized on the fund's underlying assets and are
then taxed to the general partner at the capital gains tax rate
to the extent that the funds underlying investments or profits
reflect capital gains. So, at a capital gains tax rate of 15
percent, that $30 Million of carried interest would generate a
tax liability of $4.5 Million.
From an economic perspective, a general partner in a
private equity or hedge fund undertakes a fundamentally
different role than that of the limited partners, because the
general partner is responsible for managing the fund's assets
on a day-to-day basis and the carried interest is
disproportionate to financial capital invested, that is the
general partner's own financial assets at risk, if any.
Most economists therefore view at least part and perhaps
all of the carried interest as performance-based compensation
for management services provided by the general partner, rather
than a return on capital invested by that partner. That
perspective would suggest taxation of at least some component
of carried interest as ordinary income rather than capital
gains. Almost all other performance-based compensation is
effectively taxed as labor income. For example, contingent fees
based on movie revenue for actors are taxed as ordinary income
as are performance bonuses, most stock options and restricted
stock grants.
So, too are incentive fees paid to managers of other
people's investment assets where those fees are documented as
such rather than in the form of carried interest in a formal
partnership. Although there does not appear to be any solid
analytical basis for viewing carried interest solely as a
return on financial capital for the general partner, there is
an analytical debate about whether it should be viewed purely
as compensation for management services provided or as a
mixture of compensation for management services and capital
returns.
My written testimony discusses some of the analytical
issues involved in those different perspectives. It also
examines a few recent proposals to change the taxation of
carried interest and the pros and cons thereof. I will defer to
your question period if you would like to ask more about those.
In closing, I just want to emphasize that much of the
complexity that is associated with taxation of carried interest
arises because of the differential tax rate on capital income
and ordinary income. In particular, because ordinary income for
high income tax payers is typically subject to a 35 percent
marginal income tax rate, whereas, long-term capital gains are
subject to a 15 percent tax rate, there is a strong incentive
to shift income into forms classified as capital gains.
Whether carried interest represented compensation for
services provided or a return on capital invested would be
largely irrelevant if the tax rate on labor and capital income
were the same.
Thank you very much.
[The prepared statement of Mr. Orszag follows:]
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Mr. LEVIN OF MICHIGAN. Thank you.
Mr. Levin.
STATEMENT OF JACK S. LEVIN,
PARTNER, KIRKLAND & ELLIS LLP
Mr. LEVIN. Mr. Chairman and Committee Members: My name is
Jack Levin. I teach at Harvard Law School and University of
Chicago Law School, and I'm author or co-author of 5,800 pages
of exciting treatises on venture capital, private equity,
mergers and acquisitions.
In my law practice at Kirkland & Ellis, I have long
represented many funds and their trade associations, but today
I appear to express my own personal views on the appropriate
taxation of carried interests.
First of all, we have two systems of taxation in the United
States: a corporate system with double tax; and a partnership
flow through system where the partners are taxed when the
partnership earns income. The partners are then taxed on the
income at the capital gain or ordinary income rate by
characterizing the income in the partners' hands at the same
characterization as in the partnership's hands.
For many decades the Code has conferred a lower tax rate on
gain from the sale of a capital asset held more than 1 year:
The capital gains rate. Throughout these decades, the Code has
never contained an absence of sweat test. For example, assume
that Warren Buffet retires from Berkshire Hathaway and invests
some of his money in stocks and real estate, working 8 hours a
day at his desk. We have a videotape demonstrating that as he
worked at his desk picking stocks and real estate in which to
invest, he did indeed break a sweat.
Is or should the capital gain that he would otherwise have
earned on these long-term investments be turned into ordinary
income?
Or, if an innovative entrepreneur like Bill Gates and his
investor group start a new computer company, is or should the
entrepreneur's long-term capital gain on sale of the computer
company's stock be converted into ordinary income because he
had many sweaty armpit days?
The Code does not make, and never has made, the absence or
presence of activity or ingenuity or even a bit of bodily
dampness the test for a long-term capital gain. Nor should we
now in my view legislatively adopt a test requiring IRS agents
to poke around in Warren Buffett's or Bill Gates' dirty laundry
searching for perspirational evidence. Rather, we should not
tax carried interest capital gains differently than other
capital gains.
When Congress enacts laws picking winners and losers with
the tax rates and rules differing by industry, for example,
taxing carried interest in venture, private equity and hedge
funds more harshly than other types of carried interests and
more harshly than other investment gains, the free market is
inevitably distorted with great risk of dire, long-term
consequences for American economic growth.
Another question: do Steve Schwartzman and his peers make
so much money that they should simply be taxed more harshly?
Let me tell you that whenever this august body has enacted
punitive tax legislation based on vignettes rather than on
careful, macro-economic analysis, our great country has been
ill-served. You all recall the famous congressional hearings
that found 21 unnamed American millionaires who paid no Federal
income tax for 1967 and which resulted in the odious, illogical
and counterproductive AMT, an albatross around all our necks
ever since.
Over the past 20 years or so, it has not been the big,
publicly traded auto companies and airlines that have provided
growth in jobs, exports and prosperity. Rather, venture
capital, private equity and hedge funds which finance companies
have made our economy the most efficient, vibrant and emulated
in the world.
I believe that if we now adopt a punitive carried interest
bill, the flow of entrepreneurial investments will indeed be
reduced. I can't tell you if it will be 10 percent, 20 percent
or 30 percent, but I believe that it will be reduced with
significant harm to American job growth, exports and business
vibrancy. After all, the reason that we have a lower rate on
long-term capital gain is to precisely encourage investment of
entrepreneurial risk capital in American business to create the
jobs, exports and prosperity that we have had in recent years.
[The prepared statement of Mr. Levin follows:]
Prepared Statement of Jack S. Levin, Partner, Kirkland & Ellis LLP,
Chicago, Illinois
Mr. Chairman and Committee members, my name is Jack Levin. I teach
at Harvard Law School and University of Chicago Law School, am author
of a 1,400 page treatise on structuring venture capital and private
equity transactions, and am co-author of a 4,400 page treatise on
mergers and acquisitions. In my law practice at Kirkland & Ellis LLP, I
have long represented many private equity, venture capital, and hedge
funds and their trade associations, although I appear today to express
my own personal views on the appropriate taxation of carried interests.
In my brief testimony, and at more length in my written statement,
I will try to answer 6 questions:
First question, why do we tax long-term capital gain--that is, to
use the Code's verbiage, gain from the sale of a capital asset held
more than 1 year--at a lower rate than ordinary income, such as wages
or interest income?
Several reasons: By imposing a lower tax on long-term capital gain
than on ordinary income, Congress encourages the investment of risk
capital in American business. I agree with this approach because the
more risk capital invested into American business, the more our
companies expand, create jobs and exports, and spread American
prosperity.
Another reason for the lower tax rate on long-term capital gain is
the recognition that it frequently takes many years to realize gain
from a capital investment, by which time inflation has reduced the
sales proceeds' real value. Stated another way, much of the so-called
long-term capital gain does not really represent true gain because
inflation has reduced the proceeds' value.
Second question, when a partnership recognizes long-term capital
gain, why is the portion flowing to a carried-interest holder taxed as
long-term capital gain?
We have traditionally had two systems of business taxation in this
country. The corporate taxation system is very complex with double
taxation (once at the corporate level and a second time at the
shareholder level when the corporation makes distributions), Sec. 312
E&P calculations, Sec. 302 redemption recharacterizations, Sec. 305
stock dividend rules, Sec. 306 tainted preferred stock, Sec. 368
reorganizations, and 6 mind-numbing interest deduction disallowance
rules.
The second system, for partnerships and LLCs, uses a flow-through
approach and is designed to be much simpler and more economically
rational, with a single level of tax, imposed on the partners when
income is recognized at the partnership entity level, by allocating the
partnership's income among the partners based on each's economic right
to receive such income, with the income allocated to each partner
retaining its entity-level characterization as (e.g.) ordinary income
or capital gain.
This simpler partnership flow-through tax approach--designed to
encourage groups of people to join forces by combining their capital,
labor, and know-how to start, build, and expand businesses--has
contributed mightily to the vibrancy of America's entrepreneurial
economy.
So if a partnership holds stocks or other capital assets for more
than 1 year, its gain on ultimate sale of those assets constitutes
long-term capital gain in the hands of all the partners, both the pure
capital investor and the part-capital part-management carried interest
partner.
This is appropriate for a venture capital, private equity, hedge,
or real estate fund because the general partners serve as the fund's
principals or owners, selecting the fund's investments, sitting on the
boards of the fund's portfolio companies, and making the fund's buy and
sell decisions (like any owner of an investment), and generally making
a substantial capital investment in the fund. General partners are not
merely agents of the partnership, who have no capital at risk, merely
making recommendations and following the dictates of their investor
clients.
Third question, should carried interest partners be taxed at
ordinary income rates on their share of the partnership's long-term
capital gain because as joint venture managers they are really
receiving sweat equity?
For many decades the Code has conferred the lower long-term capital
gain rate on gain from the sale of a capital asset held more than 1
year and throughout these decades the Code has never contained an
absence-of-sweat test.
For example, assume Warren Buffett retires from Berkshire Hathaway
and invests some of his money in stocks and real estate--working 8
hours at his desk every day, including Saturdays, to pick which stocks
and real estate to buy, hold, and sell--and assume we have a videotape
of his activities showing that on many days he did indeed break a sweat
while studying reports and placing buy and sell orders. Is (or should)
his long-term capital gain on his stocks and real estate held more than
1 year be converted into ordinary income?
Or if an innovative entrepreneur like Bill Gates and his investor
group start a computer company, is (or should) the entrepreneur's long-
term capital gain on sale of the computer company's stock be converted
into ordinary income because he had many sweaty armpit days?
My point is that the Code does not make, and never has made, the
absence or presence of activity and ingenuity--or even a bit of bodily
dampness--the test for long-term capital gain, nor should we now
legislatively adopt a test requiring IRS agents to poke around in
Warren Buffett's or Bill Gates' dirty laundry searching for
perspirational evidence.
But if we tax carried interest capital gain differently than other
capital gain, isn't that the next step? If venture capital, private
equity, and hedge fund managers who invest substantial capital and
contribute substantial intangible assets in the form of (e.g.) know-
how, reputation, goodwill, contacts, and deal flow are to be tainted by
sweat, shouldn't the same rule apply to Warren Buffett and Bill Gates
in my examples?
Fourth question, do Steve Schwartzman of Blackstone and his peers
make so much money that they should be taxed more harshly?
Whenever this august body has enacted punitive tax legislation
based on vignettes, rather than on careful macro-economic analysis, our
great country has been ill served. Perhaps the best example is the
famous 1969 Congressional hearings that discovered 21 unnamed American
millionaires paid no Federal income tax for 1967. The direct result of
those hearings is the odious, illogical, and counterproductive
alternative minimum tax (or AMT) which has been an albatross around all
our necks ever since, and which threatens to affect 25 million
taxpayers in 2007 and 56 million by 2017.
Let's not repeat our past tax-legislation-by-vignette approach.
Just because some private equity investors, or some athletes, or some
thespians, or some computer-company founders make substantial amounts
of money doesn't mean it is in America's best interests to impose tax
penalties on them without carefully examining the macro-economic
ramifications.
Fifth question, will changing the long-standing definition of
capital gain to impose ordinary income tax on carried interests in
long-term capital gain be harmful for the American economy?
Over the past 20 years or so, it has not been the big publicly
traded auto companies and airlines that have provided growth in jobs,
exports, and prosperity. Rather it has been the venture capital,
private equity, and hedge fund financed companies that have made our
economy the most efficient, vibrant, and emulated in the world.
If the carried-interest bill passes, will the flow of venture
capital and private equity money into American business be reduced by
10 percent? By 20 percent? By 30 percent? Will American job growth,
exports, and business vibrancy be curtailed? I believe there is
substantial risk the flow of entrepreneurial investments will indeed be
reduced, with significant harm to our vibrant economy.
So beware the law of unintended consequences and be slow to start
down an opaque road if you don't know where it leads.
The basic principle of our free enterprise capitalistic economy is
that American employment, growth, and prosperity will be maximized by
allowing the free market to operate.
It is the antithesis of the free market when Congress enacts tax
laws targeting specific activities and designating winners and losers,
for example, taxing carried interest in venture capital, private
equity, real estate, and hedge funds more harshly than other types of
carried interest and more harshly than other investment gains. When
Congress enacts laws picking winners and losers, with the tax rates and
rules differing by industry, the free market is inevitably distorted,
with great risk of dire long-term consequences for American economic
growth.
Sixth question, will a slowdown in venture capital/private equity
investing hurt only fat cat venture capital/private equity
professionals?
Among the largest investors in venture capital/private equity funds
are pension plans and university endowments. Thus, a slow down in
venture capital/private equity formation and investing harms not only
new and growing American businesses that do not receive the funding
necessary to start up, grow, and prosper, but also the millions of
American workers whose pension plans are the single largest venture
capital/private equity investors and also the millions of American
students whose tuition is reduced by their university's endowment
profits.
I would be happy to answer any questions.
Mr. LEVIN OF MICHIGAN. Thank you.
Mr. Steuerle.
STATEMENT OF C. EUGENE STEUERLE, Ph.D, CO-DIRECTOR, URBAN-
BROOKINGS TAX POLICY CENTER, AND FORMER DEPUTY ASSISTANT
SECRETARY OF THE TREASURY, FOR TAX ANALYSIS, REAGAN
ADMINISTRATION
Mr. STEUERLE. Mr. Chairman, Ranking Member McCrery, and
Members of the Committee, I appreciate the opportunity to
appear before you today. I must mention again that each time I
appear before Ways and Means, I stand in great reverence, both
for its history and its mission.
Let me begin, if you will, with a story. Once upon a time
there was a fairly rich society, and in this society was a
fairly exclusive club of people who paid low, individual tax
rates. Some got into this club because they didn't have a lot
of income. Others got in because they didn't realize much of
their income. Some belonged because the society's legislature
decided to grant a reprieve for multiple layer taxes, but did
it in a way that also benefited some who paid almost no tax.
Still, others belonged because they figured out how to
arbitrage differentials built into the tax system. This last
group became very prolific as time went on.
Now, there was another club in this society: those who paid
fairly high marginal tax rates on money they actually saved.
This club included students going to college, many welfare
recipients, those who put their money into bank accounts, and
some fairly successful executives. Many people belonged to
neither club.
One day, there arose a debate over whether one particular
set of members, those who arbitrage both their financial
returns and tax differentials, deserved to belong to this
first, exclusive club of low tax rates. While there was a very
technical debate about the consistency of membership, most of
the debate boiled down to the following.
Those who were threatened with loss of membership argued
that they were as deserving of membership as other rich Members
of the club. Their opponents argued that they were no more
deserving than many of those already excluded. Both were right.
Mr. Chairman, Mr. McCrery, Members of the Committee: you
have asked that I testify on the basis of my experience as
economic coordinator and original organizer of the Treasury tax
reform effort that led to the Tax Reform Act of '86 and later
as Deputy Assistant Secretary of the Treasury for Tax Analysis.
The basic principles of taxation lead to many of the same
conclusions today as they did then. Whenever possible, tax
differentials should be reduced. These include differentials
due both to double taxes and preferences. Today, tax
professionals are extraordinarily adept at leveraging those
differentials and applying them far and wide.
As a matter of both efficiency and equity, capital gains
relief is best targeted where tax rates are high, such as in
the case of double taxation of corporate income. The case for
providing capital gains relief for carried interest is
relatively weak, resting primarily upon whether the
administrative benefits of the simple partnership structure
needs to be maintained in this arena. It does not rest upon
arguments for favoring capital income, entrepreneurs or risk,
which can be done in a more efficient manner.
Many people pay high, explicit or implicit rates of tax on
their capital income including those whose net worth is in
interest bearing accounts, welfare recipients, kids saving for
college, and some owners of corporate equity. Relief might be
more efficiently and fairly targeted in their direction.
Hopefully, Congress will 1 day turn to these broader reform
issues. The reasons stretch beyond equity to economic growth.
In particular, the tax arbitrage opportunities the tax system
makes available reduce national income and product, encourage
too much production of some items and too little of others, and
shunt many talented individuals into less productive
activities. Perhaps some of those talented individuals are here
today. It substantially increases the amount of debt in our
economy.
Finally, I suggest that Congress engage the Treasury and
the IRS in a much more extensive and continued effort to
develop better data about who in society and at various income
levels pay multiple taxes and who pay little or no tax at all.
Thank you.
[The prepared statement of Mr. Steuerle follows:]
Prepared Statement of C. Eugene Steuerle, Ph.D., Co-Director, Urban-
Brookings Tax Policy Center, and Former Deputy Assistant Secretary of
the Treasury for Tax Analysis, Reagan Administration
The views expressed are those of the author and should not be
attributed to the Urban Institute, its trustees, or its funders.
Portions of this testimony are taken from the author's column,
``Economic Perspective,'' in Tax Notes Magazine.
Mr. Chairman and Members of the Committee:
Thank you for the invitation to testify before you today on the
taxation of carried interest and its relationship to the broader issue
of how a tax system should be designed to meet the goals of equity and
efficiency.
You have asked that I testify because of my experience as economic
coordinator of the Treasury tax reform project leading to the Tax
Reform Act of 1986 and, later, as deputy assistant secretary of the
Treasury for tax analysis. In particular, I will address how we
succeeded, at least in the view of many, in promoting equity and
improving the performance of the U.S. economy. Note that the 1984-86
work was not really aimed at changing revenues or the progressivity of
the tax system. The goals were efficiency and equal justice under the
law for people in similar circumstances.
A succinct summary of my conclusions today is as follows:
Any time Congress creates differentials in taxation, tax
professionals are extraordinarily adept at leveraging up those
differentials and applying them far and wide.
As a matter of both efficiency and equity, capital gains
relief is best targeted where tax rates are high, as in the case of the
double taxation of corporate income.
The case for providing capital gains relief for carried
interest is relatively weak, resting primarily upon whether the
administrative benefits of the simple partnership structure needs to be
maintained in this arena; it does not rest upon arguments for favoring
capital income, entrepreneurs, or risk.
Many people pay high explicit or implicit rates of tax on
their capital income, including those whose net worth is in interest-
bearing accounts, welfare recipients, kids saving for college, and some
owners of corporate equity. Relief might be more efficiently and fairly
turned in their direction.
Hopefully, Congress will one day turn to broader reform
issues, including corporate integration and removing many differentials
in taxation. The reasons stretch beyond tax policy to economic growth.
For instance, the way that debt is favored over equity not only
provides some of the juice for private equity firm transactions,
regardless of how they are taxed, but builds up our debt-laden economy.
Differentials in Taxation and Tax Arbitrage
Let me get an important technical distinction out of the way
first--the distinction between financial arbitrage and tax arbitrage.
Financial arbitrage involves selling lower-return assets and buying
higher-return assets. This activity is not confined to hedge-fund
managers or private equity firms. Most households and businesses engage
in financial arbitrage when they borrow to buy a home or equipment that
produces a higher return than the interest rate at which they borrowed.
Tax arbitrage also works off of leverage, but it takes advantage of
tax differentials, not necessarily any real productive opportunities.
In the case of normal tax arbitrage, it involves the creation of
additional assets and liabilities to effectively transfer ownership so
that the most highly taxed items are owned by low- or zero-rate
taxpayers, and the least highly taxed items are owned by taxpayers
facing higher rates. The tax system has provided enormous incentives
for creating a debt-magnified economy, so that interest-bearing
accounts, bonds, and even implicit debt instruments can be held by non-
taxpaying institutions and individuals, while those with higher tax
rates then use those loans to hold onto other assets not so heavily
taxed.
Sometimes there are also ``pure'' tax arbitrage opportunities,
whereby the taxpayer makes money essentially by borrowing from him- or
herself. For instance, many households borrow and pay interest to buy
retirement assets. Tax arbitrage explains how the United States can
have such high rates of gross deposits in accounts and retirement plans
and still have a negative personal saving rate.
Tax arbitrage opportunities are created and enhanced when Congress
establishes differential rates of taxation for certain types of income.
Some of these differentials work off of the requirement that income be
realized before it is taxed; some reflect inaccurate accounting for
inflation; others work off of such differentials as capital gains
versus ordinary income, debt versus equity, corporate versus
noncorporate forms of organization, and taxable versus tax-exempt
organizations.
Many partnerships, including private equity firms and hedge funds,
figure out ways to write off expenses immediately and in full, while
declaring only a portion of currently accrued income or paying a lower
rate on realized income. Others sell short or borrow from those in low
or zero tax brackets, who, in turn, declare all nominal gains or
interest receipts, including fictional income due to inflation, as
taxable. Meanwhile, the interest deductions and short sale losses are
fully written off by the higher bracket firm members or their clients.
Their receipts and other positive declarations of income might be
treated as capital gains or avoid taxation because they are not
realized.
One reason for the interest carried into this hearing--pun
intended--is that tax arbitrage pervades the economy. One doesn't even
have to think about it to perform it. Think how common it is for
individuals to put money into 401(k) accounts, then later borrow a
little more on the house when the cash needed for a vacation is now
tied up in the 401(k) account. Similarly, while many hedge fund
managers and private equity firm partners might look mainly for
financial arbitrage opportunities, at the same time their tax lawyers
help them find ways to avoid tax, restructure deals and the character
of their transactions, convert labor to capital gains income, and
transfer money into and out of different instruments and tax
jurisdictions.
You can quickly see how complex these issues can become. Not
surprisingly, the issue of ``what to do'' correspondingly becomes
complicated very quickly. If A is taxed favorably relative to B, who,
in turn, is taxed favorably relative to C, then how can you create
parity if you only make one change at a time? If you change the law to
tax B like A, then C is further disadvantaged. If you instead change
the law to tax B like C, then A is further advantaged.
The equity issues are somewhat obvious. If my income is from widget
making, which is favorably taxed, and yours from carpentry, which
isn't, then the tax laws discriminate against you as a carpenter.
But the efficiency issues are extraordinarily important as well. I
want to be absolutely clear. The tax arbitrage opportunities the tax
system creates reduce national income and product, encourage too much
production of some items and too little of others, shunt many talented
individuals into less productive and sometimes nonproductive
activities, and add substantially to the debt and other financial
instruments in the economy. But when money gets invested for tax rather
than economic reasons, the economy gets too much widget making and too
little carpentry. Elsewhere, I have attempted to show how tax arbitrage
drives the stagnation than accompanies higher rates of inflation.
As a result, most tax theorists, whether liberal or conservative,
Republican or Democrat or Independent, believe that reducing and
removing differentials helps promote a more vibrant and healthy
economy, no matter what level of progressivity or revenues Congress
sets. Taxing income equally regardless of source or use was one of the
major principles accompanying the Tax Reform Act of 1986.
Capital Gains
Taxing income the same regardless of source, however, is easier
said than done. In particular, take the case of capital gains, which is
partly at the heart of the debate over carried interest. In a study
that Professor Daniel Halperin of Harvard and I conducted years ago, we
concluded that aggregate capital gains over time could almost all be
attributed either to inflation or the retained earnings of
corporations. I suspect that recently the bubble market in real estate
and stock valuations might lead to additional gains over and above
inflation and retained earnings, though these gains could be temporary
(and modest when considered over several decades).
In effect, then, much capital income can end up doubly taxed if
there are not adjustments for inflation and income already taxed once
at the corporate level. The first can be dealt with either by keeping
inflation rates low, indexing the tax system for inflation, which is
somewhat complex, or, as we do under current law, taxing net capital
gains on a realization, rather than accrual, basis. The latter can be
dealt with through corporate integration and also taxing on a
realization basis. At one time, the corporate integration debate
centered mainly on dividends, but researchers have increasingly
realized that capital gains can also be double taxed.
In the U.S. tax system, corporate integration has been rejected in
favor of simple relief for capital gains and dividends. The consequence
is that some capital income is taxed at very low rates--it faces no
corporate tax and an individual tax at a favored rate. Through adequate
leveraging, some capital income, at least at the margin, is taxed at a
negative rate. On the other hand, other capital income can be doubly or
triply taxed if realized as accrued and subject to corporate,
individual, and estate taxes--not to mention some of the myriad taxes
like franchise taxes and property taxes on equipment that states
sometimes employ.
Besides inflation and the corporate tax, there is a third
justification for capital gains relief. The U.S. tax system is mainly
based upon the realization, not the accrual, of income. For many
investors, then, realizing capital gains is discretionary, and the
capital gains tax is a discretionary tax. Hence, whenever the tax on
capital gains is lowered, people recognize more of their capital gains
as income. This limits the revenue loss from capital gains relief,
especially when tax rates are higher. Even if there were substantial
revenues from higher capital-gains tax rates, people can get locked
into holding onto their assets for tax rather than economic reasons.
Hence, efficiency, too, argues for limiting the extent of ``lock in.''
Carried Intrest
So what does all this mean when applied narrowly to so-called
carried interest and, more broadly, tax reform in general? Nowhere, as
best I can tell, do those employing their brain power to make money
through carried interests meet the classic justifications for capital
gains relief--the avoidance of double taxation because the corporate
income has already been taxed or because of inflation, or the
prevention of too much lock in.
A very strong case can also be made that carried interest income is
more like labor income than capital income, although this distinction
is arbitrary for the business owner. In any case, partners can put
their own saving aside to achieve capital gains relief on that actual
saving. And there are a variety of ways of charging customers for
handling their money; I have great faith in the legal community's
ability to find ways to allocate real saving by a partnership into tax-
preferred form. Moreover, entrepreneurial labor in these types of firms
is already favorably treated--in this case, because we do not tax the
accrual of partnership interests until they are realized.
Admittedly, it is often difficult to separate capital from labor
income, which is one reason for the simplified treatment of
partnerships. Don't forget, however, the other side of this coin: some
entrepreneurial partners and sole proprietors in small businesses pay
labor tax in the form of Social Security and Medicare tax on their
capital income. Thus, we don't allow self-employed cleaning people or
home-based computer wizards or restaurant owners to reduce their Social
Security tax on the basis of an imputed return to their cleaning
equipment, computers, or restaurant buildings. They stand in contrast
to those who may pay capital gains tax and no Social Security and
Medicare tax on some or most of their labor income.
Some arguments against reform in this area need to be rejected. One
is that capital taxes need to be kept moderate. There are better ways
of keeping capital taxation at reasonable levels. One is corporate
integration through forgiveness of capital gains and dividend taxation
for income already taxed at the corporate level. Another is a lower
corporate tax rate. Congress could also lower taxes for those who
provide the real saving--the people who put money in bank accounts and
don't borrow elsewhere.
Another misleading argument is that we should subsidize
entrepreneurial labor. Again, yes, we should keep tax rates at a
moderate level, but the tax system is never very good at defining who
provides entrepreneurial labor and who does not. My guess is that, as
in most business, some firms are very entrepreneurial at reallocating
capital efficiently and some are very entrepreneurial at selling bad
products to mislead investors or consumers. Why lower tax on this type
of business but tax other entrepreneurial small and large business much
more heavily? Moreover, to the extent there are temporarily forgone
labor earnings or accrued property interests due to entrepreneurial
efforts, these already receive favorable tax treatment, as they are
expensed. That is, if I put $100,000 worth of my labor into a firm, and
that $100,000 generates expertise and good will that is exchanged for a
property interest that will provide cash returns later, then I really
have earned $100,000 currently. But the Tax Code nonetheless allows me
to write it off as an ``investment'' and expense the forgone earnings
until I later begin to realize the actual cash returns. This labor
income, then, is already preferred to earnings subject to tax
immediately.
Finally, some suggest that the Tax Code should subsidize risk. This
is not a tax policy argument. Some risk is good, some is bad; risk is
certainly not good in and of itself. If risk is to be favored, in any
case, one wouldn't go into one select area with a lot of risk takers
and throw money off the roof to them.
Taxpayers Low and High Tax Rates on Their Capital Income
I don't want to skip over the disparities in tax rates faced by
many different types of taxpayers. Some taxpayers do pay fairly high
tax rates when they earn additional income:
A taxpayer in the 25 percent tax bracket whose entire
savings are in a bank paying 4 percent interest in a world of 3 percent
inflation effectively pays a tax rate of 100 percent on his 1 percent
real return.
Asset tests and rules in many social welfare programs mean
that a person saving a few extra dollars can lose thousands of dollars
in benefits. Once again, this can translate sometimes to confiscatory
tax rates on additional capital income. The additional tax on the
saving, measured as a percentage of the return to the saving, is often
several hundred percent.
A student who cuts grass or babysits and saves the money
in a bank account for college may pay not only tax on the initial
earnings, but, more importantly, find that the loss of Pell grant
assistance will be a substantial multiple of any interest earning on
the saving. Thought of as a tax on capital income, it would be several
hundred percent; thought of as a tax on entrepreneurial labor, the rate
could be 67 percent or more.
On the flip side, many other individuals, not just those in firms
with carried interest or handling private equity or venture capital,
face fairly low tax rates, thanks mainly to tax arbitrage and the
failure to recognize income.
Many people remember Leona Helmsley's famous quip that
``Only the little people pay taxes.'' But what many failed to realize
is that many owners of real estate, such as Ms. Helmsley, effectively
achieved their low tax rate through the tax arbitrage made possible by
highly leveraged investment. One of the more revelatory moments in the
1984-86 reform process came when a group lobbied against tax reform on
the basis that it wanted the progressivity made possible by high tax
rates. It turned out that the group represented the tax shelter
industry, which liked the high tax rates that applied to their
deductions, such as for interest expense.
The very rich generally pay individual tax rates that are
effectively 10 percent or less on their accrued income, since they only
occasionally realize this income for tax purposes. Even if capital
gains were given no preference, their effective tax rates would remain
very low. However, some pay significant corporate tax on their income,
depending upon how highly leveraged they are at the individual and
corporate levels.
Another way that some higher-income persons pay lower
rates (and an issue for carried interests and private equity) is
through avoidance of that portion of the Social Security tax associated
with Medicare--the Hospital Insurance tax. As noted, many sole
proprietors and partnerships pay this tax on all their returns from
these businesses, even returns that might be thought of as returns to
capital. Meanwhile, those who get such income counted as capital or
capital gain income avoid this tax altogether for that income.
Broader Reform Issues
Given all the differentials in the tax system, it is easy for
almost anyone to argue that someone is making out even better. The
complication is that serious analysis requires recognizing that
lowering one person's relative tax burden by definition means raising
another's. Taxes are a price of government, and their aggregate level
is set largely by the level of expenditures of government, not by
current collections.
The basic principles of taxation lead to many of the same
conclusions today as when we were constructing major tax reform two
decades ago:
Whenever possible, tax differentials should be reduced.
This is not an issue of progressivity or revenues but of efficiency and
equal justice under the law for those in equal circumstances.
Removal of differentials should not mean the creation of
new differentials through double taxes. Efforts still need to be
expended on removing double taxation of capital gains and dividends and
avoidance of a high inflation tax or subsidy for debt.
If the tax on capital income is to be lowered, relief
should be concentrated broadly, as through corporate integration or a
lower corporate tax rate.
Labor income should be taxed similarly regardless of
source.
The Tax Code should not favor debt over equity. Currently,
this provides some of the juice can generate profits for private equity
firms without any necessary gain to the economy from the transactions--
regardless of what tax rate the partners pay.
Given the very high tax rates many low- and moderate-
income taxpayers face, we probably ought to pay more attention to the
taxation of their assets and returns from capital. The reasons for the
opposite, upside-down focus on providing relief mainly for the richest
and most successful members of society seems driven more by lobbying
dollars than economic considerations.
Finally, let me offer one additional suggestion for which there is
also an analogy with tax reform days. In the mid-1980s, the Treasury
engaged the IRS in studies of the various ways income was being
sheltered from tax. Congress found these data useful in considering
what changes it would undertake. As I have noted, tax professionals
exhibit an enormous ability to take advantage of differentials in
taxation. I suggest that Congress ask the Treasury and IRS to engage in
a much more serious and continual effort--combining policy, statistics,
and enforcement personnel--to expose who, at various income levels, pay
multiple taxes and who pay little or no tax at all.
Mr. LEVIN OF MICHIGAN. Professor Jones.
STATEMENT OF DARRYLL K. JONES, PROFESSOR OF LAW, STETSON
UNIVERSITY COLLEGE OF LAW
Mr. JONES. Thank you.
So, there's going to be a lot of paperwork and documents in
the record after this hearing is over with, and those papers
are filled with theories, opinions and even dire predictions.
But I'd like to point out one thing that we know absolutely for
sure.
We know that somewhere in America is a family, perhaps with
a son or daughter fighting in Iraq or Afghanistan, making
$70,000 a year and paying tax at a marginal rate of 25 percent.
We also know for sure that there is a fund manager somewhere,
who according to some press reports, made about $684 Million in
1 year and paying taxes at 15 percent.
A recent paper published by Professor Michael Knoll of the
University of Pennsylvania suggested or concluded that if we
taxed secured interest the same way that we taxed a regular
worker, an average American worker, we would obtain between Two
and Three Billion Dollars a year. In preparing for my
testimony, I tried to come up with the starkest example of what
that really means in human terms, and I found in Internet that
it costs about $7,500 to fully equip a soldier or marine with
full body armor to protect him or her against hot shrapnel
going into her Adam's apple or into his groin, it costs about
$7,500.
That means that it costs a little bit less than $1 Billion
per year. So, that's what it would mean if we taxed fund
managers the same way we tax other service providers. I might
add that it's never been the case, as Prof. Levin has pointed
out, that sweat equity disqualifies an investor of previously
taxed capital from the capital gains rate. But neither has it
been the case that sweat equity alone grants you access to the
preferential tax rates that are contained in the capital gains
taxation system.
You know, when I was preparing for my testimony, I really
got indignant about some of the arguments that are being made,
particularly by people in the fund management industry, because
I thought that they were extremely, intellectually dishonest. I
was prepared, really, to come in and pound the podium and call
them a bunch of liars and so forth. But I'm heartened by some
of the testimony I've heard today, particularly from Mr.
Shapiro. On your next panel, Mr. Hendry and Mr. Stanfield, who
will admit that even after their 20 years of experience they
know that what their doing is earning money the same way you
and I are earning money, and that is through their human
capital.
Closing the carried interest loophole is not an attack.
It's not a Trojan horse attack on the capital gains rate. This
is what Republican Senator Grassley says about the carried
interest tax scheme. He says that this isn't the carried
interest tax scheme is an attack on the integrity of the
capital gains tax rates.
If we allow the carried interest tax scheme to continue,
we're allowing the opponents of capital gains taxation a
legitimate opportunity to attack the integrity of the tax.
That's what Republican Senator Grassley said. So, if there is a
Trojan horse attack on the carried interest, the people inside
that horse are a bunch of very dangerous fund managers, not a
bunch of Democrats or even Republicans who are trying to attack
the capital gains rate.
A couple years ago President Bush appointed a Presidential
commission to talk about tax reform. That Presidential
commission stated that every time that we grant a special
privilege for one group of taxpayers, it costs everybody else a
lot of money. That's what's going on right now. The Tax Code is
about two things: efficiency and fairness. It doesn't take a
PhD in Economics to see how unfair it is that an average
working family pays taxes at 25 percent and somebody who's
making a lot more money in much nicer digs is paying taxes of
15 percent.
Since this issue has come to the attention of the American
people, there's been a lot of theory and attempts at trying to
justify this inequity [continuing]. I think that Congress will
soon enough see through the smoking mirrors and come to the
right conclusion and tax the carried interest as ordinary
income just like every other worker.
Thank you very much.
[The prepared statement of Mr. Jones follows:]
Prepared Statement of Darryll K. Jones, Professor of Law,
Stetson University College of Law, Gulfport, Florida
Chairman Rangel, Ranking Member McCrery and Members of the
Committee:
Thank you for this opportunity to talk to the committee regarding
an important issue of tax policy and fundamental fairness. By now, most
people are acutely aware of the problem with which this Committee is
rightly concerned. Most of the debate regarding the taxation of carried
interests has been articulated in rather dry academic terms without
focusing on the real human impact. Before I, too, launch into a
philosophical discussion, I want to describe the obscene problem in
terms understandable to real American families. A modest American
family making $70,000 per year, and having one son fighting in Iraq
with other average American men and women, pays taxes at a 25 percent
marginal rate.\1\ Those taxes help fight the wars we decided are
necessary to fight.
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\1\ Compare, Nancy Duff Campbell, Close Loophole Designed To
Benefit Hedge Fund Managers, The Miami Herald, August 21, 2007,
available at http://www.miamiherald.com/851/story/209866.html. (noting
that something is ``deeply wrong'' when a single mother earning just
over $40,000 per year is in a higher tax bracket than millionaire
bosses at hedge funds).
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On the other hand, a fund manager making more than $3 or $4 million
per year, with means plenty sufficient to keep his son or daughter out
of Iraq or Afghanistan pays taxes at a maximum rate of 15 percent. The
only study to date regarding the revenue loss occasioned by fund
manager manipulations states that if fund managers were taxed just like
average American families--not a tax hike--the government would raise
between $2 and $3 billion dollars annually.\2\ To understand what that
really means, consider that it cost about $7,500 (the price of a small,
late model used car) to equip each soldier, sailor, and marine fighting
in Iraq or Afghanistan with full body armor--armor that protects not
only the chest and back, the base of the neck, the buttocks and the
groin. That is less than $1 billion dollars to adequately equip our
fighting forces against flying shrapnel. With the money obtained if
fund managers simply paid their fair share we could save many of those
fighting for the very system fund managers so gleefully exploit.
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\2\ Michael S. Knoll, The Taxation of Private Equity Carried
Interests: Estimating the Revenue Effects of Taxing Profit Interests as
Ordinary Income, University of Pennsylvania Law School Research Paper
No. 07-32, available at http://www.law.upenn.edu/academics/institutes/
tax/index.html.
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There are three primary reasons why we tax some income (i.e.,
``ordinary income'') at comparatively higher rates than capital income.
My testimony in this regard is neither new nor groundbreaking. Indeed,
every person who has ever really thought about capital gains taxation
knows of these reasons, though many people disagree that they justify a
lower tax rate on some income than others.\3\ Assuming the reasons are
valid, they would nevertheless not in any way justify the application
of capital gains rates to service compensation earned by fund managers.
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\3\ Some have proposed, for example, that rather than engender the
complexity and avoidance provoked by capital gains taxation, we should
simply ``index'' basis so that it is adjusted by the rate of annual
inflation.
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The first reason pertains to the economic definition of income and
the reasonable belief that only real economic gains should be taxed.
Suppose a taxpayer earns $100 (net after tax) during a time when one
year inflation is 6 percent. The $100 is previously taxed income and,
of course, should not be taxed again. If the taxpayer buys property for
$100, and after one year sells the property for $106, she will reap and
pay tax on $6.00 nominal gain. This, despite the fact that she is no
richer than when she invested the $100 in the property one year ago.
She has a nominal gain under IRC 1001 but no economic gain. Because of
inflation, her $106 one year later gives her no more purchasing power
than she had one year earlier. Thus, taxing the $6.00 nominal gain
amounts to an additional tax on the same accession to wealth. The
upshot of this economic result is that the taxpayer who earns $100 is
better off immediately consuming it, instead of saving it long term
presumably in a manner that generates greater societal benefit. That
is, the tax on capital encourages immediate over-consumption.
The second reason for the capital gains preference relates to the
taxpayer who wishes to reinvest her previously taxed income in a better
place but declines to do so because she knows she will be taxed on the
transition from one investment to another. If, for example, the
taxpayer who earned and invested $100 during a period of 6 percent
inflation decides she no longer wants to invest in eight track tape
players because MP3's represent better technology, she would have to
sell her investment in eight track tape players, pay a tax (largely on
inflationary gain) and then reinvest the net amount. The tax imposed on
the sale of the eight track investment might very well discourage her
from withdrawing from a burned out investment and using the previously
taxed income to invest in a more profitable and socially beneficial
investment. That is, she might continue her original investment in the
manufacture of eight track tape players when MP3 are better solely
because of the tax cost occurred by shifting to a better investment.
This latter point is referred to as the ``lock-in'' effect.
Implicit in both of these first two examples is that there has been
a beneficial ``savings''--referred to economically as ``investment''--
of previously taxed income. A later tax, again largely on inflationary
gain, amounts to a second tax on the same income and some people find
this inherently unfair for good reason.
Neither of the first two justifications for capital gains taxation
applies to the tax that ought to be imposed on the carried interest. In
the typical case, fund managers have not ever been taxed on income
subsequently invested in long term assets, such that we should be
concerned about the deleterious effect of taxation on nominal as
opposed to real economic gain.\4\ Fund managers invest untaxed human
capital--what Ms. Mitchell referred to in her testimony before the
Senate Finance Committee as ``sweat equity'' \5\--not previously taxed
financial capital. The tax on human capital is a single tax, since we
do not tax people on their potential to earn. If we taxed people on
mere earning potential, and then again upon the financial realization
of that potential, we should rightly be concerned about the double
taxation. We do not tax earning potential so there is no double
taxation, nor is there a prior taxing event that would encourage people
to ``lock up'' their earning potential to avoid a second tax. We don't
have to worry that people will not get a job, particularly when the
market compensates them so handsomely for doing so. Clearly, then, none
of the long accepted policy reasons justifies the application of
capital gain tax rates to fund manager compensation.
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\4\ To the extent fund managers make capital contributions from
previously taxed or specifically exempted income, they should be
granted capital gain treatment on their long term yields because in
that instance the double tax or lock-in effect applies. HR 2834 would
provide such treatment. Senators Baucus and Grassley have introduced a
bill to tax publicly traded fund management partnerships as
corporations. Members should not confuse the discussion of the proper
taxation of carried interests with the question of the taxation of a
publicly traded management company, though some of the same people
would be affected by both initiatives. Whether or not the publicly
traded management company is taxed as a corporation, individual fund
managers will continue to be compensated by means of carried interests
in other partnerships that hold the investments that the publicly
traded company manages.
\5\ See http://www.senate.gov/finance/hearings/testimony/2007test/
071107testkm.pdf.
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A third common, but less agreed upon reason for taxing the income
from capital at lower rates is referred to as the ``bunching effect.''
The bunching problem refers to the fact that a taxpayer who holds an
investment long term will pay a higher tax than if she bought and sold
the same asset over and again on a short term basis. A simple example
helps demonstrate the problem. Assume, for example, that a taxpayer
pays $100 for property and the property's value increases by 10 percent
annually. If the 10 percent increase were taxed annually, the taxpayer
would pay a total of $6.00 in tax assuming a flat rate of 10 percent on
annual income of less than $10 and 25 percent on annual income over
$50. Table 1 shows the outcome:
Table 1: The Bunching Problem
Annual Tax
Year Appreciation Value on
increase
1 10 100...... 0
2 11 110...... 1
3 12.1 121...... 1.1
4 13.3 133...... 1.2
5 14.6 146...... 1.3
6 16.0 160...... 1.4
Total tax on $60 appreciation at 10 percent per year $6
If the taxpayer held the asset long term and sold it for $160 six
years later, her $60 gain would be ``bunched'' and her tax would be
$15.00, an increase of $9.00 merely because the taxpayer held the asset
longer and realized all of her gain in one year. Lowering the tax on
$60 long term gain to 15 percent alleviates some, but not all of the
bunching problem. The tax in that case would be only $9.00.
The bunching problem, too, is entirely inapplicable to the taxation
of carried interests, primarily because bunching refers to the creeping
appreciation in property value and fund managers are simply investing
labor--just like most other average Americans who receive no tax break
for an alleged bunching problem. In any event, if bunching were a solid
justification for taxing fund managers at lower rates, it would
necessarily require lower rates for all service providers whose income
is taxed at more than the lowest marginal rates.
The remainder of my written testimony debunks two commonly raised
justifications--more like campaign slogans--used by fund managers in an
effort to retain their special tax break. The first asserts that
capital gains taxation is justified by the alleged risks and social
rewards that fund managers assume and generate, respectively. The
second attempts to justify capital gains taxation of fund managers
because of the labor that precedes the investment of capital. Neither
of these justifications withstands the light of close scrutiny.
The notion that normal or even enhanced risk-taking justifies the
application of capital gains tax rates to fund managers is both novel
and bizarre. The notion proves too much.\6\ Every entrepreneur is a
risk taker but only entrepreneurial investors of previously taxed
income are taxed at lower rates, for the reasons discussed above not
because they are risk takers. Every economic activity presupposes risk
so the fact that fund managers undertake risk is insufficient to
justify capital gains taxation. If Tiger Woods, for example, does not
win (or place within the top performers), he receives no compensation
for his efforts. When he wins, he is taxed at ordinary rates. When
Tiger Woods' competitor wins--in an industry with much greater risk
than venture capitalism, given the presence of Tiger Woods--the
competitor's demand for taxation at capital gains rates would not be
justified by the fact that Tiger Wood's presence made the investment of
human capital by all other competitors extraordinarily risky in an
economic sense. The market itself compensates for the decision to
undertake the extraordinary risk--via extraordinary compensation--and
so there is no reason to grant a tax subsidy. The more important point
is that risk taking has nothing to do with capital gains taxation.
Every investment--whether of human or financial capital--involves risk.
A theory that capital gains taxation is appropriate for risk taking
proves too much and is nothing more than a selective plea for lower tax
rates for certain activities.
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\6\ The fact that fund managers voluntarily structure risk into
their compensation scheme has no relevance to capital gains tax rates.
``So are the incomes of movie actors, the royalties of authors and the
prize winnings of golfers--none of which is treated as capital gains''
[nor should they be]. Alan S. Blinder, The Untaxed Kings of Private
Equity, New York Times, Section 3, page 4 (July 29, 2007).
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The latter assertion is refutable only to the extent capital gains
taxation is conceptualized as a subsidy (rather than as a remedy) and
then only to the extent a subsidy is necessary to spur ``irrational''
but nevertheless socially necessary economic behavior.\7\ Two examples
demonstrate the inappropriateness of a subsidy rationale as a
justification for taxing fund management compensation at capital gains
rates. The first pertains to the research and development tax credit.
The financial cost (i.e., the risk) of research and development is so
high that rational people ought to spend their labor and money
elsewhere.\8\ The research and develop tax credit effectively lowers
the tax rate--and thus the risk--on labor and income directed towards a
certain needed and socially beneficial activity that would otherwise
not occur in the market. Providing a lower tax rate via a credit
encourages highly risky but nevertheless socially necessary labor and
capital not sufficiently provided by market incentives. A closer
example involves serving in combat. The tax rate on combat pay (zero
percent) is lower than the tax rate on other services.\9\ Going to
combat is a risky, irrational behavior with such little hope of
financial reward that we should expect it never to occur without
something to offset the risk. I am here speaking only in the economic
terms the proponents of capital gain taxation have used in the debate;
I am not referring to the higher callings that motivate my younger
brothers, my niece and others like them to engage in combat.
Nevertheless, in an economic sense, there is insufficient hope of
market reward to motivate combat services. It is only when we can make
that conclusion--that the market insufficiently provides needed
services--that non-ordinary taxation on services such as that performed
by fund managers is justifiable. We cannot make that assertion to
service as a fund manager because the hope of financial reward is so
high that the socially beneficial behavior will inevitably occur in
sufficient quantities.
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\7\ There are various assertions that capital gains taxation
subsidies greater wealth for the wealthy. I take no position on these
assertions but instead accept the notion that capital gains taxation
remedies the double tax and lock-in effect.
\8\ IRC 41 (1986). ``The intent of the R&D tax credit was to
encourage R&D investment by the private sector. Congress believed that
the private sector was not investing enough in research and
development. Legislative history indicates that Congress believed that
the private sector's lack of investment in research and development was
a major factor in the ``declining economic growth, lower productivity,
and diminished competitiveness of U.S. products in the world market.''
Belinda L. Heath, The Importance of Research and Development Tax
Incentives in the World Market, 11 MSU-DCL J. Int'l L. 351, 352-53
(2002).
\9\ RC 112 (1986).
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Moreover, removing market risk that fund managers take--if indeed,
they really are at risk--by granting tax preferences would distort the
market by causing more people to seek jobs as fund managers rather than
performing services in other areas in need of human capital. Softening
that potential risk punishment via a tax break encourages irrational
risk-taking and ought to be tolerated only when there is a demonstrable
societal benefit not otherwise provided via the market. As fund manager
compensation figures show, the market more than adequately spurs the
risk-taking that fund managers indulge when they put their service
compensation at the demonstrably benevolent mercy of investment funds.
Any losses incurred by fund managers serve only to discipline the
market by discouraging too much risky behavior that would harm the
economy.
Ms. Mitchell's testimony during Carried Interest I can be
characterized as sentimental sophistry at best. It reminded me of
Reagan's ``morning in America,'' Bush, Sr.'s ``a thousand points of
light,'' and just to be bipartisan about it, Clinton's ``don't stop
thinking about tomorrow.'' She described such wild successes as Google,
YouTube, FedEx, and Ebay as evidence of the legitimacy of capital gains
taxation for services. In each of those examples, though, there was
sufficient hope of astronomical market reward such that any non-
confiscatory level of taxation would be appropriate. Unlike research on
new drugs, or service in combat, the real risks were far outweighed by
the potential reward. There was at least enough hope that the true
investors of previously taxed capital could easily attract the sweat
equity--previously untaxed, by the way--necessary to put other peoples'
previously taxed capital to work. Some of the witnesses during Carried
Interest II conceded this point but responded by arguing that in the
absence of U.S. capital gain treatment, investors of previously taxed
capital would invest their money in offshore funds where fund manager
compensation is cheaper. The easy answer to that is, ``all well and
good.'' If investors can find the same labor at cheaper prices,
domestically or overseas, it is not the Tax Code that is diverting
capital to foreign markets. It is instead the overpriced demands made
by domestic fund managers. Chyrsler, Ford, and GM have to compete with
cheaper sources of labor, why shouldn't fund managers have to do the
same, and in doing so, they save more of their pension fund or
charitable foundation for their intended purposes. The argument, then,
that capital gains taxation is necessary to maintain domestic capital
domestically is both anti-competitive and protectionist. At bottom, the
capital gain preference is plea subsidize the investment management
industry. A tax subsidy, though--either via exemption or merely lower
tax rates--is unnecessary when the rational hope of getting rich is
sufficient to spur the services upon the industry is dependent. The
rational, realistic ``hope,'' not the guarantee, of market rewards,
spurs needed economic service and renders tax preferences superfluous.
If the risk of reward outweighs the risk of loss, such that the
activity will occur in optimal quantities anyway, a tax subsidy is an
extremely unwise use of tax dollars. Indeed, providing a tax subsidy
when the market provides the sufficient hope of reward so that the
behavior would have occurred in sufficient quantities is against
societal interest. They generate an oversupply of the thing subsidized.
Moreover, tax subsidies are not limitless. The tax subsidy--the
unnecessary tax subsidy--spent to encourage labor already in sufficient
supply could have been better spent for more research and development
or higher combat pay.
Finally, and with due respect, Mr. Solomon's example during Carried
Interest I regarding a business built with the combination of labor and
capital proves the opposite of what he intended because it omits
necessarily implicit facts. The example states:
Entrepreneur and Investor form a partnership to acquire a corner
lot and build a clothing store. Investor has the money to back the
venture and contributes $1,000,000. Entrepreneur has the idea for the
store, knowledge of the fashion and retail business, and managerial
experience. In exchange for a 20 percent profit interest Entrepreneur
contributes his skills and know how [i.e., human capital or services].
Entrepreneur and Investor are fortunate and through their combination
of capital and efforts, the clothing store is successful. At the end of
5 years, the partnership sells the store for $1,600,000, reflecting an
increase in the going concern value and goodwill of the business.
Entrepreneur has $120,000 of capital gain and Investor has $480,000 of
capital gain.\10\
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\10\ http://www.senate.gov/finance/hearings/testimony/2007test/
071107testes.pdf.
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Note that the example asserts that the appreciation is attributable
solely to the increase in going concern value and goodwill. Going
concern value and goodwill could not possibly have been generated
without previous realization and recognition of ordinary income via the
sale of inventory and the performance of services. If the partnership
is sold with inventory or accounts receivable [e.g., for services] on
hand, the first part of the gain will be correctly taxed at ordinary
rates, regardless of whatever value the parties ascribe to going
concern or goodwill.\11\ If instead, the store previously sold all of
its ordinary income assets--haute couture clothing and services, for
example--without having ever distributed a portion of the gains to the
service partner, the service partner would have nevertheless recognized
ordinary income,\12\ before being granted access to the capital gains
rates applicable to the sale of the partnership interest.\13\ This
would, of course, be appropriate because the undistributed, previously
taxed ordinary income would be economically analogous to previously
taxed income invested in long term property.
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\11\ IRC 751 (1986).
\12\ IRC 702(b) (1986).
\13\ Mr. Solomon's example actually only demonstrates a timing
issue--whether the service partner should recognize ordinary income
upon receipt of the partnership profit interest, or as profits are
actually earned. I have stated elsewhere that it is at least tolerable
to defer recognition until profits are actually earned by the
partnership. Darryll K. Jones, Taxing the Carry, 115 Tax Notes 501
(2007). Other commentators have made convincing arguments that
ordinary income should be recognized upon the grant of the profit
interest. See Lee Sheppard, Blackstone Proves Carried Interests Can Be
Valued, 2007 TNT 121-2 (June 20, 2007). In any event, there is no
conversion tolerated in this example.
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In the most fanciful of all desperate attempts to retain an
unjustified tax break, David Weisbach opines that capital gains
taxation of carried interest is justified because of the labor that
goes into the decision where to invest one's previously taxed capital.
Weisbach states that fund managers should continue to enjoy capital
gain treatment for services because:
the labor involved in private equity investments is the
same type of labor
that is intrinsic to any investment activity. Sponsors
[Weisbach avoids the more accurate label, ``managers'' for good reason]
select the investments, arrange the financing, exercise control rights
inherent in ownership of the portfolio companies, and eventually decide
when to dispose of the assets. If the performance of these tasks were
sufficient to deprive sponsors of capital gains treatment, capital
gains treatment would not be available to any investor.\14\
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\14\ Weisbach's paper can be found at http://
www.privateequitycouncil.org/wordpress/wp-content/uploads/carried-
interests-07-24-07-final.pdf. The paper was ``funded'' by the Private
Equity Council and should therefore not be mistaken for disinterested
academic discussion.
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This argument, like that pertaining to risk assumption, proves
entirely too much. It is indeed true that investors of capital aren't
``deprived'' of capital gains preference merely because they labored to
find a good place to invest previously taxed capital. It is just that
the argument is wholly beside the point. Of course the expenditure of
labor is insufficient to deprive the yield from previously taxed wealth
of capital gains tax rates, but so too is the expenditure of labor
insufficient to obtain capital gains taxation. We are talking about the
right to obtain, not retain capital gains taxation.\15\ It is only the
investment of capital that obtains and retains capital gains rates, for
the reasons stated above; all labor preliminary to that investment is
wholly irrelevant and indeed insufficient. That's why the same type of
labor involved in the selection of a job by a plumber or the
determination of which inventory a mom and pop grocery store should buy
wholesale does not make compensation from the job or retail profit from
the sale of inventory taxed at capital gains rates.
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\15\ If an investor places his capital at risk and then personally
rides roughshod over her managers, she is not thereby ``deprived'' of
capital gains rates on the gains derived from the investment of her
profits.
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Mr. LEVIN OF MICHIGAN. Thank you.
Professor Fleischer.
STATEMENT OF VICTOR FLEISCHER, ASSOCIATE PROFESSOR OF LAW,
UNIVERSITY OF ILLINOIS COLLEGE OF LAW
Mr. FLEISCHER. Thank you for inviting me here to present my
views.
The current tax treatment of carried interest is
problematic because it treats labor income as if it were
investment income. By taking a portion of their pay in the form
of partnership profits, fund managers defer income derived from
their labor efforts and convert it from ordinary income into
capital gain.
This quirk in the tax laws is what allows some of the
richest workers in the country to pay tax on their labor income
at a low rate.
I will make three quick points. First is to elaborate on
this idea that carried interest properly understood is labor
income and not investment income. Carried interest is incentive
compensation received in exchange for managing other people's
money.
From a business point of view, carried interest works well.
It aligns the incentives of the fund managers and their
investors. If the fund does well, the managers share in the
treasure. This alignment of interest concept, which works well
for business purposes, does not magically transform that
compensation into capital gain. It is still compensation for
services rendered. Fund managers share in the appreciation in
the fund, but they bear little downside risk. Carried interest
thus diverges from the tax treatment of other compensatory
instruments. Carried interest is treated more favorably than
partnership capital interest, corporate stock or stock options.
Carried interest is the single most tax efficient form of
compensation available without limitation to highly paid
executives.
The second point is that the partnership tax rules were
designed with small business in mind, not billion dollar
investment funds. I will talk a second about how I think we got
to where we are today.
Various changes in the capital markets have taken a modest
subsidy from mom and pop businesses and turned it into a
subsidy for large investment firms. These changes in the
capital markets include massive inflows of capital into the
private equity sector, an increase in the number of tax exempt
investors, adoption of new investment strategies that have
increased demand for these alternative asset managers, and the
aggressive conversion of management fees into carried interest.
Congress should respond to these changes in the investment
world by bringing the law up to date.
My third and final point is that there is widespread
agreement among tax professors and economists that the status
quo is problematic. There is ample room for disagreement about
the scope and mechanics of different reform alternatives, but
most of us view current law as troubling. It offends basic
principles of sound tax policy like seeking a broader tax base
which allows for lower tax rates overall. That is something
that most tax professors and economists agree on, broad-based
lower rates overall.
By taxing asset management activities at a low rate, we
must tax other activities of equal social and economic value at
higher rates. This is neither fair nor efficient.
Among the various reform alternatives, H.R. 2834 makes a
lot of sense. It provides a simple baseline rule that would
treat carried interest as ordinary income; by taxing carried
interest like other forms of compensation, it will improve
economic efficiency and discourage wasteful gamesmanship.
These changes would also reconcile private equity
compensation with our progressive tax rate system and widely
held principles of distributive justice.
Obviously, there are a lot of details that I have written
about elsewhere and are in my testimony. I look forward to
answering your questions. Thank you.
[The prepared statement of Mr. Fleischer follows:]
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Mr. LEVIN OF MICHIGAN. Thank you very much.
Professor Gergen.
STATEMENT OF MARK P. GERGEN, PROFESSOR OF LAW, THE UNIVERSITY
OF TEXAS SCHOOL OF LAW, VISITING PROFESSOR, HARVARD LAW SCHOOL
Mr. GERGEN. Thank you for inviting me. I am going to
abbreviate my remarks because I think there is no serious
policy or fairness argument against a taxing distributive share
that is compensation as compensation.
All the policy and fairness arguments you hear are rhetoric
or special interest pleading.
There is one serious argument against it, and that is what
I want to talk about. That is that the change is going to
increase complexity without raising revenue.
We all want a tax system that is workable. What I want to
tell you is that argument, while it is a serious argument, is
finally not a good reason to reject this change.
First, H.R. 2834 will simplify tax law on one important
dimension. It will clarify the relationship between partnership
tax and the rules in section 83 on the taxation of receipt of
property for services.
In one direction, it is simplification. This now is a
problem for tax lawyers and it is a problem for the Treasury,
which is trying to figure out how these two different rules fit
together.
Second, many of the technical problems that are raised by
H.R. 2834 are easily dealt with in existing Subchapter K. I
talk about this in my prepared statement. I will not repeat it
here. We have rules in section 704 and section 737 that make
sure we tax compensation when a partner liquidates their
interest or when the interest is sold.
Subchapter K is there to make the solution work. Complexity
is increased only on one dimension. There is one new issue that
H.R. 2834 raises, and that is identifying the part of the
distributive share that is compensation. That is a new issue.
The law is going to be more complex on that dimension.
For many partnerships where partners contribute equal
capital and take equal distributions or where they all
contribute equal labor, it is not going to be an issue. The
issue does not arise. It only arises in those partnerships
where some contribute capital and some contribute labor.
In those partnerships, they know the deal they are
negotiating. I contributed capital. You contributed labor. You
are going to get a smaller return, or part of your return is
going to be for labor.
The argument that the bill will not be effective, that it
will not raise revenue, is that there are various things people
in the industry can do to avoid having their income
characterized as a return on labor, to treat it as a return on
capital.
Victor Fleischer has talked about one of them. They will
make an interest free non-recourse loan to create a capital
account.
Another possibility in the venture capital context is they
will say I actually contributed capital in the form of a zero
basis intangible called goodwill. A third is they might try to
say that some of this carried interest is really return on
whatever my capital contribution was in return for bearing
greater risk or taking a deferred return.
I talk about these matters in my paper. Two points we can
take away from it, you will get some income. You will identify
some of this as compensation, not all of it. You are not going
to be over taxing the return to labor. At the end of the day,
whatever you are going to do, you are going to be under taxing
the return to labor because of these various possible evasions.
Finally, these are the sort of issues we deal with on a
daily basis in the income tax. Most of these can be dealt with
in a very general way in the statute and then you turn it over
to the Treasury.
I think this bill is a no brainer. Finally, I would fix
H.R. 2834 by expanding it. You are attracting a lot of
criticism because you are targeting investment services. You
should not limit this to investment services. It should apply
to any partnership where somebody is contributing labor and in
return getting a return from somebody else's capital.
Thank you.
[The prepared statement of Mr. Gergen follows:]
Prepared Statement of Mark P. Gergen, Professor of Law,
The University of Texas School of Law, Austin, Texas
How to Tax Carried Interests
Mark P. Gergen*
There is a fairly simple solution to the problem of the taxation of
carried interests: amend Section 702(b) to treat a partner's
distributive share as ordinary income when the partner receives the
distributive share as compensation for services rendered by the partner
to the partnership.\1\ The capital accounts system, which is the core
of modern Subchapter K, makes it possible to identify compensation.
This change would also solve some other substantive and technical
problems under current law.
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\1\ Section 1402 also should be amended to make this income subject
to the self-employment tax.
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The Carried Interest Problem
Managers of private equity funds typically are compensated for
their services by being paid a base fee of 2 percent of the fund's
assets plus 20 percent of the fund's profits after investors receive a
specified return. The 2 percent is ordinary income to the manager and
an expense to the fund. The 20 percent is taxed as if it was an
investment return. If the profits are in the form of capital gains,
then this part of the manager's compensation is taxed at the capital
gains rate (15 percent) and not at the ordinary rate (35 percent or
more with phase outs). If it is interest income, then the manager
avoids the self-employment tax (the 2.9 percent Medicare or Hospital
Insurance tax has no ceiling). If it is tax exempt income, then the
compensation is tax free. The unfairness of this is evident.\2\ It may
also be inefficient as it may distort contract design and resource
allocation.
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\2\ David Weisbach, The Taxation of Carried Interests in Private
Equity Partnerships, 2007 TNT 122-77 (July 30, 2007), argues to the
contrary that similarly situated taxpayers who profit from managing
their own money are treated as having capital gains. Of course, fund
managers are different because they profit from managing other people's
money. Weisbach elides this important difference by analogizing to the
case where a taxpayer profits from intelligently managing investments
made with borrowed money. It is an inapt analogy. A taxpayer who
invests borrowed money would have to pay interest (putting to the side
investments made on a margin account). Investors in a fund have a
preferred return, they do not have a guaranteed return. There is little
economic difference between a carried interest and an alternative
structure where investors fund a manager's capital account with a
nonrecourse loan. I will come back to this point. But there is an
important tax difference. If adequate interest is not charged on the
loan, or if charged interest is foregone when a manager's share of a
fund's profits is insufficient to pay the interest, then interest will
be imputed as ordinary income under Sec. 7872.
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Current Law
The question of how to tax a partner who receives a profits share
as compensation for services is an old one. It has long been settled
that a partner who receives a capital interest in a partnership as
compensation has ordinary income, generally when the interest no longer
is subject to forfeiture. Regulations proposed in 2005 would settle two
open questions.\3\ One question regards the measure of income. The
choices are between the market value of the interest (what a buyer
would pay for the interest in an arms-length transaction) and the
liquidation value of the interest (what the partner would receive if
the partnership sold all of its assets for their fair market value,
repaid its debts, and then liquidated). The market value of an interest
may be lower than the liquidation value because of such factors as
illiquidity or a minority discount. The other question regards the
treatment of other partners. In particular, if the partnership has
appreciated assets, then do the other partners recognize gain on the
exchange of the interest for services, as they would have recognized
gain had they exchanged the underlying assets for the services? The
proposed regulations provide the service partner is taxed on the
liquidation value (assuming an election is made) and that other
partners do not recognize gain or loss on the underlying assets.
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\3\ See Notice 2005-43, 2005-24 IRB 1221.
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Debates over how to tax a partner who receives a profits interest
for services generally have focused on the possibility of taxing the
service partner on receipt of the interest. Two cases that are staples
of the partnership tax course, Diamond \4\ and Campbell,\5\ hold that a
service partner has income on receipt of a profits interest. In the odd
circumstances of Diamond (and maybe of Campbell), the result made
sense. But there is little support for generalizing the rule. It is not
in Treasury's interest to try to tax profits interests on receipt for
several reasons. The value of an interest often will be speculative,
taxpayers have an informational advantage, and the government always
loses at the margin on valuation as only a substantial undervaluation
is likely to attract challenge and a penalty. Also an interest can be
structured in ways that minimize its value on receipt. The experience
with family limited partnerships is instructive in all of these
regards. Further, typically a partner's right to profits will be
contingent on the partner performing services during the period the
profits are earned. The risk of forfeiture gives a partner the right to
elect whether to be taxed on receipt. This election combined with
valuation problems invites strategic behavior.
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\4\ Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974).
\5\ Campbell v. Commissioner, T.C. Memo 1990-162, reversed 943 F.2d
815 (8th Cir. 1991). The government conceded on appeal that the tax
court erred in holding a service partner had taxable income on receipt
of profits interest. The Court of Appeals side-stepped the issue (while
questioning the tax court's decision on the point) by holding
Campbell's interest was of speculative value.
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Treasury responded to Campbell in 1993 with a ruling that a partner
was not taxed on receipt of a profits interest for services, except in
three limited situations not relevant here.\6\ The 2005 proposed
regulations maintain this position while integrating it with Section
83, which generally governs the taxation of compensatory transfers of
property. Under the proposed regulations, to avoid tax on grant of a
profits interest, the partnership agreement must provide for something
called a ``safe harbor election.'' \7\ On the election the interest is
valued based on its liquidation value at the time of grant, which is
zero in the case of a profits interest. In addition, if the profits
interest is subject to a substantial risk of forfeiture, which
typically is the case, the service partner must make a Section 83(b)
election so that the profits are not taxed as compensation when the
right to them vests.
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\6\ Rev. Proc. 93-27, 1993-2 C.B. 343. The exceptions were (1) an
interest in a substantially certain and predictable stream of income;
(2) the partner sells the interest within two years; and (3) a limited
partnership interest in a publicly traded partnership. Under the
proposed regulations, the safe harbor election is not available in
these situations. Rev. Proc. 2001-43, 2001-2 C.B. 19, clarified that
when a partner was granted a nonvested profits interest he would be
treated as receiving the interest on the date of grant so long as he
was treated as a partner from that date.
\7\ As an alternative to making the election in the partnership
agreement the partners may make the election individually so long as
all do so. A global election is required to prevent partners taking
inconsistent positions.
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This is not a happy resolution of the matter for reasons
independent of the problem of carried interests. It is not clear what
tax consequences follow if people do not make the elections. If general
Section 83 principles apply, then a service partner would have ordinary
income equal to the market value of a right to partnership profits when
her right to those profits is no longer subject to a substantial risk
of forfeiture. The other partners would include the service partner's
share of profits in their income and get a deduction equal to the
amount of the service partner's income when her right to the profits
vests. This may temporarily shift income from the service partner to
the other partners if her right to the profits vests in the year after
they are earned. And, if the right to profits is valued at either a
discount or a premium, this creates offsetting built-in gains and
losses between the service partners and the other partners.\8\ While it
is hoped that taxpayers will make the required elections to avoid these
problems, it is odd to require taxpayers to make two elections to avoid
a trap.
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\8\ Consider an example. Assume A manages assets worth $1 million
and the partnership earns $100,000 in year one. Her share of profits is
$20,000. Assume that her right to these profits is worth only $15,000
(this could well be the case if the profits are undistributed, A does
not have the power to compel a distribution, and the interest is
illiquid). Under general Section 83 principles, A would have $15,000
ordinary income and the other partners would have $85,000 income (their
share of profits, plus A's share, minus an expense equal to A's
income). Comparing the basis of the interest and the capital account, A
would have a $5,000 built-in gain and the other partners a $5,000
built-in loss. If A's right to the profits vested in a year after they
were earned, then the other partners would have $20,000 income on
profits that probably would ultimately go to A and an offsetting
deduction of $15,000 when A's rights to the profits vests.
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The proposed regulations also leave the carried interest problem
uncorrected. Treasury is not to be faulted for it does not have the
statutory tools to solve the problem.\9\ But a solution is available
within the general framework of Subchapter K.
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\9\ Section 707(a)(2)(A) is not a reliable tool. It empowers
Treasury to issue regulations to recharacterize allocations and
distributions to a partner for the performance as services as a
transaction with a nonpartner if they are properly so characterized.
This rule is alongside and was enacted with the rules on disguised
sales in 1984. The concern was that a partnership might avoid
capitalizing an expense by giving a service provider a temporary, low-
risk interest in partnership income. To solve the problem of carried
interests using Section 707(a)(2)(A) Treasury would have to take the
position that a fund manager was not truly a partner. This is untenable
unless one is willing to take the position that to be a partner in a
capital-based partnership a person must contribute and risk capital.
See Mark P. Gergen, Reforming Subchapter K: Compensating Service
Partners, 48 Tax L. Rev. 69, 75-81 (1992).
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The Solution Available in the Capital Accounts System
Congress could take an important step towards solving the problem
of carried interests by amending Section 702(b) to provide that a
partner's distributive share shall be treated as ordinary income when
it is compensation for services rendered by the partner to the
partnership. Section 1402 also should be amended to make this income
subject to the self-employment tax.
This is only a partial solution for it creates subsidiary problems.
The capital accounts system in Subchapter K helps to solve these
problems. Under current law, the capital account measures the value of
assets contributed by a partner to a partnership, plus the partner's
distributive share of income, minus the partner's distributive share of
losses, and minus the value of distributions to the partner. In
addition, when there is a non pro rata contribution or distribution
from a partnership, assets generally are booked up or down to their
fair market value and partners' capital accounts are adjusted
accordingly. The capital account system is a linchpin of the rules on
special allocations, built-in gain or loss, basis adjustments, and
more. It is the conceptual framework of modern Subchapter K.\10\
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\10\ I discuss the evolution of the system in Mark P. Gergen, The
End of the Revolution in Partnership Tax?, 56 S.M.U.L.Rev. 343 (2003).
Later I discovered that the principal creator of Subchapter K proposed
a similar system to deal with precontribution gain and loss and related
problems. See Mark P. Gergen, The Story of Subchapter K: Mark H.
Johnson's Quest, Business Tax Stories 207 (Foundation 2005).
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The capital account makes it possible to identify when a
distributive share is compensation. A simple rule would characterize a
distributive share as compensation if the partner performs services for
the partnership to the extent the distributive share is in excess of
the partner's pro rata share in partnership capital. There are more
fine-grained ways to identify compensation that would enable partners
who contribute both capital and labor to take a preferred return on
capital without having it characterized as compensation.\11\ The
capital account system also supplies a mechanism for handling the sale
or liquidation of an interest by a service partner when the interest
bears unrealized profits that would have been taxed as compensation to
the service partner when realized. The solution is to treat the partner
as having compensation equal to the amount of compensation the partner
would have had if the partnership had sold its assets for their fair
market value immediately prior to the sale or liquidation. The handling
of a sale follows Section 751(a). The handling of a liquidating
distribution follows Section 737. The Section 704(c) regulations
preserve the attribute of booked built-in gain as compensation through
various events in the life-cycle of a partnership.
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\11\ Any such rule should cap the amount of the preferred return
and require that the yield on the service partner's capital account,
including the preference, not be greater than the yield on other
capital.
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Different approaches are possible under the capital accounts system
in the case of an asset revaluation. Assume A performs management
services in a partnership with $1,000,000 assets in return for 20
percent of the profits. The assets grow in value to $1,500,000, which
is unrealized appreciation. At this point $500,000 new capital is
contributed to the partnership. Under current law, the partnership may
elect to book up its assets and give A a capital account of
$100,000.\12\ At some point A should have $100,000 income treated as
compensation. One possibility is to recognize the income at the time of
the revaluation. But this creates a troubling disincentive for non pro
rata contributions and distributions, which generally trigger
revaluations. Managers would become loathe to permit non pro rata
contributions and distributions if it triggered a substantial tax
liability to them. Another possibility is to tag A with that much
built-in gain on the assets, which will be treated as compensation when
A liquidates or sells the interest. It is a mistake to push recognition
past when A receives a liquidating distribution for this would permit A
to take property as compensation without paying tax. This violates
Section 83.
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\12\ Some think this is required. Such adjustments are standard in
partnership agreements, which often are drafted to track tax law rules.
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At a deeper level, the capital accounts system is consistent in
principle with recharacterizing a fund manager's share of capital gains
as compensation. The capital accounts system embraces the aggregate
theory of partnership tax. The carried interest problem exists because
Section 702(b) follows the entity theory--the character of income is
determined at the partnership level. From the perspective of the fund
income is a return to capital. From the perspective of the manager it
is compensation.
Distinguishing ``Sweat Equity'' and the Issue of Scope
Capital gains earned by a fund manager or a venture capitalist have
been likened to the capital gains realized by a sole proprietor or a
partner who builds up a business, such as a veterinary clinic or a
bagel shop, and then sells it. An entrepreneur, such as the vet or the
bagel store owner, will have capital gain on sale of the business on
amounts paid for good will or going concern value. Capital gains earned
by a fund manager or a venture capitalist are quite different from an
entrepreneur's sweat equity. The entrepreneur will earn ordinary income
in creating good will. In addition, the entrepreneur can convert good
will into capital gain only by selling the business and, typically,
structuring the sale to allocate price to good will, which often
diminishes the tax benefits to the purchaser.
The simple solution I propose would change the treatment of good
will in a business where partners made unequal capital contributions.
For example, if A and B went into a partnership to open a bagel shop,
with A contributing capital and B labor, B's gain on the sale of the
shop would be ordinary income. The current treatment of good will can
be preserved by excepting from the definition of compensation capital
gain attributable to good will on sale of a business or liquidation or
sale of a service partner's interest.
This raises the larger question of the appropriate scope of a rule
characterizing as ordinary income a partner's distributive share of
income that the partner earned by performing services for the
partnership. The Levin bill comes at this question from one direction,
characterizing as ordinary income a partner's distributive share only
insofar as the interest is received for the performance of investment
management services. Under the Levin bill, a partner who provides
services in return for an interest in a real estate development project
or in an oil and gas venture might not have his distributive share
recharacterized as ordinary income. I say might because the definition
of investment services could cover some service partners in real estate
and oil and gas partnerships. This points up two problems with the
approach taken in the Levin bill. ``Investment services'' is an
amorphous category that has uncertain application outside the targeted
case of an investment fund manager. Another objection is that it is
difficult to justify treating a fund manager differently than a partner
who receives an interest for contributing managerial or operational
services to a real estate development project or an oil and gas
venture.
The approach I propose comes at the question from the other
direction, characterizing as compensation any part of a distributive
share received by a partner who performs services for a partnership
that is in excess of the partner's pro rata share of partnership
capital. This gives rise to a different type of problem. It makes it
necessary to carve out exceptions for cases where it is thought
inappropriate to characterize a distributive share of capital gains as
compensation. For example, an exception probably should be made for
capital gain attributable to the sale of patent rights and similar
intellectual property. This preserves consistency in tax treatment with
the case of an individual who sells such property created by her
personal efforts.\13\
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\13\ The rule in Sec. 1221(a)(3) excluding from the definition of
capital assets property created by a taxpayer's personal efforts
applies only to ``a copyright, a literary, musical or artistic
composition, a letter or memorandum, or similar property. . . .'' This
has been held not to cover patent rights and trade secrets. The reason
for the different treatment is not clear.
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Is the Game Worth the Candle?
Under the Levin bill (and the approach I propose) fund managers may
use various strategies to avoid having their distributive share of
profits characterized as compensation. These include: 1) Make a capital
contribution with funds provided by the investors through an interest-
free nonrecourse loan secured by the manager's partnership interest. 2)
Take the position that the manager makes a capital contribution in the
form of intangibles. 3) Take the position that the carried interest is
a return on capital contributed by the manager.
The nonrecourse loan strategy should be permitted. Existing law
generally treats a nonrecourse loan as equivalent to a cash investment
though it is well-known that a nonrecourse loan is unlike a cash
investment or a recourse loan because the lender, and not the taxpayer,
bears the risk of loss on the investment securing the loan. Standing
alone this strategy leaves a fund manager with compensation equal to
the imputation rate under Section 7872. There is an argument that this
approximates the theoretically correct amount of compensation.\14\ The
gist of the argument is that returns in excess of (or lower than) the
risk-free return on the share of capital committed to a manager in
return for services are returns to risk-taking and not returns to
labor.
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\14\ See Two and Twenty: Taxing Partnership Profits in Private
Equity Funds, forthcoming NYU L. Rev (2008). The paper is available on
SSRN.
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The other two strategies are more problematic, particularly if they
are combined with the nonrecourse loan strategy. It would be difficult
for the government to challenge an arrangement where cash investors
agreed to credit a fund manager with having contributed intangibles,
such as good will. While the intangibles would have a zero basis their
assigned value would be credited to the manager's capital account.
Under the Levin bill (and the approach I propose) that fraction of the
manager's distributive share would not be characterized as
compensation.\15\
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\15\ Under Sec. 704(c), a manager might be allocated ordinary
income equal to annual depreciation of the good will as this is the
amount book depreciation of the good will would exceed tax
depreciation. However, this would happen only if the partnership
elected a method other than the traditional method or if the
partnership was required to use the remedial allocation method under
the anti-abuse rule. If a partnership was required to use the remedial
allocation method, then the manager would have ordinary income and the
other partners an ordinary deduction, which would reduce the advantage
to the managers of characterizing part of their contribution as
intangible assets.
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Insofar as the law recognizes that returns to capital may be non
pro rata when differential allocations are made to suit partners risk
and time preferences, the possibility exists for managers to
characterize what in truth is a return to labor as a return to capital.
A concrete example is useful. Assume manager (``M'') contributes 5
percent of the capital to a venture and limited partners (``LPs'')
contribute 95 percent. Profits (net of M's guaranteed compensation) are
allocated first to the LPs until they receive an 8 percent return.
Thereafter profits are allocated 20 percent to M and 80 percent to the
LPs. M will take the position that more than one-quarter of its 20
percent share of profits is a return on its investment of 5 percent of
partnership capital because part of the premium is compensating it for
bearing greater risk of return on its 5 percent. How aggressive M can
be in characterizing the 20 as a return to capital depends on the rule
policing such matters. One could imagine a rule of thumb developing
that permits a return to be treated as a return to capital up to a
stipulated multiple of a partner's relative capital account balance,
such as 140 percent.\16\ This rule of thumb would allow M to treat 7 of
its 20 percent as a return to capital. M could increase the amount of
its 20 percent return that is treated as a return to capital by using
the nonrecourse loan and intangible contribution strategies to increase
its capital account. Assuming a 140 percent rule of thumb, for example,
M could treat its entire 20 percent as a return to capital by ginning
up a capital account totalling slightly more than 14.3 of partnership
capital with a combination of real capital, intangibles, and a
nonrecourse loan. M's compensation would be the interest imputed on
that fraction of the capital account funded with the interest-free
nonrecourse loan.
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\16\ I use this number for illustrative purposes.
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This simple illustration suggests that claims that the Levin bill
(or the approach I propose) create complexity without changing results
are overblown. Some fraction of a fund manager's 20 percent share will
be taxed as compensation. The size of the fraction depends on details,
in particular the rule delimiting what will be treated as a return to
capital, and on how people respond to the change. Measures can be taken
to increase this fraction. For example, a capital contribution funded
with an interest-free nonrecourse loan may be allowed to be treated as
bearing a return no greater than the imputation return. And the
government could announce a policy of scrutinizing contributions of
zero-basis intangibles. Such measures add complexity but it should be
manageable.
Side Benefits
The proposed change solves some other problems. It makes it
possible to exclude profits interests from Section 83. The receipt of a
right to profits need not be treated as a receipt of property to be
taxed as compensation when the profits themselves will be taxed as
compensation when they are earned. This eliminates the need under the
proposed regulations to make one or two elections and avoids the
problems that arise in the absence of an election. Remaining is the
question of how to handle the case where retained profits are subject
to a substantial risk of forfeiture. Consistent with Section 83, the
partner could make a Section 83(b) election and be taxed on the
distributive share\17\ or the partner could forego the election and
wait and be taxed on the value of the profits accumulated in her
capital account when the interest vests. If the election is not made,
then the distributive share would be taxed to the other partners, who
would get an off-setting expense when the service partner takes the
profits into income, bringing the other partner's tax position and
capital accounts into line. This leaves some differences between the
taxation of a compensatory grant of a profits interest and the taxation
of a compensatory grant of an option, which can be economic
equivalents. This is a more general problem that results from the
reluctance to treat an option holder as a partner until the option is
exercised. The option arrangement enables the service partner (or any
other option holder) to defer recognition of income on its distributive
share until the option is exercised.
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\17\ In the event the interest is forfeited, it is necessary to use
either a deemed guaranteed payment or a side-agreement requiring the
partner to forfeit his partnership interests to the other partners.
From the perspective of the service partner, the deemed guaranteed
payment is preferable because it provides an ordinary deduction to
offset the ordinary income.
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The proposed changes foreclose some other troublesome
possibilities under current law. In the 1980s I heard rumors of a film
deal where an actor took a profits interest. The plan was that the
partnership producing the film would buy property to be used in the
production. When the film was done, the actor received the property in
liquidation of his interest without paying tax. Current law on profits
interests allows people to evade the rules on equity compensation. For
example, if an employee is given a stock appreciation right, then he
will have ordinary income on the amount of any appreciation. Instead
put a block of the same stock in a partnership and give the employee a
profits interest in its appreciation. After the stock appreciates,
distribute to the employee stock equal in value to her share of the
appreciation. The employee will be taxed on only part of the gain under
Section 731(c) and it will be capital gain. Under the rules I propose
the actor and the employee would have taxable compensation on the
distribution.
Some of the problems addressed by Section 707(a)(2)(A) would not be
solved. Section 707(a)(2)(A) is primarily directed as cases such as
where an established partnership that develops and holds real estate
gives an architect a short term interest in its rental income in return
for services designing a new building. This allows the partnership to
get a result equivalent to a short-term write off of the architect's
fee and to avoid capitalizing the expense. Changing Section 702(b)
would treat the rent as compensation to the architect. But it would not
require the partnership to treat it as an expense and to include the
architect's share of rents as income to the other partners.\18\
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\18\ A partnership would have the ability to treat the compensation
as an expense by actually paying profits-based compensation or by
making a guaranteed payment. If the profits are to be retained within
the partnership, then the service partner would recontribute the
payments.
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* Fondren Chair for Faculty Excellence, University of Texas School
of Law. This significantly revises and supplements testimony I
presented to Senate Finance Committee in July 2007.
Mr. LEVIN OF MICHIGAN. Thank you very much.
Under the rules that were used for the last panel and Mr.
McCrery has agreed that we will follow them, we will do this.
Those who did not ask questions the last time, the last panel,
will go first. In view of the hour, we will limit our back and
forth to 3 minutes. I think that is only fair. We have another
panel to go.
First, following that rule, will be Mr. Tanner. You are
first.
Mr. TANNER. Thank you, Mr. Chairman. I like this rule.
[Laughter.]
I have just one question. I want to thank all of you for
your participation and for your most provocative comments.
Mr. Orszag, I read your testimony last night before Senate
Finance and then today's, and I am intrigued by the implicit
loan perspective. May I ask if you would elaborate on that for
the panel and how you would treat the non-recourse loan
basically as ordinary income and so on?
Mr. ORSZAG. Sure. I would note that since Professor
Fleischer is on the panel, this idea has been discussed in some
of his work. Let me just describe it briefly.
Mr. TANNER. Yes, whoever.
Mr. ORSZAG. I can do it.
Very quickly, providing a 20 percent carried interest is
equivalent to providing a non-recourse loan from some
perspectives, equivalent to 20 percent of the fund's capital.
So one could at least view the carried interest as equivalent
to that implicit loan, for example, with no hurdle rate, a zero
interest rate, on that implicit loan.
The tax treatment that would follow from that would tax at
the bond rate of return or the Treasury rate of return, the
interest on that implicit loan as ordinary income, and anything
above that as capital income.
That is one of the perspectives that would lead to a kind
of mixed outcome, somewhere between ordinary income and the
current treatment for capital gains generated income.
I would note, however, that implementation could become
quite complicated.
Mr. LEVIN OF MICHIGAN. Mr. Fleischer.
Mr. FLEISCHER. I would just add there is an easier way to
think about this implicit loan concept. Instead of getting all
capital gain on the back end, the fund managers take some
ordinary income up front as the income accrues and then get
capital gains on the back end.
This is a lot like taking cash salary every year. If the
fund managers just took cash salary and then re-invested in
their own funds, we would give them--if they pay tax on the
cash salary, they are going to get capital gains treatment on
the back end, just like any other investment. Nobody has been
talking about trying to do away with the capital gains
preference generally. If you actually make a real investment,
you get capital gains treatment on the back end.
The implicit loan concept is just taking a portion and
taxing it, ordinary income, like an accrual method, and then
giving capital gains on the back end.
I think this reaches a reasonable policy result.
Mr. LEVIN OF MICHIGAN. Go ahead.
Mr. TANNER. Just one follow up. In practicality, you
mentioned maybe the complexity of enforcement and so forth.
Could you give us some idea of what you mean by that
observation?
Mr. ORSZAG. Sure. For example, I mentioned that the
implicit interest rate would be presumably, at the Treasury
bond interest rate. There is a broader set of questions about
whether risk should be taken into account because obviously
that loan, basically that transaction, has different
characteristics than a Treasury bond.
Changing that with regard to this particular example would
then raise lots of questions for the broader set of loan
subsidies and their treatment in the Tax Code. There also are
issues that could potentially arise with regard to loan
forgiveness and other things.
The point is there is not an actual loan being made, so the
construct is useful analytically, but implementing it as an
actual tax procedure could become quite difficult quickly.
Mr. LEVIN OF MICHIGAN. Mr. Camp.
Mr. CAMP. Thank you. Mr. Levin, there is legislation that
would subject holders of carried interest to ordinary income
tax treatment, and if carried interest is taxed at that level,
should there not also be an offsetting deduction to the capital
investors to account for their payment of compensation to the
managers?
If it is income, should there not be a countervailing
business deduction?
Mr. LEVIN. Yes, under any rational system of taxation if
you were to view the fund as paying compensation to the general
partners, then the limited partners should get an equal and
offsetting deduction, but the bill that is pending now does not
call for that.
Mr. CAMP. Does not do that. Therefore, the score, as
everyone around here looks for money, the score on the bill
would be much less because the offsetting deduction was not
taken into account in the scoring of the bill.
Is there any other place in the Tax Code that income is
characterized based on the identity of the recipient as opposed
to the source of the income?
Mr. LEVIN. There is no comparable place in the Internal
Revenue Code where gain from the ultimate sale of a capital
asset held for more than 12 months is transmuted into ordinary
income.
As other witnesses have said, we have a partnership system
of taxation utilizing a flow through approach. Where a
partnership recognizes a long term capital gain on an asset,
that gain flows through to all the equity owners as capital
gain under our existing system. That is designed to encourage
people to invest in entrepreneurial businesses and to help
American business and employment grow.
The same set of rules should apply to a person investing in
stocks and real estate, as I talked about in my testimony, even
if that person devotes serious labor every day, 8 hours a day,
studying what stocks and real estate to buy and sell, so he or
she is taxed as capital gain when the stocks and real estate
are sold, because he or she has purchased a capital asset and
held it more than 12 months. I do not see a reasoned
distinction when you turn instead to an entrepreneur, such as
Bill Gates, who starts a business along with investors, and Mr.
Gates has a higher percentage of the common stock than his
capital would have purchased. His gain at the sale of the
company should be taxed as capital gain.
Then we move to a third example, which is a private equity
fund, and perhaps the private equity general partners put in,
e.g., 10 percent of the capital, but perhaps get 20 or some
higher percentage of the gains. They are the principals. They
are the owners. They make the buy and sell decisions. They act
for themselves, not as agents. Therefore, if we were to take
capital gain treatment away from private equity general
partners because they produce sweat, whether we should take it
away from Mr. Gates when he starts the computer company and
works at it for 10 years before selling at a capital gain or
from Mr. Buffett who buys stocks and real estate and works at
it 8 hours a day for several years.
Until now, our Internal Revenue Code has made the test
whether you are an owner or part owner of a capital asset held
for more than 12 months. The Code has not asked us to get into
subjective issues like is there any sweat involved.
Nor have we had a law that differentiated between
industries, designating the investment advisory industry or the
real estate industry as tainted, so that carried interest from
those, in capital gain generated by those tainted industries is
taxed as ordinary income, but the oil and gas industry or
manufacturing or distribution are not tainted industries.
This approach takes an otherwise over complicated Internal
Revenue Code, badly over complicated, and makes it even more
complicated. While people talk about this bill as if it were
simple and just said capital gain becomes ordinary income if
you have a carried interest in capital gain generates by
certain industries in reality, this bill is ten pages long,
adds another ten pages to the Internal Revenue Code.
Every time we do that with special legislation, singling
out industries, singling out taxpayers, seeking to designate
sweat as a tainting factor, we make the Internal Revenue Code
more complex and less administratable.
Mr. LEVIN OF MICHIGAN. Thank you.
Mr. CAMP. Thank you, Mr. Chairman.
Mr. LEVIN OF MICHIGAN. Mr. Larson.
Mr. LARSON. Thank you, Mr. Chairman. I am working up a big
sweat over here. There is a lot of sweating going on.
I saw Mr. Orszag's consternation as Mr. Levin was answering
this. I would like to ask him if he would like to rebut Mr.
Levin's response.
Mr. ORSZAG. I am not in the business of rebutting, but let
me offer some comments on the sweat equity issue.
I actually think the Joint Committee on Taxation's document
that was prepared for this hearing treats this issue quite well
and in some detail on pages 57 and 58.
CBO's testimony has a box on sweat equity. As the Joint
Committee notes, the better analogy to the sweat equity for Mr.
Gates may be what happens to the management fund itself, the
general manager, that is, when the general manager or the fund
in particular goes public.
I do not think anyone would argue that a capital
appreciation on that fund, which is typically organized as a
partnership, as opposed to the investment fund itself, that
should not be given capital gains treatment under current law.
That is not really what is at question. The question is
what should happen to the flow of income to the general partner
in the intervening period while you are sort of building up
that capital asset, which is then sold when the management fund
goes public.
That is a different question.
Mr. LARSON. Reclaiming my time on the question----
Mr. ORSZAG. Sure, I'm sorry.
Mr. LARSON. One of the common criticisms we have heard
about the Levin bill is that essentially what this is going to
do is drive hedge fund managers offshore, as we heard this
morning in testimony, that is already going on.
If the Levin bill were to become law, would there be a mad
rush for these firms to go offshore, in your opinion?
Mr. ORSZAG. There may be some pressure. Again, I would note
that the general managers themselves, ultimately you have to
tie this back to an individual. U.S. individuals are generally
taxed on their worldwide income regardless of where they
reside, and therefore, it is very difficult to escape U.S.
taxation.
The fact that there is so much activity abroad already
suggests--I will leave it at that. The written testimony
discusses this.
Mr. LARSON. Mr. Levin, just a quick question for you, is
there a policy or public policy reason why hedge funds and
private equity managers should be treated differently than
those in any of the big investment firms, outside of the sweat?
Mr. LEVIN OF MICHIGAN. If you would answer quickly because
the 3 minutes are up and Mr. McCrery has to leave and wanted to
ask a few questions.
Mr. LEVIN. The answer is there is. In this country, we have
two systems of taxation, the corporate system of taxation,
under which employees of a corporation who receive compensation
from that corporation are taxed as ordinary income.
We have a second system which is a partnership or flow
through system under which you look at the nature of the income
recognized by the entity, the partnership.
In those years when the partnership is operating a business
and earning $100 of ordinary income, when that flows out,
either as carried interest or capital interest, to the
partners, it is taxed as ordinary income.
So many people have erroneously stated that carried
interest is taxed as capital gain. It is not. Carried interest
in ordinary income is taxed to them as ordinary income.
When the partnership ultimately sells the business and
recognizes a long term capital gain, gain from an asset held
for more than 12 months, and that capital gain flows out under
our partnership system, which was adopted in order to encourage
people to put labor, capital, know-how and goodwill together
and build businesses, under that system, when the capital gain
ultimately is recognized, it flows out as capital gain, it
retains its character.
There is a thus a profound difference between the corporate
system and the partnership system. If this Committee would like
to reform the Code and adopt one integrated system, not a
corporate system, not a partnership system, but one system,
that would simplify the Code.
I so testified in front of the President's Tax Reform Panel
2 years ago, that it was desirable to go to one integrated tax
system. That is not going to happen now.
Mr. LEVIN OF MICHIGAN. Thank you, sir. Mr. McCrery.
Mr. MCCRERY. Thank you, Mr. Chairman.
One example that you did not use, Mr. Levin, is something
that happens all the time in my hometown of Shreveport. You
have two guys that get together, maybe two brothers. One of
them might be a banker. The other one is a carpenter. They get
together and buy a house. The banker gets the money. He
provides the money, buys the house. His brother gets in there
and rehab's the house, and then 18 months later, they sell it.
Is that a capital gain? Of course, it is.
Mr. LEVIN. What their enterprise realizes is a long term
capital gain----
Mr. MCCRERY. It is a capital gain. Does the brother who got
in there and did the work, does he pay ordinary income on that?
No.
Mr. LEVIN. If this bill applied----
Mr. MCCRERY. No, current law.
Mr. LEVIN. Under current law?
Mr. MCCRERY. He does not pay ordinary income, does he? He
pays----
Mr. LEVIN. Under current law, if the entity recognizes a
capital gain----
Mr. MCCRERY. Because the capital asset was sold. You have
two guys. One with money, one with sweat.
Mr. GERGEN. Mr. McCrery, that house is not a capital asset.
It is like inventory. They are holding it to sell in the
ordinary course of trade and business.
Mr. LEVIN. If this is the only house they bought, it would
not be inventory.
Mr. GERGEN. If you were in the business of subdividing land
and selling it off, that is treated as inventory and it is
ordinary income. If you are in the business of developing
houses and selling them, that is ordinary income, at the entity
level as well as the individual level.
Mr. MCCRERY. You are telling me that if these guys buy a
house and they hold it, they fix it up----
Mr. GERGEN. Not as an investment. They hold it to develop
it, improve it and sell it, that should be an ordinary asset in
their hands if they are complying with the rules distinguishing
capital assets from ordinary assets.
Mr. LEVIN. If I may just disagree and qualify. If they buy
one house and rehab it and sell it, that is clearly capital
gain after 18 months. On the other hand, if they buy 100
houses, it becomes inventory to them because they are in a
regular trade or business of selling rehabed houses.
I believe that the example we were given is two brothers
buy a house. That would be capital gain.
Mr. MCCRERY. That is the example I gave. However, I will
say in fairness, Mr. Gergen brings up an interesting point. I
am still learning this stuff. That is something we should
consider if these guys are in the business.
Another distinguishing factor, I think, with respect to
private equity partnerships, in most arrangements, it is my
understanding that there is a claw back provision in which if
there is not a certain level of gain realized for the
investors, the partners do not get as much return; is that
right?
Mr. LEVIN. That is correct.
Mr. MCCRERY. Is that not far different from just the
examples that some have given of it is sweat equity so it ought
to be ordinary income? That is risk, is it not?
Mr. LEVIN. It is risk.
Mr. MCCRERY. That is the whole point behind preferential
treatment for capital gains, encouraging people with money to
take a risk and invest that money in productive endeavors.
Thank you.
Mr. LEVIN OF MICHIGAN. My guess is we will get back to that
when my turn comes. Thanks, Mr. McCrery. We will go back to our
regular line here. We are asking people who did not have a
chance last time, and then we will go back.
Mr. Kind, you are recognized for 3 minutes. We will try to
stick to that, all of us, and also all of you. This is an
important subject and I know it is hard to do that. Let's try.
Mr. Kind.
Mr. KIND. Thank you, Mr. Chairman. I want to thank the
panelists for your testimony here today. It is important and it
is somewhat complicated.
Let me try this. I am going to ask you each the same
question. I am afraid it is going to require a longer perhaps
complicated question. I think it is important to ask, in light
of the carried interest issue that we are dealing with.
If we were to take the carried interest issue and treat it
as ordinary income, can you think of any significant adverse
economic consequences of us doing that, the impact it would
have?
Do you want to take a shot at that, Mr. Gergen? We will go
right down the line. If you think there is a more detailed
answer that you need to have, maybe you can supplement your
response a little later for the Committee.
Mr. GERGEN. I can think of no long term adverse economic
impact.
Mr. FLEISCHER. I think the adverse consequences would be
minimal, they would occur just at the margins.
Mr. KIND. Mr. Jones.
Mr. JONES. I would agree. I would add the investors are not
just passive people. They are not going to just succumb to
demand for higher salaries in order to make up for the tax.
Mr. STEUERLE. Generally, I am asked to think about these
questions in a revenue neutral manner. I could take the
revenues from this particular bill, apply it more equitably
across capital income, especially to the highest taxed assets,
and actually improve efficiency in the economy.
Mr. KIND. Thank you. Mr. Levin.
Mr. LEVIN. I do believe there would be adverse economic
consequences in several respects. First of all, right now, we
attract the best and the brightest, many of the best and the
brightest in our society to private equity and venture capital
and in making investments that better our economy, that create
jobs.
Inevitably, when you reduce the take home pay for any job,
you lose some of those best and brightest. There turns out to
be another profession that is more attractive. That is the
first thing.
The second thing is that inevitably, your best funds who
have been content with 20 percent up until now, are going to
say if it is going to be taxed more heavily, I would like to
have 25 percent or 30 percent carried interest. You are going
to get into negotiations between the general partners and the
limited partners when you have this smaller pie to split up,
that are going to be disquieting negotiations.
The better funds, some may get it. Some may not. You are
going to inevitably in my view because of these two reasons
reduce the efficacy of private equity and venture capital
investing in our society.
Right now, we have venture capital and private equity
driving our society to a more entrepreneurial job creating,
prosperity creating society. I think it is the law of
unintended consequences that if you are not careful and you do
not know what you are achieving in terms of economics, you will
find some surprises.
Mr. KIND. Thank you. Mr. Orszag.
Mr. ORSZAG. I think there may be some short term
complexities that are created and some short term effects as
people who did not anticipate the change when they first made
arrangements for a particular fund to have to adjust to the
fact that there are changes.
Over the longer term, I think most of the effect will be on
the return that the general partners receive. I would suspect
that most of the effect would be on that component.
I am somewhat skeptical that there would be very
substantial effect on the labor supply of people into the
private equity and hedge fund industry as a result. I think the
biggest effect is likely to be on the after tax returns for the
general partner, basically.
Mr. KIND. Thank you. Thank you, Mr. Chairman.
Mr. LEVIN OF MICHIGAN. Next, following our rules, Mr.
Tiberi. We are doing those who did not question the last panel.
We agreed on that.
Mr. Tiberi. You do not have to.
Mr. TIBERI. I will go ahead and yield my time back to you,
Mr. Chairman.
Mr. LEVIN OF MICHIGAN. Ms. Schwartz.
Ms. SCHWARTZ. Thank you very much, Mr. Chairman.
I appreciated your comments on the last question. One of
the other issues or one of the other concerns in terms of
harmful effects if we make changes into the carried interest is
on our public pension funds. This is a question for the next
panel, but I thought I would ask your opinion about this as
well.
With what some of the fund managers are saying, the public
pension funds in particular, and as you know, as a state
senator, I advanced the change in Pennsylvania to move from a
legal list to a prudent person standard that ended up being
hugely successful, lucrative for the Pennsylvania State
Retirement System, which is great.
I fully support that. I think they have been responsible
and it has reduced the amount of money that school districts in
the state have had to pay into their state and teachers'
retirement funds.
You said they are saying they are going to be hurt if we go
ahead and make a change on this, that the fund managers will
behave differently or they will not take on the pension funds
or there will be an adverse consequence, or that they will
somehow pass along the costs to those pension funds, and that
the pensioners themselves will have to pay it somehow.
Could you speak to whether you in fact think that would be
the effect and what has been successful would in fact be harmed
by any change we might make in the carried interest?
I will ask which of you would like to take that on or if
each of you would like to take that on, and again, I understand
it has to be done briefly.
Mr. Fleischer.
Mr. FLEISCHER. Thanks. I think the concern is really
overblown. Pension funds have a lot of different assets in
their portfolio. I am not sure what the data is on
Pennsylvania's fund. Typically, 5, 10, maybe as much as 50
percent in alternative assets.
We are only talking about a portion of the portfolio, and
then we are talking about raising the tax rate only on the 20
percent upside that general partners take. We are talking about
a subset of that portfolio.
Then you have to try to figure out if general partners can
unilaterally raise their fees in response to the tax fee. It is
pretty clear in a competitive market that they cannot do that.
Ms. SCHWARTZ. That has been the suggestion, that they would
have to raise their fees and somehow that would be so
significant to really have a broad impact. It is hard to
imagine it would be that significant. That is really my
question.
Mr. ORSZAG. Can I actually add on that? Over on the other
side, the Senate Finance Committee also had a hearing on this.
Professor Alan Auerbach from Berkeley answered this question
directly. I am just going to quote to you from his written
testimony.
``If half of the tax increase were shifted to investors,''
and I want to note I actually think that is too high, ``the tax
burden would imply a reduction of at most two basis points in
the annual return on these pension funds' assets and quite
possibly much less.''
To translate that, that is instead of a return of 7.02
percent per year, that would be 7.00 percent per year. Again,
he thinks it could be quite possibly much less.
Ms. SCHWARTZ. I do understand the pension funds initially
wrote a letter saying it would be a problem and then took it
back. California, in particular, the retirement fund there said
they do not really see it as having much of an effect.
Mr. STEUERLE. Ms. Schwartz, just a couple of other quick
comments. If we are worried about the impact on pension funds,
there are also the managers of mutual funds, the managers of
the pension funds themselves who pay ordinary tax rates.
We are encouraging those managers to move. If you are
worried about incentives, we are encouraging those managers to
move over and join the hedge funds instead.
You have a lot of these types of shifts. One can also worry
about the taxes that are implicitly or explicitly paid by the
pension funds. I again remind the Committee that we should be
looking at the corporate tax rate, which is where the tax on
capital income is much higher than it is in the case of capital
gains taxes.
Thus we are concerned about the taxes the pension funds pay
or the amount of money they have to pay their managers, there
are a lot more efficient ways to get at that issue than trying
to worry about what tax might be paid by a very narrow set of
managers within hedge funds.
Ms. SCHWARTZ. Mr. Jones, did you want to add to that?
Thank you very much. It is reassuring to hear that. Thank
you, Mr. Chairman. I yield back.
Mr. LEVIN OF MICHIGAN. Following our rules, we will go this
way. Mr. Cantor, you will go next. I will go last. Mr. Becerra,
Mr. Doggett, Mr. Thompson, Mr. Emanuel, Mr. Blumenauer, and Mr.
Pascrell. I will go at the end.
Mr. Cantor, you are next.
Mr. CANTOR. Thank you, Mr. Chairman. Mr. Chairman, again, I
want to thank the panelists for your indulgence and being here.
I respectfully want to say first of all that some of the
testimony given today in my opinion does not really reflect the
true nature of an entrepreneur who may be operating out there
today that wants to employ the partnership structure in order
to invest in.
There has been a lot of discussion about private equity,
about the richest Americans, about fund managers, about special
interest rhetoric.
I think that the proposal that is on the table in the House
at least, the Levin-Rangel bill, would have such a broad sweep
to pull in the brothers that Mr. McCrery was talking about,
assuming it was not their every day ordinary business, it was
not characterized as inventory, and it was just an ownership
interest in a partnership that was doing one house or that
house.
To me, the nature of carried interest emanates from the
need for partners, general and limited, to align their
interests, and that when one takes a risk with his capital and
is the money investor or the limited partner, that partner
wants to have a general in there in the partnership with the
same interest to see that deal, to see that investment through
to the end with a similar interest.
Therefore, to me, I do not care how much investment or
monetary investment, as Mr. Levin has said, you have sweat
equity, you have a risk of your time that certainly has value,
that may not pan out.
To me, it is the speculative nature of that capital that
would qualify it or at least make it consistent with
Congressional policy for decades, as was said earlier, that we
want to prefer that investment because that is the way we can
continue to see growth in our economy through entrepreneurial
investment.
When we say--I think it was you, Mr. Jones, who may have
said it is not fair to allow somebody making all this money to
not pay taxes and to then tax the wage earner, I am looking at
the mom and pop, the mom and pop partners that are out there.
They are getting the same kind of treatment.
I do not know. Mr. Jones, if you want to take a stab at
responding to me. I would like to hear some others as to the
real nature of the interest we are talking about.
Mr. JONES. Every employer wants to align employees'
interest to take into account the----
Mr. CANTOR. It is an ownership, and that is the difference.
Mr. JONES. Every incentive compensation scheme is designed
to make the employees or the service providers' motivations
more similar to the owner's motivation.
Mr. CANTOR. Is there not liability on the other side as
well? If you have an employee, that employee is not at all
liable in terms of being an owner the way a partner is.
Mr. JONES. Neither is the general partner in a venture
capital fund. He is not liable for any losses.
Mr. LEVIN OF MICHIGAN. We are going to try to adhere to the
3 minute rule so we can get through this. If someone has to
leave, we may ask indulgence that he or she go before.
Next is Mr. Becerra.
Mr. BECERRA. Thank you to all the witnesses for your
testimony.
Let me pick up on the last series of questions and
comments. Is there a case--and I would ask you to please be
brief so I can try to get more than one question in--is there a
case to be made that carried interest should be treated
differently based on the type of investment or the industry
involved?
We have been approached by folks who are publicly traded
partnerships. We have had folks who are in real estate
investment who have said there might be a difference between
what a private equity firm does in that industry and what these
other industries might do.
Is there a reason to consider treating an industry or a
particular investment in those types of industries differently
for purposes of carried interest?
Mr. GERGEN. Can I answer that?
Mr. BECERRA. Yes.
Mr. GERGEN. I think there are two, if you took my global--
--
Mr. BECERRA. If you do it briefly.
Mr. GERGEN. One is the genuine sweat equity. The people who
buildup a business, maybe one only contributed labor, and then
they sell it and they have capital gains goodwill on the sale
of the business.
We should preserve taxing that at a capital gains rate. The
Joint Committee on Taxation report explains how that is
different from carried interest. It is fairly clear why it is.
The other, which is one you might overlook, is if somebody
is building up intellectual property in the nature of patent
rights. If you as an individual create a patent right, unlike a
copyright, you have capital gains when you sell it. We should
preserve that just to preserve continuity between the treatment
of partnerships and individuals.
Mr. BECERRA. Appreciate that. Do investment fund managers
that are able to take advantage of carried interest today have
differing levels of risk in what they do as general partners
based on the type of investment that is made?
Do some investment managers who are general partners--let
me ask this question of Mr. Orszag--carry different levels of
risk in what they do as opposed to other fund managers who are
general partners in a different type of investment?
Mr. ORSZAG. Sure; yes.
Mr. BECERRA. Let's say there is a different level of risk.
If a general manager carries risk, does that enhance the
argument that that fund manager should be allowed to treat any
compensation received as capital gains?
Mr. ORSZAG. I do not think that necessarily follows. Again,
as I said in my oral remarks and in the written testimony,
there is a whole variety of performance based compensation. A
movie actor with a take on the movie revenue faces a different
degree of risk than I do as a public servant on my income,
hopefully. Yes, so far.
Yet that movie actor's compensation is taxed as ordinary
income. The presence or lack thereof of risk, I do not think is
the issue. The issue really is returns on capital invested and
capital income, just because human capital faces risk does not
mean it should necessarily be accorded capital income
treatment.
Mr. LEVIN OF MICHIGAN. All right.
Mr. BECERRA. Thank you.
Mr. LEVIN. I have to make a comment.
Mr. LEVIN OF MICHIGAN. Wait. My colleagues have told me not
to allow that. We will come back to you.
Mr. LEVIN. I want to make a comment on risk.
Mr. LEVIN OF MICHIGAN. Okay. I think others might, too,
including me. There are so many of us on the majority side. I
am going to do two for one. I think it is fair.
Mr. Doggett, you are next.
Mr. BECERRA. Thank you, Mr. Chairman, for yielding the
time. I yield back. I thank the panel.
Mr. DOGGETT. Professor Gergen, I would like to explore with
you the portion of your testimony that focused on how folks
might try to circumvent the Levin bill.
Do you feel there is a need for any modification to it or
other sections of the Code that it may not address to deal with
someone who would claim goodwill as capital or would use these
interest free loans as a way to get around the bill?
Mr. GERGEN. I think you should not try to fix the interest
free loan. The problem is woven too deeply into the Code. I
would not fix it, it is woven too deeply, and you do pick up
some ordinary income and compensation if they go that route.
They are really opting into Professor Fleischer's approach as a
way of avoiding uncertainty.
On over valuation, you just say it has to be reasonable.
That is about all you can say in legislation. Let Treasury
write regulations.
On zero basis intangibles, again, I would just have
Treasury say if you put in substantial intangibles with a zero
basis, we are going to come look at you, and then trust that
people will be conservative in trying to over value
intangibles.
Mr. DOGGETT. Separate from the Levin bill, is there any
action that we need to take to address circumvention by moving
offshore?
Mr. GERGEN. I would defer to somebody who knows more about
international tax than I do.
Mr. DOGGETT. Any of the others of you want to respond on
the offshore issue?
[No response.]
As far as what the impact of this bill is in terms of
economic stimulation, I think I understood your testimony, Dr.
Steuerle, to be that it could have positive impact to approve
the bill so long as the benefits are distributed to others that
would be engaged in economic activity.
Mr. STEUERLE. Yes, Mr. Doggett. I was asked to testify with
reference to the principles we apply to tax reform in general.
Whether with respect to either capital income or labor income,
we should try to provide a level rate of taxation. Where we tax
some people very high and some people very low, as opposed to a
more even level, assuming they are at the same income level, we
actually make the economy less efficient.
Mr. DOGGETT. Thank you. Professor Gergen, you suggested
that we needed to go beyond investment services. What other
types of partnerships do you think the same principle should be
applied to?
Mr. GERGEN. I think the right approach is to make it global
and then back out what still should be capital gains. I just
said goodwill on the sale of a business or liquidation or sale
of an interest and capital gain from the sale of patents and
similar rights.
I may have missed something, but be global and then back
out. The other thing I would do is just write an exception for
partnerships that are below a certain value of assets or income
level. There is not going to be that much revenue there and
then those small partnerships do not have to worry about the
rule.
Mr. DOGGETT. You and Mr. Fleischer and Mr. Jones then agree
that the Levin bill is ready to go as it is written?
Mr. GERGEN. No, I would broaden it. There are some
technical defects that I do not want to bore you with.
Mr. DOGGETT. Mr. Fleischer.
Mr. FLEISCHER. Minor details aside, I think it is ready to
go.
Mr. DOGGETT. Mr. Jones.
Mr. JONES. I do agree that to single out the service
partners in one industry is probably not a good idea. We need
to fix the whole topic of service partners. The Treasury
Department has proposed some regulations which are not simple
at all. This bill, if it applied more globally, I think that is
what Professor Gergen means, should apply to all service
partners regardless of the industry.
Mr. DOGGETT. Thank you. Thank you, Mr. Chairman. I think my
time is up.
Mr. LEVIN OF MICHIGAN. Mr. Ryan. Then it will be Mr.
Emanuel and Mr. Pomeroy.
Mr. RYAN. Thank you, Mr. Chairman.
Let me just ask you down the line, Peter on down, accepting
for argument sake that we will tax carried interest as ordinary
income on the private equity partners, the limited, would it
not be appropriate tax principle and policy to then deduct that
tax that is paid to the managers by the other partners?
Mr. ORSZAG. In general, yes. That would be the traditional
tax policy.
Mr. STEUERLE. Yes.
Mr. JONES. Yes.
Mr. FLEISCHER. Yes.
Mr. GERGEN. It does not necessarily follow that you would
but----
Mr. RYAN. Come on, we are on a roll. Everybody else is
saying yes.
[Laughter.]
Mr. GERGEN. There is a strategy people could use where if
you did not give them a deduction, they could get it anyway,
called the circle of cash.
Mr. RYAN. Yes, I am familiar with it.
Mr. GERGEN. Even if you do not go get the deduction, you
might as well give it to them.
Mr. RYAN. I realize the bill does not do that but let me
ask you, Dr. Orszag, if this bill were to be amended as most
people agree it ought to be if we want to follow regular tax
principles and policy, what would happen to the score of this
bill if this tax was deductible for the other partners?
Mr. ORSZAG. As you know, the score will be determined by
the Joint Committee on Taxation.
Mr. RYAN. I know.
Mr. ORSZAG. I would just note the treatment of taxable--
most limited partners, the ones who put in the financial
capital, are not taxable entities in the United States. For
those that are, it is a little bit complicated because it will
have the deduction but then there are various limitations on
the value of the deduction that Congress has adopted, including
a floor and an overall limit, and then we have the alternative
minimum tax.
Mr. RYAN. Sure.
Mr. ORSZAG. I have to defer to the Joint Committee on
Taxation. Obviously----
Mr. RYAN. It would dramatically reduce the revenue raised
by this bill if you applied----
Mr. ORSZAG. In general, a deduction that actually
successfully flows through to the taxable limited partners
would reduce the revenue effect.
Mr. RYAN. Mr. Levin, you seem to want to comment. I will
give you a little bit of my time if you want.
Mr. LEVIN. No, I am in agreement with that.
Mr. RYAN. Let's go to the tax principle of taxing the money
and not the man. Taxing the source of the income and not the
individual of the income. By introducing this policy, does it
not set a new precedent of taxing the recipient rather than the
type of income from which it came?
Mr. ORSZAG. Again, I would be interested in the tax
practitioners and the tax lawyers, but what I would say is I
think the issue here from an analytical perspective is the
characterization of the services that are provided by the
general manager, and whether that is more in the form of
compensation for services provided and not a return on capital.
That is what I see as the key issue.
Mr. RYAN. Go ahead, Mr. Levin.
Mr. LEVIN. Yes, I think it does. If you broaden the bill as
the Professor has proposed to cover all carried interest, or
even to be broader and cover all sweat, what you are going to
find is there are an awful lot of people whose capital gain is
then converted to ordinary income. For example, Sally starts a
business and her father finances it and puts the money in and
Sally has a carried interest.
Bill Gates starts a business and investors put money in but
Bill Gates gets more of the stock than the money he put in
would draw. He has a carried interest.
If we broaden the bill, we are going to find that carried
interests arise throughout our economy. If we do not broaden
the bill and we leave it like it is, then only certain carried
interest, that is private equity, venture capital, real estate,
are covered, and there is no reasoned rational distinction
between those industries and the other industries.
Mr. RYAN. Thank you.
Mr. LEVIN OF MICHIGAN. I hate to do this, and we need to
talk about that, but we need to follow the 3 minute rule.
Mr. Emanuel.
Mr. EMANUEL. Mr. Chairman, I will try to be quick here.
First of all, having worked a little in this industry, I just
want to note if you were writing a book, economic book, about
America's economic history of the last 50 years, I do not think
you could write just a chapter alone on the last 20 years about
the role of both venture capital funds, hedge funds, and
private equity and their contribution to making the American
economy dis-competitive.
It has been all three of those sectors, venture capital,
private equity, hedge funds. They have been enormous
contributors to the competitiveness of the American economy as
it stands worldwide.
Without going into a series of questions as it relates to
carried interest, I have wrestled with this issue. I do think
some of the activity has risk involved but also has capital
risk involved. Some of the partners of those actually put their
capital into the fund.
On the other hand, there is a recognition that they are
getting paid a fee for a service they are providing as a
general partner, which is what I think led to--I find this
almost intriguing, and I know I am going to mispronounce it--
Greg Mankiw's position, President Bush's former economic
advisor, who said deferred compensation, even risky
compensation, is still compensation and it should be taxed as
such. The administration is on the wrong side of this issue.
Another economic advisor, the Chairman of the CATO
Institute, economic advisor to President Reagan--I would be
more than willing to have these guys as witnesses--said the
share of investment profits are basically fees for managing
other people's money.
Having worked with my own fair share of economic advisors
to Presidents, they are scholars.
What I found more intriguing in all this is when Blackstone
filed their IPO, the Blackstone IPO, and I quote from it, ``We
believe,'' and this is in their own words, obviously lawyers
and accountants helped write this, ``We believe that we are
engaged primarily in the business of providing asset management
and financial advisory services and not in the business of
investing, re-investing or trading in securities.
We also believe that the primary source of income from each
of our businesses is properly characterized as income earned in
exchange for provision of services.''
This is what they filed with the Securities and Exchange
Commission when they were doing their IPO, which somewhat
acknowledges that they are getting paid a fee for a service, in
their own words. Nobody asked them to do this. This was for the
IPO.
I think the other two economic advisors noted there was a
fee for a service. I do think what are the unintended
consequences, what is going on in London, what is going on in
Europe, what is going on in Asia as it relates to private
equity, hedge funds, the ability of capital to move.
I think what we have here is a situation where the
compensation for fund managers does reflect--one of the reasons
we are trying to untangle this--is both activities. There is
risk and there is also being paid for a service.
How you come up with a structure, a tax number, that
reflects that activity is what we are trying to untangle here.
I was wondering if anybody would want to comment on do you
really see this as a pure play that is a fee for service, do
you see some risk, a la (a) the tradition of what we described,
capital at risk, and (b) do you see that the only choice is one
or the other and there is no other way to come up with an
alternative?
Mr. LEVIN OF MICHIGAN. Let's do this because we are going
to follow the 3-minute rule, if it is okay.
Mr. EMANUEL. Can we go to a three and a half minute rule? I
got it, Sandy.
Mr. LEVIN OF MICHIGAN. You are already beyond three and a
half minutes.
[Laughter.]
Mr. EMANUEL. Thank you for my Rosh Hashanah blessing,
another half hour. Thank you, Sandy.
Mr. LEVIN OF MICHIGAN. Following general rules as best we
could. These are good questions. I think now, Mr. Pomeroy, and
then Mr. Tiberi, you are next.
Mr. Pomeroy, under this procedure, you are next for 3
minutes, without a blessing otherwise.
Mr. POMEROY. Thank you. I will try to follow up on the
question very well posed by my colleague.
Mr. Steuerle, you indicate as a principle of taxation,
labor income should be taxed similarly regardless of source.
That would indicate along the line of what Mr. Emanuel was
asking.
Income related to a fee charged for a service, that is
labor income. The rationale to have that taxed at capital gains
or corporate dividend rates versus ordinary income rates does
not exist.
Would you care to elaborate?
Mr. STEUERLE. Yes, Mr. Pomeroy. It seems to me there are
two things going on that are causing the conflict here. One is
that the Congress has decided at various stages to try to tax
capital income different than labor income. The second is we
have adopted in the partnership and sole proprietorship world a
simplification that says we often cannot distinguish capital
from labor income, so for certain purposes, we are going to
treat them the same.
Those two are coming into conflict, and that is part of the
debate.
I would just remind the Members of the Committee that on
the flip side of that simplification, there are many people who
are sole proprietors and partners who are very entrepreneurial,
who are not only paying full labor tax on their labor income,
but in fact on their capital income from investments, the
equipment they buy actually flows through income on which they
pay Social Security tax.
Thus on the one side in this partnership form, we have some
people who are paying 45 percent tax rates on their capital
income and on the other side, we have some people who are
paying 15 percent tax rates on their labor income.
That is the conflict that you are trying to deal with here.
Mr. POMEROY. In the district I represent, we have a lot of
people that fall in that latter category that you speak of.
At the time the differential was created, I was on this
Committee. We were told the national savings rate was going to
go up because people suddenly saved to invest. We heard this
morning that the national savings rate has been negatively
impacted to the tune of better than 1 percent by those very
reforms creating the differential, and now we have a
differential that people are gaming.
In the last 30 seconds of my time, Mr. Orszag, what is the
budgetary impact from this, basically, taxation of labor at the
capital gains rate?
Mr. ORSZAG. As I said before, the score for any change in
that current tax treatment would come from the Joint Committee
on Taxation, which has not yet released an analysis. I will
leave it to them for that.
Mr. POMEROY. Thank you, Mr. Chairman. I yield back.
Mr. LEVIN OF MICHIGAN. Mr. Tiberi.
Mr. TIBERI. Thank you, Mr. Chairman.
Mr. Levin, you had tried to make a point earlier regarding
partnership risk, and you were unable to further make that
point. If you could clarify that, and the second question is,
can you comment on how this is taxed, how carried interest is
taxed in competing countries, where capital obviously might
flow if we tax it here, in Europe, in Asia, primarily?
Mr. LEVIN. Yes. First, the point I wanted to make on risk
is that risk is essential for capital gain; when you look at
the capital gain sections of the Code, it is gain from the sale
of an asset, capital asset, held more than 12 months. That is
stocks, real estate, things you invest in and take a risk on.
Risk is essential to capital gain, but risk is not always
sufficient. There are circumstances if you are an executive at
a company, at a corporation, and you are given a bonus that is
contingent on sales, you have a risk, but that does not give
you capital gain.
The key in the Code has always been a capital asset held
for more than 12 months, and what this bill seeks to do is to
change that rule. Once you change it, there are ever so many
other changes you can make. You put a lot of things at play,
and you are not sure where you are going to come out.
Secondly, you asked about other countries. In the vast
majority of countries that I am familiar with, there is a
differential between capital gain and ordinary income, higher
rate for ordinary income than capital gain.
In the vast majority of the countries that I am familiar
with, where you have a partnership arrangement, like a private
equity fund, with capital gain flowing through to the people
who run the fund, they get capital gain. U.K. is one of those.
One can point out that since this country began its careful
re-examination of this, other countries such as the U.K. have
announced they are going to re-examine it. It does not mean
they are going to change it any more than we are going to
change it, but it would be, I think, a pity for us to change
it, tax capital gain carried interest as ordinary income if
other countries do not.
I think there will be some leakage then of money into funds
in other countries. That is a complex issue of where do the
general partners pay tax, where is the fund formed, but there
will be some, in my opinion, leakage of money out of this
country.
Mr. TIBERI. Dr. Orszag.
Mr. ORSZAG. I would just add very quickly that the issues
facing many other countries are different from the ones facing
the United States because of the way that we tax U.S. citizens.
That differs from the way, for example, the United Kingdom
taxes its citizens, and the tradeoff's that the U.K. Government
may face in changing its tax treatment differ from those that
the United States faces.
Mr. LEVIN OF MICHIGAN. By the way, England is also facing
this issue. We are not the only ones.
Mr. CAMP. If the gentleman will yield, Mr. Tiberi.
Mr. LEVIN OF MICHIGAN. His time is up. If we might, Mr.
Thompson is next.
Mr. THOMPSON. Thank you, Mr. Chairman. Thank you to all the
witnesses.
Mr. Levin, I have heard from folks, and I think we are
going to hear in the next panel from the real estate community,
that the issue, the tax treatment of carried interest is an
incentive to revitalize areas that are poor or economically
disadvantaged or under served.
If we do in fact alter this carried interest or do away
with it, what is the impact going to be, in your view?
Mr. LEVIN. I think it is the same as I talked about for
private equity and hedge funds and venture capital, that is, if
you increase markedly the taxation on the general partners, who
devise the projects, operate the funds, make the investments
and act as principals, and only give capital gain to the
passive investors, it seems to me that it is almost upside
down, and you do give a disincentive as compared to where
things are now for people to redevelop or make investments.
I cannot tell you that there is going to be a 90-percent
reduction, but I can tell you I believe there will be a 10- or
20- or 30-percent reduction in some of these investments, and
that alone is enough to harm the growth of our economy.
Mr. THOMPSON. We have heard it argued that fund managers
can easily convert their fee income into carried interest, and
this is a question for anyone who wants to take a shot at it.
How easy is it really for such a fee to be converted and
how often is this being done?
Mr. LEVIN OF MICHIGAN. Professor Fleischer.
Mr. FLEISCHER. You can look in Mr. Levin's book for a
guideline on how to do it. It has become quite common. The fund
managers do have to take some economic risk in order to get the
tax treatment that they want, but it is not as much risk as you
might imagine. They take a priority allocation of the next
year's profits, so they have to wait a few more months, instead
of getting their management fee in 1 year, they have to wait a
few more months, and then they get it in capital gains terms in
the next year.
Mr. THOMPSON. Anyone else want to take a shot?
Mr. LEVIN. I would just comment that I think it is
substantial risk.
Mr. STEUERLE. May I just add there is no principle in the
Tax Code for subsidizing risk per se. Risk can be good or bad.
Risk is not good in and of itself.
Mr. THOMPSON. Thank you. I yield back.
Mr. LEVIN OF MICHIGAN. Who is next? I think it is Mr.
Blumenauer.
Mr. BLUMENAUER. Thank you, Mr. Chairman.
First, on behalf of my friend, Mr. Emanuel, I wanted to
indicate that if any of you folks wanted to make a reaction to
this question and have it entered in the record, he would
appreciate it.
We have heard from Mr. Levin about the negative potential
impacts on these extraordinarily highly skilled people who are
managing these investments if we change the rules of the game
and tax them more like most Americans are taxed, that it would
have some effect on their behavior.
I guess I am more interested about what are the effects on
the millions of Americans, and Dr. Steuerle, you alluded to it
in your testimony, lots of people are paying actually much
higher marginal rates, under more difficult circumstances with
less resources to cope with.
I am curious if you have any thoughts about are they less
sensitive to price signals? Are they less bright, that they do
not know about it? If you multiply these millions of people who
are presumably productive, at least at some level, paying these
very high marginal rates, does that not have some impact on our
society, as well in terms of the economy and what happens to
them, not in a moral sense, but in practical dollars and cents,
in terms of how the economy behaves?
Mr. STEUERLE. Yes. One of the principles of tax policy is
that some of the greatest inefficiencies or distortions are
caused when the rates are the highest. That means that often
the people we want to look at most, if we are trying to provide
relief, are the people who pay the highest marginal tax rates
on their investment.
I alluded to several of them in my testimony, including the
kid who is putting money in a savings account to pay for
college. That person is taking risk. He might be an
entrepreneur. There are also small businesspeople. There are
cleaning ladies. There are people who provide all sorts of home
services. They are in businesses and they are undertaking
entrepreneurial risk.
It is very difficult to justify subsidizing some groups at
very low rates just simply because they have high incomes and
therefore can afford a bit better some lobbyists to favor them.
Mr. BLUMENAUER. Mr. Chairman, at some point, as we move
forward with this discussion as a Committee, I would like to
see if there is a way to frame this, about the people in
society who are at the edge, who are paying higher marginal
rates, and the impact that the tax system has on them. I hope
at the end of the day we are able not to pick winners and
losers; to the contrary, that we are able to even this out in
some fashion.
I appreciated the reference that Dr. Steuerle had, and I
would hope there would be a way for us to focus in on that,
maybe gather a little more information and actually talk about
it.
Mr. LEVIN OF MICHIGAN. I hope we will. This is not an
effort to pick winners or losers.
There has been general agreement that we are going to go to
the next panel before we lose it, except Mr. McCrery has
agreed, and he will go next.
Mr. Pascrell, I understand you have a 30-second question.
Go ahead.
Mr. PASCRELL. Mr. Chairman, before I do that, I know our
back sides are sore, but our spirits are liberated. This is
such a refreshing thing that has happened in the last 6 years.
We have reporters at the table. We have firemen at the table.
We have money managers and laborers at the table.
We are going to get a fair shot here down the road.
Mr. Levin, in your book on pages 10-15 (of the 2007
edition)----
Mr. LEVIN OF MICHIGAN. Which book?
[Laughter.]
Mr. PASCRELL. The book is ``Structuring Venture Capital and
Private Equity'' et cetera.
Mr. LEVIN OF MICHIGAN. I only say that because I have five
books. Sorry.
We have just limited time.
Mr. PASCRELL. You describe a situation in which an
investment fund manager can waive a portion of its management
fee in exchange for an increased allocation of the fund
profits, stating that ``This technique should convert
management fee income which would have been taxed as ordinary
income into long-term capital gain.''
Does the ease with which the author describes the
investment which can be converted for compensation income into
capital gains trouble anybody on this panel?
Mr. Gergen.
Mr. GERGEN. Yes.
Mr. PASCRELL. How does it trouble you?
Mr. GERGEN. Fairness and efficiency. We have talked about
it the last hour and a half.
Mr. LEVIN OF MICHIGAN. We are going to go down the row very
quickly. Mr. Fleischer.
Mr. FLEISCHER. It is quite troubling, and the economic risk
that the fund manager has to take is not in many cases so
substantial because the fund manager knows the assets in the
portfolio that might be realized in that next year.
Mr. PASCRELL. Mr. Jones.
Mr. JONES. That is right; what Victor just said is
absolutely correct. Risk has nothing to do with it in any
event, but there is no real risk. They wait until they about
know what their profits are going to be and then they exercise
their options.
Mr. PASCRELL. I want to thank each of the members of the
panel, everybody; you guys did a fantastic job, and I really
appreciate it. Thank you very much.
Mr. LEVIN OF MICHIGAN. With that note, and I think we all
agree, thank you very, very much. This has been really
informative.
Now, our last panel, the most patient people in Washington,
let's go. As you come forth, I am going to introduce you.
Leo Hindery, who is the Managing Director of InterMedia
Partners in New York. Mr. Stanfill, who is the founding partner
of TrailHead Ventures in Denver. Orin Kramer of the New Jersey
State Investment Council. Jonathan Silver, Managing Director of
Core Capital Partners. Adam Ifshin of DLC, and Bruce Rosenblum.
It may not be in that order. We will take you in the order
you are seated.
Mr. LEVIN OF MICHIGAN. Each of you has 5 minutes now. I do
not think we need to apologize. I think you probably know, some
of you are veterans of these battles, that being the fourth
panel meant it might be a less prominent place, but it really
is not.
We are going to do two things, make sure everybody sees
your testimony, and we will distribute it through the Committee
directly, and secondly, this is just the first of our
discussions, and we will probably be tapping you in the future.
I introduced you as you were walking up. Each take your 5
minutes. We will go from there.
Mr. Hindery, we are going to start with you.
STATEMENT OF LEO HINDERY, JR., MANAGING DIRECTOR, INTERMEDIA
PARTNERS
Mr. HINDERY. Thank you, Mr. Chairman, and Members for
convening this important hearing, as late in the day that it
is, its importance justifies our being here.
As many of my colleagues have commented today, at the
onset, I speak only for myself and certainly not my firm. As
you will hear from my comments, many would think I do not speak
for my industry as well.
I am the Managing Partner of InterMedia Partners, which is
a private equity firm I formed in 1988, and I ran continuously
until 1997 when I became the chief executive officer of
Telecommunications, Inc. or TCI, and later, its successor, AT&T
Broadband.
I returned full time to private equity in 2001, and my
business career includes nearly 20 years of direct and indirect
involvement with investment partnerships. As a consequence, I
am intimately familiar with their history, their realities and
their economics.
As we have heard often today, hundreds of thousands of
Americans throughout the U.S. economy work hard every day
managing things for other people, ranging from grocery stores
to gas stations to money.
All of these managers earn a base level of compensation and
in addition, most of them earn some form of performance fee.
Except for one group of individuals, all of them pay ordinary
income taxes on their personally earned management income.
I am here today to talk about the management income being
earned by that one particular group, namely those women and
men, of whom I am one, who use special purpose investment
partnerships to manage money belonging to others.
The management income which we earn, which we call
``carried interest,'' is taxed as capital gains, when I and
others believe it should instead be taxed as ordinary income.
Of course, because the 15 percent capital gains tax rate is
less than half, the 35 percent maximum ordinary income tax rate
paid by virtually every other manager and by regular Americans,
how this issue is resolved will have an enormous impact on the
nation's tax receipts on the order, as we have heard, of $12
billion a year.
The reason this tax loss figure is so high is simply
because of the magnitude of the earnings which are now escaping
ordinary income taxation.
To fully appreciate this, all this Committee has to do is
reflect on the fact that in 2006, the top 20 hedge fund and
private equity managers in America earned an average of $658
million a piece. That is 22,255 times the pay of the average
U.S. worker, and of course, most of these earnings were taxed
at just the 15-percent rate.
I should note that my concern today is not about the
taxation of the operating income earned by any of these special
purpose partnerships, although there is very substantial
inconsistency and thus abuse in how income from operations is
currently being taxed from one type of partnership to another.
I should further note that while much of the public's
attention to this issue has been directed at hedge funds and
private equity managers, the management income earned by
managers of all investment partnerships needs to be scrutinized
alike, hedge funds, private equity, oil and gas, real estate
and timber.
It really is not all that hard to decide how to properly
tax carried interest. Is carried interest income which a money
earns on his or her personal investments or instead is it the
performance fee earned for managing other people's investments?
If carried interest is personal investment income, then it
is properly entitled to capital gains treatment. However, if it
is a performance fee, and my 20 years of firsthand experience
clearly tells me it is, then it should be taxed as ordinary
income.
Simply put, Members, a very bright line needs to be drawn
between investor type partners who invest their own money and
are thus entitled to capital gains treatment on the investment
income they earn and manager type partners who contribute only
their services.
A prominent private equity manager recently contended to
this Congress that investment manager earnings are ``Capital
gains in every technical and spiritual sense.''
All I can say in answer is no church or synagogue I know
would consider it very spiritual to each year selfishly
characterize as capital gains literally billions of dollars of
management income that has absolutely no down side risk to the
managers, especially when doing so comes at such a great
expense to the rest of our Nation's taxpayers.
On the issue of risk, about which much has been said today,
I would note that there is a very, very big difference between
the risk of losing one's money, which is real risk, and the
risk of not making as much as you hoped, which is not risk in
any meaningful way.
Some of my fellow investment partnership managers also say
that this hearing is nothing more than a vindictive singling
out of their firms because of their extraordinary success, and
they say that increasing the tax rate on their earnings to the
ordinary income level will create an investment tax of sorts
with dire, dire unintended consequence for the entities whose
money is being managed and for the American economy.
These conclusions are self serving and they are poppycock.
Congress is not considering changing the tax rates on the
investments made by investors. Congress is only considering
restoring fairness in how the women and men who manage these
investments are individually taxed compared to other managers
and to regular workers.
It is beyond disingenuous to predict dire unintended
consequences when no consequences at all will occur.
A tax loop hole the size of a Mac truck is right now
generating unwarranted and unfair windfalls to a privileged
group of money managers and to no one's surprise, these
individuals are driving right through this $12 billion a year
hole.
Congress, starting with this Committee, needs to tax money
management income, what we call ``carried interest,'' as what
it is, which is simply plain old ordinary income.
I hope, Mr. Chairman and Members, that my comments have
been helpful. I look forward to your comments and your
questions. Thank you, Mr. Chairman.
[The prepared statement of Mr. Hindery follows:]
Prepared Statement of Leo Hindery, Jr., Managing Director, InterMedia
Partners, New York, New York
Thank you, Mr. Chairman and Members, for convening this important
hearing on the taxation of carried interest for investment
partnerships.
I am Leo Hindery, and I am the Managing Partner of InterMedia
Partners, a private equity fund which I formed in 1988 and ran
continuously until 1997 when I became CEO of Tele-Communications, Inc.
(TCI) and later its successor AT&T Broadband. I returned full time to
private equity in 2001. My business career includes nearly 20 years of
direct and indirect involvement with investment partnerships, and I am
intimately familiar with their history, realities and economics.
Hundreds of thousands of Americans throughout the U.S. economy work
hard every day managing things for other people, ranging from grocery
stores to gas stations to money. All of these managers earn a base
level of compensation, and in addition, most of them earn some form of
performance fee. And except for one group of individuals, all of them
pay ordinary income taxes on their personally earned management income.
I am here today to talk about the management income being earned by
that one particular group, namely those women and men, of whom I am
one, who, using special purpose investment partnerships, manage money
belonging to others. The management income which we earn, which we call
carried interest, is taxed as capital gains, when I and others believe
it should instead be taxed as ordinary income.
And of course because the 15 percent capital gains tax rate is less
than half the 35 percent maximum ordinary income tax rate paid by
virtually every other manager and by regular Americans, how this issue
is resolved will have an enormous impact on the nation's tax receipts,
on the order of $12 billion a year.
This reason this taxes loss figure is so high is simply because of
the magnitude of the earnings which are now escaping ordinary income
taxation. To fully appreciate this, all this Committee has to do is
reflect on the fact that in 2006, the top 20 hedge fund and private
equity managers in America earned an average of $658 million each,
which is 22,255 times the pay of the average U.S. worker. And of course
all of these earnings were taxed at just a 15 percent rate.
I should note that my concern today is not about the taxation of
the operating income earned by any of these special purpose
partnerships, although there is very substantial inconsistency and thus
abuse in how income from operations is currently being taxed from one
type of partnership to another.
And I should further note that while much of the public's attention
to this issue has been directed at hedge fund and private equity
managers, the management income earned by managers of all investment
partnerships needs to be scrutinized alike: hedge fund, private equity,
oil-and-gas, real-estate, and timber.
It really isn't all that hard to decide how to properly tax carried
interest. Is carried interest income which a money manager earns on his
or her personal investments, or, instead, is it the performance fee
earned for managing other people's investments? If carried interest is
personal investment income, then it is properly entitled to capital
gains treatment--however, if it is a performance fee, as my 20 years of
first-hand experience clearly tells me it is, then it should be taxed
as ordinary income.
Simply put, a very bright line needs to be drawn between investor-
type partners who invest their own money and are thus entitled to
capital gains treatment on the investment income they earn, and
manager-type partners who contribute only their services.
A prominent private equity manager recently contended to this
Congress that investment managers' earnings are (and I quote) ``capital
gains in every technical and spiritual sense'' (unquote). All I can say
in answer is that no church or synagogue I know would consider it very
``spiritual'' to each year selfishly characterize, as capital gains,
billions of dollars of management income that has absolutely no
downside risk to the managers, especially when doing so comes at such a
great cost to the rest of our nation's taxpayers.
Some of my fellow investment partnership managers also say that
this Hearing is nothing more than a vindictive singling out of their
firms because of their extraordinary success. And they say that
increasing the tax rate on their earnings to the ordinary income level
will create an ``investment tax'', of sorts, with dire unintended
consequences for the entities whose money is being managed and for the
American economy.
These conclusions are similarly self-serving, and they are complete
poppycock.
Congress is not considering changing the tax rates on the
investments made by investors. Congress is only considering restoring
fairness in how the men and women who manage these investments are
individually taxed compared to other managers and to regular workers.
And it is beyond disingenuous to predict dire unintended consequences
when no consequences at all will occur.
A tax loophole the size of a Mack truck is right now generating
unwarranted and unfair windfalls to a privileged group of money
managers, and, to no one's surprise, these individuals are driving
right through this $12 billion-a-year hole. Congress, starting with
this Committee, needs to tax money management income, what we call
carried interest, as what it is, which is plain old ordinary income.
I hope my comments have been helpful. Thank you very much for this
opportunity to speak with you today, and I welcome your questions.
Chairman RANGEL. [Presiding] I apologize for not being
here. We really want to thank this panel. We had no idea that
the hearing was going to last this long. We thank you so much
for your patience.
I want to make it abundantly clear that it came to the
attention of this Committee, both the Ranking Member and I,
that we had a moral, political, legislative obligation to
eliminate the alternative minimum tax. We agreed to that.
Our problem was how do you do it and how do you pay for it.
In the course of these hearings, anyone that has said that the
Chair or any Members were out to raise taxes or to attack, yes,
we said loop holes, yes, we said we want to simplify the Tax
Code. Yes, we want to say we want to make it revenue neutral.
I am really amazed as to people who believe that the
difference between 15 percent in capital gains tax rate and 35
percent tax rate, that we should leave it alone or that we are
attacking people, I have never seen anyone that is not even on
the agenda, except that we are looking at everything in the
Code, scream so loud when no one even mentioned their names.
Naturally, we want experts like you to share your opinion
so that we do not do anything dramatically, but it is not the
intention of this Committee to continue to be just a revenue
raising Committee.
We want to simplify the Code. We want to make certain that
economically it provides incentives necessary for the economy,
and we have to have it perceived as being fair and equitable by
all taxpayers.
I only say that because we just left a meeting where people
said we wanted to tax the rich and all of that. I just want to
get us back on target. It started out how do you eliminate the
alternative minimum tax on 23 million people, and the answer is
with great difficulty.
We are moving. I want to thank you once again for your
patience.
William Stanfill, founding partner of TrailHead Ventures.
Thank you for being here.
STATEMENT OF WILLIAM D. STANFILL, FOUNDING PARTNER, TRAILHEAD
VENTURES
Mr. STANFILL. Chairman Rangel, Ranking Member McCrery, and
Members of the Committee, as the Chair noted, my name is
William D. Stanfill, founding partner and head of the Denver
office of Trailhead Ventures, a private venture capital
partnership investing in information technology.
At the outset, I would like to make clear that I speak not
on behalf of my firm, and certainly not on behalf of the
industry. Rather, I speak as a private citizen who has been
involved in venture capital for 25 years.
Beginning in 1982, I was responsible for a fund of funds
that invested in 30 venture partnerships. In turn, those
partnerships invested in some 600 to 700 venture backed
companies. These portfolio companies were scattered across the
U.S. from coast to coast, from Massachusetts to California. I
have read the earlier Senate testimony about the wonderful
things that we venture capitalists do. I think this is an
idealized version of our industry, a vision of the Wizard of Oz
comes to mind.
Those venture capitalists and I do the same kind of work.
We just come to different conclusions about what is appropriate
tax treatment for our earnings.
All workers add value to a greater or lesser extent. Randy
Testa is a gifted teacher. He inspired and challenged our son,
David, and his third grade classmates, developing and enriching
human capital. Yet, the tax rate on my carried interest is less
than the tax rate on his salary.
There has been more than a hint of Chicken Little in the
dire predictions of the havoc this tax change will cause. In my
judgment, they will not come to pass any more than the end of
the automobile industry, which was predicted when seat belts
and emission standards were mandated.
I do not think many if any firms will move offshore or if
they do, they will be motivated by investment opportunity as
opposed to tax treatment. We have always found plenty of
investment opportunities in our own backyard.
Or that limited partners will stop investing. This change
does not affect their taxes. Most of them are tax exempt
entities anyway.
I do not think losing the carried interest tax break would
drive other venture capitalists out of the field. We get ample
compensation, financial and psychic, for the work we do and the
risks we take with other people's money, by the way, in the
form of a share of profits.
I have been in the business for 25 years and the basic
compensation structure of 2 and 20 has survived all of the tax
changes over that time.
How long will we tolerate the ever widening gap between
rich and poor? Although my preference is for major tax reform,
I do believe it is fair, equitable and appropriate to work on
the issue of tax equity where we can.
We should not do nothing because we cannot do everything. I
am especially disturbed by suggestions that we cannot afford to
provide health insurance for low income children or first rate
medical care for our injured soldiers.
I am disturbed that these and other human priorities are
unaddressed, while we pretend we can afford to continue these
tax breaks.
In conclusion, our earnings are compensation and should be
taxed the same way the compensation of everyone else is in the
country. It is neither fair nor just for teachers and
firefighters to subsidize special interest tax breaks that cost
billions of dollars each year. It is unacceptable that those
tax breaks also rob the Medicare system of much needed revenue.
We and our representatives in Congress have a choice. We can
change the Tax Code in favor of equity and fairness or we can
come to the same conclusion reached by Walt Kelly and his mouth
piece, Pogo. We have met the enemy and he is us. I would be
happy to entertain your questions.
Thank you.
[The prepared statement of Mr. Stanfill follows:]
Prepared Statement of William D. Stanfill, Founding Partner, TrailHead
Ventures, Denver, Colorado
Chairman Rangel, Ranking Member McCrery, and Members of the
Committee, my name is William Deming Stanfill, founding partner and
head of the Denver office of Trailhead Ventures, a private venture
capital partnership whose investment focus is information technology.
At the outset, I would like to make clear that I speak not on behalf of
my firm and certainly not on behalf of the industry. Rather I speak as
a private citizen who has been involved in the venture capital industry
for 25 years.
I joined the Centennial Funds of Denver in 1982 and was responsible
for a fund of funds activity wherein we invested in thirty venture
partnerships around the United States. The venture partnerships
collectively invested in 600-700 portfolio companies including
telecommunications, medical, and information technology. Those
portfolio companies were scattered across the U.S., from Massachusetts
to California, Florida to Oregon, Colorado and Utah, Arizona, Texas,
and New Mexico, Alabama and Georgia, Idaho and New Hampshire.
What We Do
In 1995, I left the Centennial Funds, purchased the fund-of-fund
activity and formed Trailhead Ventures to invest directly in early
stage information technology enterprises. By industry standards we are
a small fund. Our advantage is our ability to provide seed and early-
stage capital of $2-4 million to start-up companies. A $500 million
partnership, by contrast, cannot manage 125 to 250 investments of $2-4
million each. Our limited partners include state and corporate
retirement funds, university endowments, and the occasional high net
worth individual.
Basically we back entrepreneurs who have good ideas and an
obsession to bring them to market. We help surround the entrepreneur
with a world-class management team. If the team performs well, we have
the good sense to stay out of their way. The last thing most venture
capitalists want is for the management team to hand them the keys to
the enterprise. That said, we serve on boards, assist with business
strategy, help interview and select members of the senior leadership
team, and introduce the entrepreneurs to professional and other service
providers who can bring value to the enterprise.
How We Are Compensated
We receive a management fee, based on a percentage of committed
capital, to cover salaries and expenses. After payback, when limited
partners have recouped their investment, we then share in the profits
on an 80/20 split. This is the ``carried interest.'' Both the
management fee and the carried interest represent compensation for the
work that we do. The general partners also invest at least 1 percent of
the fund's capital. The earnings on that 1 percent are, of course, not
compensation, but qualify for capital gains treatment along with our
investors' earnings.
How Our Compensation is Taxed
Our management fee is taxed as ordinary income. However, the
carried interest, even though it is compensation, is primarily taxed at
capital gains rates. I can understand why many in my industry want to
preserve this special tax advantage. Clearly, it has served U.S. and ME
well. The tax subsidy each year to private equity fund, hedge fund, and
venture capital fund managers is in the billions of dollars. But I
think this special tax break is neither fair nor equitable.
All workers add value--to a greater or lesser extent. Randy Testa
is a gifted teacher--he inspired and challenged my son David and his
third grade classmates--enriching human capital. But the tax rate on my
carried interest is less than the tax rate on his earnings. Or how
about the veterans of the Iraq war, in particular the 26,000
casualties? Do I deserve a tax break more than they do? Ben Stein
doesn't think so. Nor do I.
Many Americans invest sweat equity in their jobs and their
businesses, take risks, contribute to the economy, and may have to wait
a long time before their hard works pays off. But they still pay
ordinary income tax rates on their compensation. To the extent we take
risk, we take it with other people's money. As Bill Gross, the managing
director of PIMCO Bond Fund noted, ``[w]ealth has always gravitated
towards those that take risk with other people's money but especially
so when taxes are low.''
In addition to the lower income tax rate on the compensation earned
in the form of carried interests, this income is also earned free of
payroll taxes. The revenue cost to Medicare is estimated to be about a
billion dollars a year. This is unacceptable at a time when the aging
American population depends increasingly on the services provided by
Medicare and when the Hospital Trust Fund is expected to experience
substantial shortfalls in just a few years.
Consequences of Changing the Tax Treatment
I don't think that changing the tax law to require me and other
managers of venture capital firms, private equity firms, and hedge
funds to pay tax on our compensation like other working taxpayers would
have the dire consequences that some are predicting.
Many predict that firms will locate overseas, taking jobs and tax
revenue out of the country. My firm is too small to play in the
international field--the learning curve is too steep and the expenses
are too high. And if you are doing seed investing, we've always found
sufficient deals in our own backyard. And my accountant advises me
that, even if we did move our fund offshore, as a U.S. citizen I would
still be subject to U.S. tax on my income.
I don't see why my limited partners would stop investing in our
fund just because my tax treatment changes. It doesn't affect their
taxes--most of them are non-taxable entities anyway. If my investors
ask me what this tax change means to them, I'm going to tell them
``nothing.'' And I'd still have a strong incentive to do the best for
my investors. After all, I don't earn profits until they do. I have
been in the business for 25 years and the base compensation structure
of 2 and 20 has survived all of the tax changes over that time.
What limited partners should expect from a venture capital
investment is a 500 basis point (5 percent) premium over a portfolio of
publicly-traded securities. And that premium is not a risk premium, but
a premium for illiquidity. Why? Because we are a 10-year partnership.
But in addition to that premium, the investor gets a lottery ticket and
the results can be substantial. In the first Trailhead Fund, we have
produced a 54 percent internal rate of return net to the investor and
if we liquidated the remaining public securities today, we would return
10 to 11 times our partners' capital.
I have read the statements by others in my industry defending the
special tax treatment of our earnings by talking about the wonderful
things we venture capitalists do. I think this is an idealized view of
our industry--a vision of the Wizard of Oz comes to mind. We don't lead
every deal in which we invest. Occasionally we are followers, along for
the ride. Am I the only one who finds these claims just a bit self-
serving?
What is interesting about early-stage venture investing is the
rewarding collaboration between the limited partners who bring dollars
and trust, the venture capitalist who brings judgment and experience,
and the entrepreneur who brings an idea and a fire in his or her belly.
That combination can create wonderful, profitable results. But there is
a first among equals here that we should never forget, and is the key
to the equation, and that is the entrepreneur.
I have loved my work over the last 25 years and I would not stop
doing it because my tax rate was adjusted to the level of other
citizens'. And I don't think losing the carried interest tax break
would drive other venture capitalists out of the field. We like the
excitement and satisfaction of assisting management in transforming
good ideas into successful businesses. We get ample compensation,
financial and psychic, for the work we do and the risks we take, in the
form of a share of the profits. There is more than a hint of Chicken
Little here. But our industry won't end or be significantly disrupted
if this legislation is enacted any more than the auto industry's dire
predictions of doom came to pass after mileage standards, seatbelts,
and air bags were mandated.
Does Venture Capital Deserve Special Tax Breaks?
I could make a public policy case for excluding venture capital
from this legislation. For unlike private equity and hedge funds, the
venture capital industry does create jobs. We fund small start-ups
rather than restructure huge companies. And we don't use leverage to
pay ourselves back and leave the portfolio companies saddled with debt.
But I won't. I still think our earnings are compensation and should be
taxed the same as the compensation of everyone else in this country--
from teachers and firefighters to athletes and movie stars. I don't
think it is fair for those teachers and firefighters to subsidize
special tax breaks for me and other venture capitalists. Or for private
equity and hedge fund managers.
Wealth Inequality
How long will we tolerate the ever-widening gap between rich and
poor? Though my preference is for major tax reform--increased standard
deductions, a base rate for all income: wages, salaries, dividends,
royalties, and capital gains with some progressivity built in--major
tax reform is not on your agenda. However, I do believe it is fair,
equitable, and appropriate to attack the issue of tax equity at the
margins. We should not do nothing because we can't do everything. I am
especially disturbed by suggestions that we can't afford to provide
health insurance for low income children, first rate medical care for
our injured soldiers or fund--at the Federal level--the mandates of No
Child Left Behind. I am disturbed that these and other human priorities
are unaddressed while we pretend we can afford to continue these tax
breaks.
Conclusion
I'm delighted to be part of the venture capital business--it's been
a wonderful 25 years. We funded a lot of companies--many of them
successful. We've worked hard and I think we've earned our
compensation. My point simply is that fairness and equity dictate that
we pay ordinary tax rates on that compensation.
Was Ben Franklin prescient when he warned us that our republic
would fail because of corruption, greed, and, dare I say it, special
interests? Doesn't gross inequity in our Tax Code, maintained by the
very people who benefit from it, come close to the same thing? We and
our representatives have a choice. We can change the Tax Code in favor
of equity and fairness. Or we can come to the same conclusion reached
by Walt Kelly and his mouthpiece, Pogo, ``we have met the enemy and he
is us.''
Thank you and I would be pleased to answer any questions.
Chairman RANGEL. Thank you so much. Now it is my pleasure
to welcome an old friend, and he will have to share with me how
the New Jersey State Investment Council is located in New York,
New York, but as long as it is there, it is okay with me.
Chairman Kramer, welcome.
STATEMENT OF ORIN S. KRAMER, CHAIRMAN, NEW JERSEY STATE
INVESTMENT COUNCIL
Mr. KRAMER. That is where your office found me, Mr.
Chairman. Mr. Chairman, Mr. Ranking Member, Members of the
Committee, can I ask in the interest of time, which has to be a
priority of yours, that my brief comments be entered into the
record, and I will just summarize.
Chairman RANGEL. Thank you. Without objection, and for all
of those that have been patient, as you have been, again, I
apologize for the lateness, but your entire statements will be
in the record. Please feel free, if there are additional
remarks that you would like to bring before the Committee, we
would welcome them.
Mr. KRAMER. I am happy to answer any questions. Briefly, I
am Chair of the Oversight Board of the Jersey Pension System.
It is an $80 billion system. I think it is the ninth largest
pension fund in the United States.
In my private life, I manage a hedge fund, and therefore, I
benefit from the lower capital gains treatment, which I try to
get as much of as I can, on carried interest.
I am happy if you want during Q&A to go into the broader
philosophical issues, but I have been asked to address the
narrow question of whether higher tax rates for private equity
and hedge funds would be detrimental to public pension funds
and therefore to those retired teachers and police officers and
so forth.
Leaving aside the question of what the appropriate tax
treatment is and how we should think about capital gains versus
ordinary income, in simple terms, in competitive markets,
basically firms cannot automatically pass their costs on to
their customers, and it is actually no different in the money
management business than in any other business, whether it is
higher rents or higher costs of recruiting somebody away from
his firm, or higher taxes, whatever creates higher operating
costs.
The fees are essentially set by the market. There are some
firms that charge more than the standard 2 and 20. The firms
that charge more than the standard 2 and 20 do it because (a)
they want to and (b) there is some pool of investors for them
who say I think I am going to get a high enough return that it
is worth paying 3 and 40. I suspect there are more people who
would charge 3 and 40 if there were more investors who were
willing to pay 3 and 40.
If people get enamored of the returns, maybe someday
people, a lot of people, will be paying 3 and 40. If returns go
south, maybe someday people will be paying 1 and 10.
I think it is a function of market forces and not where you
set your tax rates. Actually, having worked in this city when
Chairman Rangel was already an important Member, when I was
working up the street 30 years ago, and actually back then, the
capital gains rates were higher. The marginal rates on the top
income earners were higher than they are today. Money managers
made much less money than they make today.
Today, we have much lower rates, marginal rates, my top
rate. We have lower rates on capital gains. We have this record
number of money managers who are charging fees that were
inconceivable when I last worked in this city.
Actually, if we look at history, we say there must be this
inverse relationship between the level of fees and the level of
tax rates because they have gone in the opposite directions,
but enough.
[The prepared statement of Mr. Kramer follows:]
Prepared Statement of Orin S. Kramer, Chairman, New Jersey State
Investment Council, New York, New York
My name is Orin Kramer. I am chair of the New Jersey State
Investment Council, which is the fiduciary board overseeing the state's
$80 billion public pension system. At last count, New Jersey was the
ninth largest public pension fund in the United States. In my private
life, I manage a hedge fund. I have served on the boards of various
financial services firms and on presidential commissions and task
forces. I have also been Executive Director of gubernatorial
commissions in California and New York, spent four years on the policy
staff of the Carter White House, taught at Columbia Law School, and
published a variety of policy studies. The views expressed here are
mine alone and should not be attributed to other members of the State
Investment Council.
I have been asked to address the question of whether higher tax
rates for private equity and hedge fund managers would be detrimental
to public pension funds and their beneficiaries. As I understand it,
the argument is that higher taxes are a cost which asset managers will
pass on to clients, thereby diminishing client returns.
Thirty years ago when I worked in this city, tax rates on high
income earners and capital gains were higher than today and fee levels
generated by the top money managers were lower than today. Now we have
lower marginal tax rates and an unprecedented number of people
generating record fees from money management. So from a purely
historical perspective, there seems to be an inverse relationship
between tax rates and the fees clients permit us to charge for managing
assets.
In my experience, private equity and hedge fund managers tend to be
highly sophisticated about business economics, and they know that firms
in competitive markets cannot automatically pass higher operating costs
on to customers. I would be reluctant to entrust capital to an
investment manager who did not share this view. Today the standard
compensation arrangement for private equity and hedge firms is a 2
percent management fee plus 20 percent of profits, or the incentive
fee. A small number of managers charge higher fees. They do so because
it is their choice, and because there exist for those managers pools of
investors who believe that their returns net of fees will justify the
higher payments. Since the capitalist instinct among money managers
appears to be robust, if asset managers believed that the institutional
investor community would accept fees above the 2/20 arrangement, I
suspect those fees would rise. But if asset managers choose to increase
their level of personal consumption, or if they incur higher operating
costs such as higher taxes, fees do not rise because the after-tax
savings of money managers diminishes. Fees rise when the return
expectations of limited partners increase, justifiably or not, to
levels which warrant higher fees.
I can imagine two scenarios where this analysis would be incorrect.
The first is that money managers operate under cartel-like industry
structural conditions which would create greater price elasticity. I
don't believe this is true. If it is true, there are other policy
implications. The second possibility is that public fund fiduciaries
are not financially sophisticated, and that they believe that fees
should be driven by the after-tax income of managers rather than risk-
adjusted expected returns. If we do live in a world where managers can
dictate fees in a manner disconnected from higher expected investor
returns, then arguably public funds will and do deserve to pay higher
fees.
AFTER 6:00 P.M.
Chairman RANGEL. Thank you. The Chair would now like to
recognize Jonathan Silver, Managing Director of Core Capital
Partners. Thank you for your patience.
STATEMENT OF JONATHAN SILVER, MANAGING DIRECTOR, CORE CAPITAL
PARTNERS
Mr. SILVER. My pleasure, Congressman. Thank you.
Mr. Chairman, Ranking Member McCrery and Members of the
Committee, my name is Jonathan Silver. I am the founder of Core
Capital Partners, a Washington, D.C. based venture capital fund
with about $350 million under management.
Core is a Member of the National Venture Capital
Association, and I am here today representing the 480 member
firms which together comprise about 90 percent of all the
venture capital under management in the United States.
Thank you for the opportunity to be part of today's
discussion. As part of your analysis, we believe it is
important to understand the unique and valuable contribution
venture capital investment makes to America's long-term
economic growth, why the venture community believes that the
current capital gains tax treatment on a venture fund's carried
interest is both correct and necessary, and how H.R. 2834, as
drafted, could damage the entrepreneurial ecosystem in the
United States.
Literally thousands of companies would not exist today were
it not for the venture capital support they received early on.
Federal Express, Starbuck's, Google, e-Bay, Genentech, Amgen,
and countless other companies were all at one time just ideas
that needed startup capital and guidance.
Last year, U.S. based venture capital companies accounted
for more than 10.4 million jobs and generated over $2.3
trillion in revenue. This represents nearly one out of every
ten private sector jobs and almost 18 percent of U.S. GDP.
What is particularly important is these are new jobs, and
in fact, often new industries. It was venture capital that made
the semiconductor industry possible. We also saw the commercial
possibilities of the Internet before others, and we jump
started the biotech industry.
Where will the next wave of new businesses come from? No
one knows. That is why venture capitalists look for
opportunities in all 50 states. It is why venture funds have
backed Music Nation in New York City, Incept Biosystems in Ann
Arbor, Michigan, Interface 21 in West Melbourne, Florida,
Boston Power in Westborough, Massachusetts, and Click Forensics
in San Antonio, Texas, as examples.
Simply put, these jobs did not exist before venture
capitalists started these companies. This is organic job
growth, not financial engineering. This is sweat equity on the
part of the entrepreneur and his or her backers, all working to
create something valuable out of nothing. No other asset class
shares this distinction.
The economic importance of these new companies cannot be
understated. They are a critical part of our National economic
engine. Over the last 5 years, the employment growth rate of
all U.S. based venture backed companies was more than two and a
half times that of non-venture backed companies.
In many important ways, we work exactly like the founders
and entrepreneurs we back. Our startup companies almost all
begin with an entrepreneur and a VC agreeing on an idea. There
is no strategic plan, no senior management team, no customers.
There is just our collective belief that the initial idea can
potentially be turned into a viable and profitable business.
The underlying technology is developed by the entrepreneur.
We get involved in building out the company. The combination of
their technical knowledge and our business knowledge is equally
responsible for the company's success.
We see no cash returns until the company we build together
goes public or is acquired. If we co-found the company, work
equally hard, and make intellectual contributions of equal
value, why should the founder's share of the sale of the
company be treated as a capital gain and ours viewed as
performance for service and ordinary income?
I believe it is important to understand that venture
capitalists are not just financiers. Along with the
entrepreneurs, we are really co-founders. Without our active
ongoing involvement, many of these companies fail or fail to
launch, and potentially important innovations remain in the
garage, incubator or lab.
As you have heard from earlier witnesses, venture firms are
generally structured as partnerships and usually receive the
right to receive 20 percent of the cumulative net profits of a
fund.
In order to be treated as a long-term capital gain, venture
capital carried interest must satisfy many requirements. It
cannot be guaranteed in any form.
If the venture capital fund loses money or just breaks
even, we do not receive any carried interest. Carried interest
must also be attributable to the sale of a capital asset that
has been held for over a year, making the payment very
different from the year end bonuses that look at performance
during a single year rather than over the long term.
Carried interest must also be attributable to the sale, as
an IPO or acquisition of a capital asset to a third party. This
is what makes carried interest different from other performance
based compensation, which takes money and value out of a
company's coffers. This is also what makes carried interest
different from a lawyer being paid on a contingency fee basis
or from an author being paid royalty income for a book or
sales. In those cases, the lawyer and the author did not give
up a capital asset to someone else.
Many venture capitalists supply tremendous effort and skill
in helping their companies grow and still never receive carried
interest compensation, but it is the possibility of earning
carried interest that is a primary incentive for the venture
capitalists to commit to the risky task of starting and funding
new companies, just as it is an important incentive to the
entrepreneurs to start those companies.
H.R. 2834 as written would change the venture capital
entrepreneur limited partner paradigm; specifically, there are
several ways in which the bill could result in fewer U.S.
companies receiving venture capital.
First, if the carried interest tax on the industry were
doubled, our ability to take financial risk will shrink.
Because we rely on the profits from our successful investments
to offset the losses on the companies that fail, an increase in
the tax rate requires funds to generate more successful company
exits; companies that are now fundable may no longer constitute
an acceptable risk, and would cease to attract venture
financing.
The net result is that venture funds will tend to favor
later stage companies in order to reduce the effort, risk and
time required to exit. Early stage companies will be harder to
start and to fund, hurting the lifeblood of the entrepreneurial
system.
Finally, you should expect that some venture capital
activity will move offshore. Many countries are actively
promoting venture capital activity through tax and regulatory
friendly environments in order to compete directly with the
United States. This is already happening.
A significant number of successful experienced venture
funds have shifted their focus to new funds in China and India
and are actively working there.
As you continue the examination of capital gains policy and
partnership tax law, we urge you to recognize the immensely
important contribution venture capital has made in promoting
investment and generating both job creation and economic
growth, and to consider the potential harm H.R. 2834 could
inflict.
By acknowledging that venture capital plays a special role
in the U.S. economy, you underscore our long national interest
in promoting innovation and job creation, and you re-affirm the
necessary and important role that risk taking has played
throughout our history.
Thank you.
[The prepared statement of Mr. Silver follows:]
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Chairman RANGEL. Thank you.
Next is Adam Ifshin, President of DLC Management
Corporation in my hometown in New York, Tarrytown. Thank you.
STATEMENT OF ADAM IFSHIN, PRESIDENT,
DLC MANAGEMENT CORPORATION
Mr. IFSHIN. Thank you, Chairman Rangel, Ranking Member
McCrery, Members of the Committee. My name is Adam Ifshin and I
am the co-founder and President of DLC Management Corporation,
an owner, developer and redeveloper of shopping centers
headquartered in Tarrytown, New York.
DLC specializes in revitalizing older shopping centers in
first tier suburbs, cities, and some small towns.
I am appearing today on behalf of the 70,000 members of the
International Council of Shopping Centers, the Real Estate
Roundtable, and other real estate organizations whose members
will be significantly impacted by proposals to tax the return
on all carried interest as ordinary income.
We understand and appreciate that H.R. 2834 is intended to
improve tax fairness and the income disparity gap. However, we
believe that H.R. 2834 is not the proper tax policy for real
estate and would not accomplish these goals.
We believe the legislation would hinder real estate
entrepreneurs at all levels and particularly those in earlier
phases of building their businesses.
Therefore, we urge Committee Members to proceed very
cautiously, as the real estate industry and the communities it
serves across the country have much at stake.
While current law is far from perfect, we believe that H.R.
2834 would result in the most sweeping and potentially most
significant tax increase on real estate since the retroactive
application of the passive loss rules in 1986.
I started DLC when I was 26 years old. Since starting with
nothing, my company has grown to become one of the nation's
preeminent owners and mid-sized operators of retail shopping
centers, with 72 such assets in 25 states.
Over the past 16 years, my firm has focused on rejuvenating
under served markets by investing hundreds of millions of
dollars in commercial real estate. DLC is dedicated to creating
value, primarily through the redevelopment of older distressed
properties in challenging environments, which often include
older suburbs and cities, such as Peekskill, New York,
properties like Levittown Mall in Tullytown, Pennsylvania, and
underserved rural and multi- ethnic city neighborhoods in
Carbondale, Illinois and inner city Baltimore, Maryland.
We re-invest most of our capital gains into new projects to
make long-term investments in communities that may not
otherwise see revitalization. I can unequivocally state that my
company as it exists today could not have been built if the
taxation on gains was at the ordinary income rates proposed by
H.R. 2834. The returns simply would not have justified the
risks.
The carried interest is the return on the entrepreneurial
risk that makes a project happen. Embedded in my business plan
and virtually every other real estate partnership over the last
several decades, is the concept that a material component of
the general partner's compensation will be capital gain.
Of course, that assumes there is long-term appreciation
that results in a capital gain. Many real estate developments
never get off the ground, still others fail or fall short of
their goals. In these cases, the general partner gets nothing
and frequently loses money. Most real estate projects take 5 to
10 years to fully mature from concept to stabilization. This
long-term investment is risky and the returns have to justify
that risk.
If H.R. 2834 were to be enacted, returns would go down as
the tax burden goes up. Some development would certainly still
occur, but the material shift in the risk/reward tradeoff for
the developer/operator would mean that fewer projects would be
built. Those that would be built would tend to be high end
developments in wealthy communities and central business
districts where there tends to be less risk.
What H.R. 2834 proposes for real estate makes under served
and given up for dead locations far less appealing to
developers. Those projects are harder to put together and
generally entail much greater risks. The net result will be to
cause the greatest harm to those communities that need
development and revitalization the most, communities where we
have done work, like Newburg, New York, Spring Valley, New
York, and the west side of Baltimore City, where there is a
fundamental lack of shopping alternatives for predominately
minority consumers.
A lack of retail options leads to higher prices for basic
commodities like milk and bread for those people who can least
afford to pay.
In the context of real estate, H.R. 2834 is based on a
flawed premise, the notion that a carried interest is a proxy
for a fee, particularly a fee for investor money management.
The real estate general partner is a manager and developer of
an asset, not a money manager.
Properties require intensive work. You cannot just buy them
and do nothing and sell them years later. A carried interest is
not granted for typically routine services like leasing and
property management, but for the value the general partner will
create beyond routine services. It is granted for bringing the
deal.
It is for committing to the venture alongside the investors
in something that will be highly illiquid. It is granted
because the general partner is subordinating his return to that
of his limited partners.
The carried interest is also granted in recognition of the
risk exposure that a general partner has in a venture.
Typically, a general partner is responsible for all partnership
liabilities such as environmental contamination, lawsuits, and
often explicit guarantees, matters such as construction
completion, operating deficits, and a mortgage on those
properties.
In the case of development, a carried interest recognizes
development risks and opportunity costs borne by the real
estate entrepreneur, both before and after the admission of the
financial partner.
Bottom line, we are asset managers of hard assets, not
money managers.
In conclusion, almost one-half of all partnership tax
returns are filed by real estate entrepreneurs. Over $1
trillion in equity is invested in real estate through
partnerships leveraged on another 30 to 40 percent.
At the end of the day, this is not a Wall Street issue; it
is a Main Street issue. At stake are job creation, economic
development, and revitalization of communities across the
country.
Thank you for holding this hearing and for giving me the
opportunity to testify. I welcome all of your questions.
[The prepared statement of Mr. Ifshin follows:]
Prepared Statement of Adam Ifshin, President, DLC Management Corp.,
Tarrytown, New York
Thank you, Chairman Rangel and Ranking Member McCrery for
conducting today's hearing on potential changes to the tax treatment of
partnership ``carried interest.''
My name is Adam Ifshin and I am the incoming chairman of the
International Council of Shopping Centers' economic policy committee
and the co-founder and president of DLC Management Corporation, an
owner, developer, and re-developer of shopping centers, headquartered
in Tarrytown, NY. DLC specializes in revitalizing older properties in
in-fill first tier suburbs, cities and some small towns.
I am appearing today on behalf of the ICSC, the Real Estate
Roundtable, and other real estate organizations listed whose members
will be significantly impacted by proposals to tax all carried interest
as ordinary income.
We understand and appreciate that H.R. 2834 is intended to improve
tax fairness and the income disparity gap. These are issues that
warrant serious attention. However, we believe that H.R 2834 is not the
proper tax policy for real estate and would not accomplish these goals.
We believe the legislation would hinder real estate entrepreneurs at
all levels and particularly those in the earlier phases of building
their businesses.
Therefore, we urge Committee Members to proceed very cautiously, as
the real estate industry and the communities it serves across the
country have much at stake. While current law is far from perfect, we
believe H.R. 2834 would result in the most sweeping and potentially
most significant tax increase on real estate owners since the enactment
of the passive loss rules of the 1986 Tax Reform Act. The application
of those rules, particularly to existing real estate investments,
triggered unintended consequences, namely the savings and loan
collapse, a credit crunch that caused a major downturn in the real
estate industry and cost taxpayers billions of dollars. H.R. 2834's
effect on entrepreneurial risk taking--especially of those whose
efforts most directly impact Main Street--would cause unintended
consequences that would ripple through the economy.
History of DLC Management
I started DLC Management when I was twenty-six years old. The
commercial real estate industry was struggling to overcome the damage
caused by the savings and loan crisis and the 1986 Tax Reform Act.
Since starting from the ground floor, my company has grown to become
one of the nation's preeminent owners and medium-size operators of
retail shopping centers with 72 centers located across 25 states. Over
the past 16 years, DLC has created value in underserved markets by
investing hundreds of millions of dollars in commercial real estate.
DLC focuses on the redevelopment of older distressed properties in
challenging environments, which often include older in-fill suburbs and
cities such as Peekskill, NY, environmentally challenged brownfield
properties like Levittown Mall in Tullytown, PA, and underserved rural
or multi-ethnic city neighborhoods like Carbondale, IL, and inner city
Baltimore, MD.
We reinvest most of our capital gains into new projects in order to
continue to make long-term investments in communities that might not
otherwise see revitalization. And I can unequivocally state that my
company as it exists today could not have been built if the taxation on
gains was at the ordinary income rates proposed by H.R. 2834. The
returns simply would not have justified the risk in many cases.
Discussion of the Carried Interest Structure
A carried interest is the return on the entrepreneurial risk that
makes the deal or project happen. Embedded in the DLC business plan,
and virtually every real estate partnership of the last several
decades, is the concept that a material component of the compensation
to the general partner is capital gain. Of course, that assumes there
is a capital gain in the end. Many real estate developments never get
off the ground. Still others fail or fall short of their goals. In all
these cases, the general partner gets nothing other than fees.
For years, many real estate transactions have been structured as
limited partnerships. In a typical limited partnership, there will be
one or more financial investors as the limited partners and an operator
or developer, serving as the general partner. The general partner
brings a combination of intangible assets, assumption of significant
risk, and intellectual capital as part of arranging and operating the
venture. In exchange, the general partner receives a share of future
partnership profits, typically after the limited partners receive a
minimum compounded preferred return generally in the range of 8-12
percent per annum and their initial equity back. The general partner's
profits are a pre-determined percentage of the residual profits that is
arrived at after the limited partners have attained their required
minimum return on the investment.
In addition to this subordinated carried interest, the general
partner typically has two other economic interests in the partnership.
The general partner or a related entity receives a non-profit based
management fee for performing day-to-day property management services.
This is taxed as ordinary income. The general partner typically also
invests capital, side by side with the investor, commonly 1-10 percent
of the total capital in the partnership. This is structured as a
limited partner interest.
What the Carried Interest Represents to the General Partner and
Investors
The industry has long favored this carried interest format because
it pairs the experience and early stage risk-taking of the real estate
developer/businessperson with the capital of the financial partner in a
flexible structure that best matches risks and rewards for both
parties. Moreover, it has survived five decades of tax legislation
including numerous overhauls of the Federal tax law relating to both
partnerships and real estate.
In the context of real estate, H.R. 2834 is based on a flawed
premise--the notion that a carried interest is a proxy for a fee--
specifically a fee for investor money management services. The real
estate general partner is a manager of an asset. Buildings require an
intensive amount of owner attention. You cannot just buy them and do
nothing until you sell years later. They require substantial amounts of
capital and management from development or acquisition through
disposition to be productive assets.
Why do the limited partners grant the general partner a carried
interest? A carried interest is granted not for routine services like
leasing and property management, but for the value it will add to the
venture beyond routine services. It is granted for the general partner
bringing the investors the ``deal.'' It's for committing to a venture
alongside the investors that will be highly illiquid. It is granted
because the general partner is subordinating his return to that of the
limited partners. It is for the general partner's business acumen,
experience and relationships. Knowing when to buy, how much to pay,
whether to expand or renovate, when to sell and to whom. This is the
``capital'' the general partner invests in the partnership.
The carried interest is also granted in recognition of the risk
exposure the general partner has in the venture. This exposure is often
far greater than the money it contributed. Typically, a general partner
is responsible for all partnership liabilities such as environmental
contamination and lawsuits, and often explicitly guarantees matters
such as construction completion, operating deficits and debt. In the
case of development, a carried interest recognizes development risks
and opportunity costs borne by the real estate entrepreneur, both
before and after admission of the financial partner.
Primary among these risks is the risk that governmental approvals
will not be obtained or, even if obtained, will not be timely or
achieved within budget. Besides zoning and development plan approvals,
such approvals include specialized permits such as those for wetlands,
sewer, and roadway-related matters. Approvals typically take years and
can cost hundreds of thousands, even millions of dollars, for a single
project. They represent a unique risk of the developer because
financial partners normally will not commit until all or most of such
approvals are obtained.
After the financial partner is admitted, the developer bears risks
disproportionate to its capital contributions because at a minimum it
alone guarantees that the building will be completed on time and within
budget. It takes considerable business acumen, experience and skill to
manage major building construction. Design changes, tenant change
orders, labor or material cost increases and schedule delays must be
managed against pre-determined budget and reserve amounts, or the
general partner will be left responsible for cost overruns.
Acquisition of existing properties also presents some of these same
development risks although on a lesser scale. Most acquisitions of
existing buildings are made with the plan to put additional capital
into building improvements. This is because many buildings are sold
with deferred maintenance obligations or at a time in the ownership
cycle when new capital infusion is needed to keep the building updated
and optimally marketable. These improvements may be in the form of
expansion or renovation of varying scale. The amount of capital added
will depend on the age and condition of the building, market demand and
what amount and type of investment the owners believe will maximize the
return on investment. Again, the general partner must manage this
capital investment wisely or bear the risk of cost overages.
Development and property management services are explicitly
compensated through fees negotiated at arm's length between the real
estate entrepreneur and the financial partner. As in other markets,
such negotiations are driven by industry practice and the size of the
project. Beyond the discipline of market forces in setting such fees,
the ``disguised fee'' rules of Section 707 of the Internal Revenue Code
have since 1984 precluded using partnership distributions as a proxy
for fees to the developer (or any other partner). Thus a developer's
carried interest represents not compensation for services but
recognition of the considerable development risk taken, the substantial
opportunity cost involved in pursuing a particular project and putting
one's balance sheet at risk to it, and the value added to the venture
from directly aligning the interests of the developer and the financial
partner. The general partner also can be at risk for recourse loans and
environmental indemnities for all loans.
H.R. 2834 Discriminates Against Partnership Form--Founders Stock
Analogy
H.R. 2834 discriminates against the partnership form. Under the
bill, if an entrepreneur managed a partnership venture and received a
carried interest, the return paid on the carried interest would be
ordinary income. However, if instead of taking in a capital partner, he
is able to borrow the capital from a bank and operates as a sole
proprietor, capital gain treatment would be allowed on the carried
interest return. The entrepreneur is conducting the same activity in
both scenarios yet the bill would result in different tax treatment.
The corollary in the corporate world is seen in companies such as
Google and Microsoft where the founders took the earliest (and
greatest) risk in launching the enterprise and were later joined by
financial partners who purchase preferred stock for a much larger
capital contribution per share than that made by the founders. Neither
Congress nor Treasury questions the wisdom or fairness of affording
capital gains treatment to such founders when they ultimately sell
their stock. The same logic should apply to a partnership between the
``founder'' of a real estate project and its subsequent financial
backer.
H.R. 2834 Would Encourage Use of Debt over Equity
H.R. 2834 would have the effect of favoring debt over equity.
Partnerships with equity contributions would be subject to the bill's
tax increase while loan arrangements would not. So, taxpayers would be
encouraged to structure a transaction as a loan from the investor to
the entrepreneur instead of forming a partnership with the investors
making an equity contribution. Encouraging debt over equity is not good
policy generally and certainly is not good policy in the current credit
and liquidity climate. The world financial markets have been roiled by
their exposure to an abundance (perhaps overabundance) of lending from
subprime mortgages to commercial conduit financing. Mortgage backed
securities are suffering steep declines in values. We will soon see how
strong or fragile these markets are. Nevertheless, this does not appear
the time to impose a tax that would affect the value of the real estate
collateralizing a significant portion of the debt market.
DLC Achievements Using the Carried Interest
Following are some illustrations of DLC's achievements of bringing
national retailers and new life into towns and properties time long
forgot--these deals were all done in a partnership format with carried
interest taxed at the capital gains rate. If current law is changed to
tax carried interest at the ordinary income rate, then the investment
viability of projects like these could be brought into question--and
eventually a disruption in the real estate marketplace could take
place.
Spring Valley, NY--DLC brought Target, Bed, Bath and
Beyond, Michaels Arts and Crafts, T.J. Maxx, 9 West and other
recognized retailers to a 70 percent vacant center in a market that is
50 percent African-American and 30 percent Latino. Most of the retail
had moved out to an upscale mall three miles away, yet through our
efforts, the center is now 100 percent occupied. During this project,
550 construction jobs were created; 650 retail jobs added. DLC paid
over $30 million for the center and has spent $12 million in
investments, the largest private sector investment in Spring Valley in
the past 20 years.
Peekskill, NY--DLC totally re-developed a 1950's shopping
center where the supermarket anchor and the junior anchor had both gone
bankrupt. We brought the first new full service grocery store, a Stop &
Shop, to this predominantly minority community in 20 years. Other
national tenants include a CVS, Dunkin' Donuts, Dollar Tree and Tuesday
Morning. The project produced 600 new construction jobs and 400-450
permanent retail jobs. Our development was 100 percent privately funded
and over four years in the making. DLC paid $14 million for the site
and invested $19 million thereafter to redevelop it.
Oxon Hill, MD--DLC acquired two underperforming grocery
anchored shopping centers in an African-American community. We fully
expanded and renovated one center and brought to 100 percent occupancy,
featuring retailers such as Shoppers Food Warehouse, A.J. Wright and
Advanced Auto. The rejuvenation of the second center is now underway
with new facades, new national tenants and the Giant grocer is
renovating and expanding.
Levittown, PA--DLC tore down an obsolete 1950's open air
mall. This project required major environmental brownfields remediation
to address more than one million square feet of asbestos-containing
material and 67 underground fuel tanks. Now there is a new center being
built featuring a Home Depot, Wal-Mart Supercenter, Ross Dress for
Less, Starbucks, Wachovia, Famous Footwear, Dress Barn, Day Care Center
and others. Over 1,000 construction jobs have been created and 1,000
retail jobs. DLC bought the property for $9.5 million and will invest
$60 million total, without any public subsidy. This center will be the
largest commercial taxpayer in the borough.
Impact of H.R. 2834 on Real Estate
Most real estate projects are not short term in nature. Projects
frequently take 5-10 years to fully mature from concept to
entitlements, to construction, to lease up, and stabilization. If H.R.
2834 were to pass the Congress some development would still occur, but
the material shift in the risk/reward trade-off for the developer would
mean that fewer projects would be built. Those that would be built
would tend to be higher-end, fancier developments in wealthy
communities and central business districts where there is less risk.
What H.R. 2834 proposes makes underserved and given-up-for-dead
locations, like those described above, far less appealing to developers
because those deals are harder to put together and have greater risk
associated with doing them. The net result will be to cause the
greatest harm to those communities that need development and
revitalization the most--communities like Newburgh, NY, Spring Valley,
NY, and the West Side of Baltimore, where there is a fundamental lack
of shopping alternatives for predominantly minority consumers. A lack
of retail options leads to higher prices for basic commodities like
milk and bread for those people who can least afford to pay.
Community leaders where we do business fully understand and
appreciate the benefits our development brings to their citizens--more
consumer choices at less cost, job opportunities, both at the
construction phase and thereafter, an increased tax base and improved
quality of life.
I should add at this point that while my business is in the retail
shopping sector, the use and importance of the carried interest is the
same for all types of real estate--apartments, office and industrial.
Examples of retail projects I've cited in this testimony could just as
easily be affordable apartment complexes or mixed-use projects that
combine residential, retail and office elements. The same
entrepreneurial risk is involved, similar investment duration and
similar subordination of the general partner's return to the investors'
return.
Effect on Tax Fairness and Income Disparity
Finally, it is often mentioned that H.R. 2834 is a matter of tax
fairness. The question is rhetorically asked, ``Why should a wealthy
Wall Street investment manager be allowed to pay at tax at a rate less
than his or her assistant?'' I acknowledge that there are significant
issues of tax fairness in the Tax Code and income disparity in the
country and the industry applauds Congress for addressing these issues.
However, I don't think the analogy is as simple or as accurate as it
first sounds. First, an executive assistant's effective tax rate is not
likely to be 35 percent. Because of the progressivity in our tax system
and the variety of exemptions or deductions that exist, it's likely the
assistant's effective tax rate is substantially less than 35 percent.
Nevertheless, and more importantly, we don't believe H.R. 2834 would be
an effective tool in addressing these issues and, in fact, would have a
counterproductive effect.
The most successful real estate managers, whether they are in real
estate or other industries, would be able to pass the increased tax
cost onto investors. These investors would have to accept this cost
shifting (at least most of it) if they want their capital invested by
the most successful real estate owner/operators. Alternatively, these
real estate managers will be able to use their resources to re-
structure their transactions to avoid the tax altogether.
Those entrepreneurs that are trying to develop their business and
are scraping and competing for capital, will not have the negotiating
leverage to pass on the increased tax to their investors. Neither would
many have the resources to re-structure transactions from the long
accepted partnership/carried interest structure. As a result, it is the
entrepreneurs at this end of the entrepreneurial spectrum that most
likely will bear the brunt of H.R. 2834's proposed tax increase. That
outcome will not promote tax fairness or mitigate income disparity.
H.R. 2834 would result in tax favored capital gain treatment being
limited to those taxpayers that have the money to invest in real
estate. Those that don't have the money to invest, but are willing to
take risk and invest sweat equity, would not be allowed favored tax
treatment. Current law allows a more balanced result and I encourage
Members of the Committee to consider this carefully as they move ahead.
Effective Date
H.R. 2834 does not have an effective date. As the passive loss
rules demonstrated 20 years ago, applying tax increases to existing
investment partnerships is effectively retroactive application. The
resulting disruption could be as dramatic as we saw in 1986. The
passive loss rules helped trigger the savings and loan crises and
billions of dollars in lost real estate value. Therefore, any
modification to the carried interest rules as they apply to real estate
should apply only to partnerships entered into on a going forward basis
and not existing partnerships.
Conclusion
According to IRS statistics, in 2005, 46 percent of partnership tax
returns came from the real estate industry. Over $1 trillion in equity
is invested in real estate through partnerships leveraged on average
another $300-$400 billion in loans. Therefore, a major change in
partnership tax rules, such as that proposed by H.R. 2834, would have a
tremendous impact to the real estate industry--a significant economic
driver in our nation's economy. At the end of the day, this is not a
Wall Street issue--it's a Main Street issue. At stake are job creation,
economic development, and revitalization of communities across the
country.
Chairman Rangel and Ranking Member McCrery, thank you for holding
this hearing and for giving me the opportunity to testify. We look
forward to working with you as you continue to examine this matter.
Real Estate Trade Association Members of The Real Estate
Roundtable:
National Association of Real Estate Investment Trusts
National Association of Realtors
National Association of Homebuilders
National Association of Real Estate Investment Managers
National Multi-Housing Council
National Association of Industrial and Office Properties
Pension Real Estate Association
Mortgage Bankers Association of America
International Council of Shopping Centers
Commercial Mortgage Securities Association
Building Owners and Managers Association International American
Hotel & Lodging Association
American Resort Development Association
Association of Foreign Investors in Real Estate
Urban Land Institute
APPENDIX A
FACTS ABOUT THE REAL ESTATE INDUSTRY
The following facts illustrate the overall contribution real estate
makes to communities and the economy:
Real estate is a vital part of our national economy
contributing, over $2.9 trillion or one third of the Gross Domestic
Product. Real estate asset values, residential and commercial, total
nearly $20 trillion. Real estate creates jobs for over 9 million
Americans--and these are not ``off-shored.''
America's real estate is the source for nearly 70 percent
of local tax revenues, which pay for schools, roads, police and other
essential public services.
U.S. commercial real estate is worth approximately $5
trillion.
Private investments in commercial real estate done
largely through partnerships have a total equity of over $1 trillion.
America's 50,000 shopping centers account for over $2.25
trillion in sales and generate over $120 billion in state sales taxes.
Multifamily construction starts in 2006 totaled 338,000
housing units for a total of $50 billion of housing investment. Housing
services for rental apartments totaled $263 billion in 2005.
Housing accounts for 32 percent of household wealth.
Total single-family (owner occupied) housing is worth approximately $15
trillion, with homeowners' equity valued at around $8 trillion.
Publicly traded real estate investment trusts (REITs)
have a total equity market capitalization of $355 billion.
Real estate partnerships make up the second largest share
of partnerships, measured in total assets, but represent the largest
share of both partnerships (1.2 million) and partners (6.6 million
people).
Real estate partnerships are responsible for investing
$2.6 trillion in assets. 59.9 percent of their income comes from long-
term capital gains; 40.1 percent is taxed at ordinary income tax rates.
Chairman RANGEL. The Chair recognizes the testimony of
Bruce Rosenblum, Managing Director of the well known Carlyle
Group and Chairman of the Board of Private Equity Council.
STATEMENT OF BRUCE ROSENBLUM, MANAGING DIRECTOR, THE CARLYLE
GROUP, AND CHAIRMAN OF THE BOARD, PRIVATE EQUITY COUNCIL
Mr. ROSENBLUM. Thank you, Chairman Rangel, Ranking Member
McCrery, and Members of the Committee.
I am pleased to appear before you today on behalf of the
Private Equity Council to present our views on the taxation of
carried interest for partnerships.
First, a few points about the private equity industry. It
is not just large firms like Carlyle. It includes hundreds of
firms, large and small, located in all parts of the United
States. Even the largest firms today were small businesses as
recently as 15 or 20 years ago, and they are still owned in
significant part by their founders.
Over the years, numerous companies, including household
names such as Auto Zone, J-Crew and Dunkin Donuts, have been
turned around or improved by the focused strategies that
characterize private equity investment, and private equity has
been extremely profitable for its limited partner investors,
comprised in significant part of pension funds, universities
and foundations.
Private equity activity is driven by firms known as
sponsors that establish private equity partnerships or funds.
The sponsor serves as the general partner of the fund, sets the
fund's strategy and makes the initial capital commitment to the
fund.
The sponsor raises additional capital from third party
limited partners, and the respective ownership rights of the
sponsor and these limited partners are established at the
inception of the fund.
Typically, the sponsor's ownership rights include a so-
called carried interest. Partnership structures using carried
interest are pervasive across many business sectors, not only
in private equity and venture capital partnerships, but also in
real estate, timber, oil and gas, small business, and family
partnerships. They have been used for many years and their tax
treatment is well settled.
Equally well settled are the principles defining capital
gains, and it could not be more clear that private equity
activity is at the core of the capital gains definition: owning
and growing the value of businesses.
While private equity firms also receive many types of
income that are not capital gains, such as fees, rents and
interest, it can hardly be disputed that the profits from the
sale of a business that is owned and improved over many years
is a capital gain.
What are the arguments in favor of changing this well
settled tax treatment? The ones I have heard rest on
fundamental misunderstandings about private equity ownership
and the nature of capital gains.
For example, the premise of H.R. 2834 seems to be that
capital gains allocated to private equity sponsors should not
be respected as such because these sponsors provide services to
the funds they establish, or because they receive profits
disproportionate to their invested capital.
But capital gains treatment has never depended on the
amount or proportionality of capital provided by one investor
as compared to another, nor is it denied to an investor whose
efforts, as well as capital, drive an investment's
profitability.
The proprietors of a small business may invest very little
capital and may generate most of their ownership value through
personal efforts, but when they sell their business, their
profit is a capital gain.
The founder of the technology company receives capital
gains from the sale of a stock interest even if he or she
contributed only a tiny fraction of the company's capital.
We also hear that owners of carried interest bear no risk.
In truth, private equity sponsors bear many types of risks. For
starters, private equity partners contribute substantial
capital to their funds. While this capital may represent only 5
or 6 percent of a fund's total capital, it usually represents a
very high percentage of these partners' net worth.
Private equity general partners also have residual
liability for obligations of the partnership, and like other
entrepreneurs, private equity sponsors bear the risk that years
of effort and foregone opportunities will not result in any
significant value for their ownership interest.
Finally, some allege that the current law is inconsistent
with tax fairness. But the taxation of carried interest
ownership is fair when understood as part of a tax system which
for many good reasons taxes long term capital gains at a lower
rate than the highest marginal ordinary income rates.
As long as one believes that a lower long term capital
gains rate is sound policy, there is no inequity in the current
taxation regime. Indeed, what fairness requires is that the Tax
Code not single out certain investors or certain types of
partnerships for less favorable treatment.
The changes that have been proposed will have economic
consequences. I do not suggest that private equity investment
will disappear, but it is reasonable to assume that a dramatic
tax increase will have a negative impact on private equity and
other forms of investment, particularly in a fragile market
environment.
In addition, the proposed tax increase could lead to lower
returns for pension funds and other investors. It could make
U.S. private equity firms less competitive with foreign firms
and foreign governments, and it could drive the center of
gravity of private equity investing overseas.
I do not believe these economic risks are justified by
whatever modest revenue would be raised by the proposals.
Thank you again for the opportunity to present our views,
and I would be happy to answer any questions.
[The prepared statement of Mr. Rosenblum follows:]
Prepared Statement of Bruce Rosenblum, Managing Director, The Carlyle
Group, and Chairman of the Board, Private Equity Council
Mr. Chairman and Members of the Committee, I am pleased to appear
before you today on behalf of the Private Equity Council to present our
views on the taxation of carried interest for partnerships. I am a
partner and managing director of The Carlyle Group, one of the world's
largest private equity investment firms, which originates and manages
funds focused across four major investment areas: buyout; venture and
growth capital; real estate; and leveraged finance. I also serve as the
Chairman of the Board of the Private Equity Council, a relatively new
organization comprising 11 of the leading private equity investment
firms doing business in the United States.\1\ The PEC was formed to
foster a better understanding about the positive contributions private
equity investment firms make to the U.S. economy.
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\1\ The members of the Private Equity Council are Apax Partners,
Apollo Management LP, Bain Capital, The Blackstone Group, The Carlyle
Group, Kohlberg Kravis & Roberts & Co., Hellman & Friedman LLC, THL
Partners, Providence Equity Partners, Silver Lake Partners, and TPG.
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The Face Of Private Equity
Before addressing the carried interest tax issue, I think it is
important to describe private equity investment. Some have a perception
that private equity investment is an esoteric form of ``black box''
finance practiced by a small cadre of sophisticated investors. The
truth is that private equity investment is about numerous
entrepreneurial firms, large and small, located in all parts of the
United States, that are integral to capital formation and liquidity in
this country. Some, like Carlyle, do multi-billion dollar transactions;
others may do transactions of $5 million or less, locally or
regionally; and, in recent years, spurred by programs like the new
markets tax credit and empowerment zones, a new cadre of entrepreneurs
have turned to private equity finance to make capital investments in
underserved urban and rural communities. Private equity investment is
also about benefits provided to tens of millions of Americans through
enhanced investment returns delivered to pensions, endowments,
foundations and other private equity investors. And private equity
investment is about thousands of thriving companies contributing to the
U.S. economy in many positive ways. When you buy coffee in the morning
at Dunkin' Donuts, see a movie produced by MGM Studios, or shop at Toys
R Us, J. Crew, Petco, or Auto Zone, to name just a few, you are
interacting with private equity companies.
Private Equity Investors
Private equity (PE) investment is driven by private equity firms--
known as general partners (GPs) or ``sponsors''--which establish a
venture in partnership form (typically referred to as a ``fund''). The
sponsor invests its own capital in the fund, and raises capital from
third-party investors who become limited partners (LPs) in the fund.
The sponsor uses the partnership's capital, along with funds borrowed
from banks and other lenders, to buy or invest in companies that it
believes could be significantly more successful with the right infusion
of capital, talent and strategy.
Private equity has been extremely profitable for the LP investors
who receive most of the profits generated by PE funds. Over the 25
years from 1980 to 2005, the top-quartile private equity investment
firms generated per annum returns to LP investors of 39.1 percent (net
of all fees and expenses). By contrast, the S&P 500 returned 12.3
percent per annum over the same period. This suggests that $1,000
continuously invested in the top-quartile PE firms during this period
would have created $3.8 million in value by 2005. The same amount
invested in the public markets would have increased to $18,200. Private
Equity Intelligence reports that between 1991-2006, private equity
funds distributed $430 billion in profits to their LPs. Clearly, top PE
funds have been exceptional investments over the past quarter century,
a major reason we are able to continue to attract capital from LPs.
The largest category of investors benefiting from these exceptional
returns have been public and private pension funds, leading public and
private universities, and major foundations that underwrite worthy
causes in communities across the country. The 20 largest public pension
funds for which data is available \2\ currently have some $111 billion
invested in private equity on behalf of 10.5 million beneficiaries.
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\2\ California Public Employees Retirement System, the California
State Teachers Retirement System, New York State Common Retirement
Fund, Florida State Board of Administration, New York City Retirement
System, Teacher Retirement System of Texas, New York City Teachers
Retirement System, New York State Teachers Retirement System, State of
Wisconsin Investment Board, New Jersey State Investment Council,
Washington State Investment Board, Regents of the University of
California, Ohio Public Employees Retirement System, Oregon State
Treasury, State Teachers Retirement System of Ohio, Oregon Public
Employees Retirement Fund, Pennsylvania Public School Employees
Retirement System, Michigan Department of Treasury, Virginia Retirement
System, Minnesota State Board of Investment.
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Let me give you a concrete example of what these numbers mean to
real people. The Washington State Investment Board, which is
responsible for more than $75 billion in assets in 16 separate
retirement funds that benefit more than 440,000 public employees,
teachers, school employees, law enforcement officers, firefighters and
judges, has been a major private equity investor for 25 years. In that
time, the WSIB has realized profits on its private equity investments
of $9.71 billion. Annual returns on private equity investments made by
the board since 1981 have averaged 15 percent, compared to 10.1 percent
for the S&P 500. Put another way, the excess returns generated by
private equity investments have fully funded retirement plans for
10,000 WSIB retirees.
Other clear benefits of private equity investment include
strengthened university endowments better able to extend financial aid
and create greater educational opportunities for students in virtually
every state in the country, and strengthened foundations better able to
carry out their social and scientific missions.
Private Equity In Practice
The best way to understand private equity ownership is to see it in
practice. The PEC has been developing a series of case studies
documenting the ways private equity firms grow companies and make them
more competitive. I want to share three concrete examples from
Carlyle's experience.
In 2005, we acquired a company called AxleTech International
Holdings, Inc., which designs and manufactures drivetrain components
for growing end markets in the military, construction, material
handling, agriculture and other commercial sectors. AxleTech was a
solid business, but it was focused on the low margin, low growth
commercial segment of the market. Under Carlyle's strategic direction,
AxleTech developed a concerted business development initiative to offer
its axle and suspension solutions to military vehicle manufacturers in
need of heavier drivetrain equipment to support the heavy armored
vehicles required to protect American soldiers in Iraq and Afghanistan.
At the same time, AxleTech expanded its product and service offerings
in its high margin replacement parts business while continuing to grow
its traditional commercial business. The result is that since Carlyle's
acquisition, AxleTech sales have increased 16 percent annually and
employment has increased by 34 percent from 425 to 568, with new jobs
created in AxleTech's facilities in Troy, MI, Oshkosh, WI, and
overseas. Indeed, it is one of the very few U.S. automotive-related
companies that are growing in this challenging environment for the
industry. And AxleTech's job growth does not take into account the
ripple effects on AxleTech's suppliers which are experiencing new
hiring and increased capital investments.
In 2002, we acquired Rexnord Corporation, a Milwaukee-based
provider of power transmission, bearing, aerospace, and specialty
components. While healthy, it was a neglected division of a large
British conglomerate. After being acquired by Carlyle and its partners,
the company refocused its business on lines with the strongest growth
prospects, took steps to improve product quality, inventory management,
procurement and customer delivery, made key strategic acquisitions, and
developed a plan to expand business in the growing China market. Under
Carlyle's ownership, total revenues rose from $722 million in 2003 to
$1.08 billion in 2006 and enterprise value doubled from $913 million to
$1.8 billion.
Finally, Bain Capital, THL Partners and Carlyle bought Dunkin'
Brands (Dunkin' Donuts and Baskin-Robbins ice cream shops) in 2006 from
a European beverage conglomerate which gave the business low priority
and minimal attention. Under private equity ownership, investing in
long-term growth is a key business strategy. Jon Luther, CEO of Dunkin'
Brands, recently told the U.S. House of Representatives Financial
Services Committee, ``The benefits of our new ownership to our company
have been enormous. Their financial expertise led to a ground-breaking
securitization deal that resulted in very favorable financing at
favorable interest rates. This has enabled us to make significant
investments in our infrastructure and our growth initiatives. . . .
They have opened the door to opportunities that were previously beyond
our reach.'' Today, Dunkin' Brands is expanding west of the
Mississippi, and is on track to establish franchises that will create
250,000 new jobs--with the further benefit of creating a new class of
small business entrepreneurs for whom owning multiple Dunkin' Donuts
franchises is a way to achieve personal financial security and success.
Understanding Private Equity Partnerships
In order to understand the issues relating to the taxation of
``carried interest,'' it is helpful to review the structure of private
equity partnerships, how they are formed and owned, and how they
operate.
As noted above, private equity investment is typically conducted
through a private equity partnership, or ``fund.'' The fund is formed
by a private equity firm, or ``sponsor,'' which is itself typically a
partnership comprised of the founders and other individual owners of
the private equity firm. Typically, the sponsor (or one of its
affiliates) serves as the GP of the fund and charges an annual
management fee to the fund that ranges from one to two percent of the
assets under management. In addition, the sponsor (often through
contributions by its individual owners) invests its own capital in the
fund, which generally constitutes between 3-10 percent of the
partnership's overall investment capital.
A fund's partnership agreement establishes the parties' respective
ownership rights and responsibilities from the inception of the fund.
Most PE funds are designed to ensure the investors' right to receive a
return of their capital and a minimum level of profit before the
sponsor receives any so-called ``carried interest.'' Thus, under a
typical arrangement, when a PE fund sells assets at a profit, the
investors are entitled first to their capital back, plus an additional
eight to nine percent per annum return on their capital (a so-called
``hurdle'' rate), as well as reimbursement for any fees paid to the
sponsor or its affiliates. Any proceeds remaining after the hurdle is
cleared and fees are reimbursed are distributed in accordance with the
partnership agreement, typically 80 percent to the investors and 20
percent to the sponsor. This allocation of profits to the sponsor is
commonly referred to as a ``carried interest.''
The carried interest is also typically subject to a ``clawback''
provision that requires the PE firm (and, thus, the individual partners
of that firm) to return distributions to the extent of any subsequent
losses in other investments of the fund, so that the sponsor never ends
up with more than its designated portion (e.g., 20 percent) of profits.
If the fund generates losses on some investments, the sponsor shares in
the downside because any profits from its carry on successful
investments are offset by the deals gone sour. If enough deals in a
fund do poorly, the sponsor could be left with no carry at all. Thus,
the sponsor's retention of a carried interest in its funds effectively
acts as both a risk-sharing mechanism and as an incentive to find the
right companies in which to invest, to use its entrepreneurial skills
to improve those companies, and ultimately to deliver outstanding
returns for LP investors.
Despite the impression you might have, not all profits realized by
a private equity sponsor from a fund are taxed at long-term capital
gains rates. Those profits may include many elements taxed at higher
rates, including rent taxed as ordinary income, interest taxed as
ordinary income, and, on occasion, short-term capital gains. The
sponsor (like any other partner of a partnership) is taxed on its
allocated share of profits based on the underlying character of the
income produced at the partnership level. It is only the allocation of
what is indisputably long-term capital gains income--the profits from
the appreciation in value of long-lived capital assets, such as the
stock of a corporation--that is taxed at ``differential'' capital gains
rates. However, since the core objective of a private equity firm is to
acquire businesses, improve their value over the course of many years,
and ultimately sell them for a profit, it is typically the case that a
large portion of the profits generated by a private equity fund are, in
fact, long-term capital gains.
Private Equity Tax Issues
The debate over carried interest taxation has many elements, some
of which are technical. I would like to focus my testimony on
correcting a series of fundamental mischaracterizations that have
emerged as this debate has unfolded. But I have also attached to my
testimony a paper prepared for PEC by one of the country's leading tax
professors, David Weisbach of the University of Chicago Law School,
which addresses many of the relevant policy and technical tax issues
associated with this debate.
A Carried Interest Is Not ``the Equivalent'' of a Stock Option.
Some have argued that a carried interest is the equivalent of a
stock option given to a private equity sponsor in exchange for its
``services,'' and thus should be taxed as ordinary income. I understand
the surface appeal of this argument. But upon analysis, it comes up
hollow. While carried interests and stock options are similar in the
general sense that they increase in value based on increases in the
value of underlying businesses, they differ in many fundamental
respects.
First, options arise out of an employer-employee relationship. A
stock option is a right granted by a corporation as compensation to an
employee. By contrast, a private equity sponsor with a carried
interest is not an ``employee'' of the limited partners, but rather is
an owner of the venture from the outset, who maintains control over the
management and affairs of the venture. In most cases, the venture would
not even exist without the sponsor's ideas, driving force, and skill.
Thus, a ``carried interest'' profits interest is an ownership
interest in a business enterprise (a fund), created by the founders of
that business enterprise in connection with their formation of the
venture. In contrast to an option, the general partner need not
exercise anything to be considered an owner of the venture and receives
allocations and distributions in accordance with the partnership terms
from the outset. In these respects, a carried interest has much more in
common with ``founders stock'' in a corporation than a corporate stock
option.
Partnership interests with carried interest allocations are also
typically subject to terms and restrictions (e.g., minimum return
hurdles, clawback provisions) not associated with stock options.
Moreover, while stock options are used in private companies (including
portfolio companies owned by private equity firms), they are most
prevalent in public companies, where (once exercisable) they entitle
the holder, at any time of his or her choosing, to acquire a liquid
security that can almost immediately be converted into cash. If,
subsequently, the value of the corporation decreases and its
stockholders suffer losses, there are no consequences for the option
holder who has exercised and taken this cash. In contrast, the holder
of a carried interest typically remains at risk for the investment
returns delivered to limited partners over the entire life of the
business enterprise (the fund), has residual risk if the venture fails
(as discussed further below), and receives cash with respect to the
carried interest only concurrent with the limited partners' receipt of
cash profits. Thus, the ``alignment of interests'' between limited
partners and holders of carried interests is much more complete than
that of stockholders and holders of stock options.
Holders of Carried Interests Bear Significant Economic Risks
Proponents of a tax change have also claimed that owners of carried
interests bear no risk, and thus should not be entitled to capital
gains treatment on their profits. In truth, private equity sponsors
bear many types of entrepreneurial risk.
First, sponsors (and their individual partners) contribute
substantial capital to their private equity funds. At Carlyle, this can
represent hundreds of millions of dollars invested in a single fund.
Whatever percentage of total partnership capital this investment
represents, it typically represents a very high percentage of the
private equity partners' capital available for investment. This capital
is subject to risk of loss, in whole or in part.
Moreover, like other entrepreneurs, private equity sponsors (and
their individual partners) contribute ideas, expertise, and years of
effort to the private equity partnerships they form and own. Like other
entrepreneurs, these sponsors (and their individual partners) bear the
risk that this investment will not result in any significant value in
their ownership interests. Private equity partners forgo other
opportunities that provide greater security and guaranteed returns in
exchange for the greater upside potential provided by ownership of
their interests in private equity partnerships. But it is worth noting
that, according to Private Equity Intelligence, 30 percent of the 578
private equity, venture, and similar funds formed between 1991-97 did
not deliver any carried interest proceeds to their GPs. The risk of
``coming up empty'' is real.
Private equity general partners also have liability for the
obligations of the partnership to the extent the partnership is not
able to meet such obligations, and they may be asserted to have
liability to third parties for certain actions of the partnership. In
addition, private equity general partners contribute their goodwill,
business relationships and reputations to their funds, and these assets
are subject to impairment.
Finally, private equity general partners may be obligated as a
business matter (even if not legally obligated) to suffer out of pocket
losses on the operations of a sponsored partnership. For example,
Carlyle formed a fund in early 2000 to pursue a specified subcategory
of private equity investments, and at the time the fund had a high
level of demand from limited partners. About two years later, however,
there had been a major shift in the prospects for these types of
investments, and many of the early investments in the fund were in fact
performing badly. At the low point, we valued the capital in these
initial investments at less than 40 cents on the dollar. As a gesture
of goodwill to limited partners, Carlyle reduced the level of
management fees; refocused the investment objectives of the fund; gave
limited partners a one-time option to reduce their unfunded commitments
(some actually chose to increase commitments based on the refocused
strategy); and, at additional cost to the firm, brought on additional
investment professionals to help execute the strategy for prospective
fund investments. Carlyle continued to devote considerable attention
and expense to this fund, with the objective of at least returning
limited partner capital, even though it was highly unlikely that there
would ever be sufficient profits in the fund to support any allocation
of carried interest profits. In fact, after several years of effort, it
is now clear that the limited partners will receive all of their
capital back with a modest profit; there will be no profits allocated
to ``carried interest'' in this fund (since the minimum profitability
hurdles will not be cleared); and the fund will be an out-of-pocket
loss to Carlyle (i.e., expenses will exceed fees).
Private Equity Funds and Their Partners Own Capital Assets
A third line of argument holds that private equity sponsors are not
owners of a capital asset and thus cannot be eligible for a capital
gain.
However, it is clear that the underlying economic activity pursued
by private equity firms is at its core about the creation of capital
gain--i.e., ownership and growth in the value of businesses. There can
be no question that capital gains are created when these businesses
(typically corporations, which pay their own level of corporate taxes)
are acquired by a private equity fund, held for the long-term, and sold
at a profit.
As discussed above, the carried interest is simply a feature of the
sponsor's ownership interest in the business enterprise (i.e., the
fund) that acquires these capital assets. Indeed, it is the sponsor
that establishes the private equity fund, sets the investment strategy
for the fund and makes the strategic decisions on which businesses to
acquire, how to finance the acquisitions and how to run the businesses.
It is the sponsor that makes the initial commitment of capital to the
private equity fund. And it is the sponsor that raises capital from the
limited partners, who are offered in return a form of ``financing
partnership interest''--an ownership interest that typically entitles
them to a return of their capital, the first allocation of profits from
that capital until they have received a minimum return or ``hurdle,''
and 80 percent of the profits from that capital once the ``hurdle'' has
been satisfied. The sponsor retains an ownership interest that entitles
it to a return of its invested capital, the profits attributable to
that capital, and 20 percent of all other profits once the ``hurdle''
has been satisfied. In sum, a private equity sponsor clearly has
``ownership'' in the capital assets held by a private equity
partnership and, like any other owner, should be taxed at capital gains
rates on the profits from the sale of those assets.
Private Equity Sponsors Do Not Benefit From ``Loopholes''
A recurring mantra of tax change proponents is that they are simply
attempting to ``close a loophole'' that has been ``exploited'' by
private equity sponsors. Nothing could be further from the truth.
Partnership structures using carried interests, or profits
allocations ``disproportionate'' to invested capital, are pervasive
across a broad swath of business sectors. These ownership structures
have been used for many years in many contexts, and are commonplace in
all forms of partnerships, including real estate, oil and gas, venture
capital, small business, and family business partnerships. The flexible
partnership structure, in which capital, ideas and strategic management
can be provided by different partners, who split profits according to
agreement, has been critical to the legacy of entrepreneurship that
characterizes the success of American business. And the tax treatment
of this ownership structure is well settled. It can hardly be called a
``loophole.''
Likewise, the principles underlying what is and what is not a
capital gain are well settled. Capital gains treatment is not tied to
subjective evaluations of the level of ``risk'' taken by an investor or
the ``worthiness'' of an investment; nor is it dependent on the amount
or ``proportionality'' of capital provided by one investor as compared
to another investor; nor is it denied to an investor whose efforts, as
well as capital, drive an investment's profitability. Instead, the
rules governing capital gains are simple and straightforward: if you
own a capital asset, hold it for more than a year, and sell it for more
than you paid for it, you are taxed at long-term capital gains rates.
Thus, the proprietors of a small business may invest very little
capital in the business, and may generate most of their ownership value
through their personal efforts over many years; when they sell the
business, their profit is nonetheless treated as capital gain. An
entrepreneur receives capital gain treatment when he or she buys a run-
down apartment building at a ``fire sale'' price, invests years of
labor rehabilitating and leasing the building, and sells it at a
profit. The founder of a technology company may put very little capital
into a business formed to develop his or her ideas. Over the years, as
he or she raises equity financing from third parties, his or her
ownership share may significantly exceed his or her share of overall
capital invested in the business. Nonetheless, the founder will receive
capital gains treatment on the sale of his or her stock ownership, even
though he or she has provided only a small percentage of the overall
capital invested in the business.
``Tax Fairness'' Does Not Require Treating Carried Interest Proceeds As
Ordinary Income
Perhaps the signature argument advanced by proponents of a tax
change is that such a change is needed to restore ``fairness'' to the
tax system.
Tax fairness is an important value. All of us should pay our fair
share of taxes. And I believe that the taxation of carried interest
ownership interests is fair when understood as part of a tax system
which, for many good policy reasons--encouraging long-term investment
and risk-taking, avoiding ``lock-in'' (i.e., significant disincentives
to selling a capital asset), mitigating the double taxation of
corporate-produced returns, and minimizing the tax on ``inflationary''
returns--taxes long-term capital gains at a lower rate than the highest
marginal rates applicable to ordinary income. In each case, the
justifications for a differential long-term capital gains rate apply
equally well to capital gains derived from carried interests as they do
to capital gains derived from other forms of ownership interests. Thus,
as long as one believes that taxing long-term capital gains at a lower
rate is sound tax policy, something Congress has affirmed repeatedly,
there is no ``inequity'' in the current taxation of capital gains
attributable to carried interests. Indeed, I believe that fairness
requires that the Tax Code not single out certain investors for less
favorable treatment.
Moreover, it is worth noting that private equity partners do not
exclusively receive long-term capital gains, nor do they pay taxes at
an ``effective tax rate'' of 15 percent. As noted above, profits
allocated to carried interests often include elements taxed as ordinary
income, and private equity firms receive fees taxable as ordinary
income. In addition, many private equity partners receive salary and
bonus income that is taxed as such. It is only to the extent that they
receive their allocable share of long-term capital gains attributable
to their ownership interests that private equity partners are taxed,
fairly, at long-term capital gains rates.
In fact, many of the commentators who have raised ``fairness''
issues about carried interest taxation have also expressed the view
that the ``bigger problem'' is the differential long-term capital gains
rate itself, which such commentators say should be abolished
altogether. Regardless of whether one agrees with this position (I do
not), I believe it is at least more ``conceptually coherent'' than
carving out for ``special treatment'' the capital gains received by
private equity and venture capital firms, as HR 2834 seeks to do. There
is no justification for treating capital gains allocated to private
equity sponsors less favorably than other capital gains--including
those earned by other successful investors and businessmen, whether
they be Warren Buffett, Bill Gates, or persons of more modest means who
have successfully invested in the stock market or a small family
business.
Nor is it accurate to describe carried interest taxation, as some
have, as a ``tax break'' that helps the ``rich get richer.'' If
anything, the history of the carried interest is that of the ``not
particularly rich''--and the ``not rich at all''--getting richer. There
are numerous examples of private equity, real estate and oil and gas
entrepreneurs from modest backgrounds building wealth through value-
creating enterprises that included carried interests as part of their
ownership structure. The relentless media and political focus on a
handful of highly successful founders of large private equity firms
ignores the fact that these individuals (like many other successful
business founders) were not necessarily ``rich'' when they started
their businesses.
Also ignored are the many thousands of business founders who employ
carried interest ownership structures in small to medium size
enterprises, or in ``start up'' businesses that are still struggling to
get themselves off the ground.
Ironically, H.R. 2834 and similar proposals would create more of a
``rich get richer'' environment, by providing that capital gains
generated in certain types of partnerships will be respected as such
only to the extent allocated to partners ``in proportion'' to invested
capital. Thus, only those who are in a position to provide significant
risk capital--and not those who build these businesses through their
ideas, vision and effort--will be in a position to derive significant
benefit from differential long-term capital gains rates.
This is one reason why the newly formed Access To Capital
Coalition, which represents many African-American and women
entrepreneurs and investment firms, has said that ``Carried interest
has played a vital role in attracting highly talented and committed
risk-taking minority and women entrepreneurs to the investment capital
industries. It also has served, and has the capacity to serve to even
greater degrees, as a mechanism for increasing minority and women
entrepreneurs' access to investment capital and capital investments in
underserved urban and rural communities.
``We believe that because of its direct impact on minority- and
women-owned firms, and its broader impact on the investment capital
industries as a whole, the legislation could impose a significant
financial burden on minority- and women-owned investment capital firms,
both with respect to their profitability and maintaining and improving
their access to investment capital, vertically and horizontally. These
developments could threaten the viability and stifle the growth of many
minority- and women-owned firms and managers in the industries. Also,
because of its larger effect, the legislation has the potential to
significantly curtail access to investment capital for minority and
women entrepreneurs and many of the communities that they serve.''
The Law Of Unintended Consequences
Finally, proponents of the proposed legislation claim there is no
risk that it will create adverse consequences for long-term investment
or the economy. I wonder how they can be so sure. I have been careful
not to declare that the sky will fall or that private equity investment
will disappear if these changes are enacted. Quite the contrary,
private equity firms--at least those, like Carlyle, that have become
large and well established--will survive. But predicting how markets
will respond to such a huge change in the economic structure of private
equity investment--or assuming that such activity will go on as if
nothing happened--is naive, especially during a time of considerable
market sensitivity to external events.
I cannot predict what actions Carlyle or any other PE firm will
take in response to a tax change. And no one can predict the
consequences of a tax change with absolute certainty. Tax costs are but
one of many variables affecting private equity investment activity.
Other factors, including interest rates, access to capital, market
liquidity, and sector and macro economic trends are all relevant. But a
change in carried interest taxation is clearly a relevant variable in
the extent to which such activity will be pursued. And it is worth
noting that since capital gains rates were lowered, the pace of private
equity investment activity has increased significantly. I think it is
reasonable to believe that a dramatic tax increase will indeed have a
negative impact on private equity investment.
Of course private equity sponsors will continue to meet their
responsibilities to their limited partners, even if the ``rules of
play'' are changed in the middle of the game. And, of course, we will
pay taxes on whatever basis is determined by Congress. But over time,
investment structures will change; incentives for new fund formation
(or formation of new PE firms) will be diminished; and there will
inevitably be less activity in the sector, at least by U.S. firms with
U.S. owners. I believe Congress ought to proceed very carefully before
risking an adverse impact on a form of investment that has been a major
and positive force in strengthening U.S. competitiveness, giving
struggling or failing businesses a new lease on life, and pumping
critically needed capital into the economy.
In addition to the general economic harm that could occur from
diminished private equity investment activity, let me cite three
specific potential consequences which should cause concern.
Lower Returns For Investors: It may be that sponsors can develop
new financing models that ensure the same level of return to PE firm
partners and our LP investors--although, if we do, it is likely that
these new structures would significantly reduce any anticipated tax
revenue expected from this change. But alternatively, PE sponsors may
look at ways to offset the higher tax burden through changes in
economic terms that will adversely impact their LPs. A likely result
would be the eventual reduction in the returns of pension funds,
endowments, foundations, and other investors who rely on these returns
to carry out important social missions. This is exactly why Pensions
and Investments Magazine, the leading trade journal for many such
investors, recently said in an editorial that ``pension funds,
endowments, and foundations, even though they are tax-exempt
institutions, might end up paying the increased taxes Congress is
considering imposing on the general partners of hedge funds and private
equity firms. . . . The result: lower returns for the pension funds,
endowments, and foundations.''
Loss of Competitiveness: Another possible consequence is that U.S.
firms will become less competitive with foreign PE firms, and even
foreign governments with huge investment war chests. The Wall Street
Journal noted in a recent article that the world's capital is going
global, reporting that many sovereign governments are actively seeking
investment opportunities worldwide. They, and the major foreign PE
firms with whom we compete, will not be as constrained by taxes, and
will be in a more competitive position to acquire companies than U.S.
PE firms with a higher ``cost of capital.''
The U.S. is the dominant capital market in the world, and this
Committee has been very supportive of protecting that status. But it is
odd that, as governments the world over are striving to make their tax
systems more competitive to attract foreign capital and challenge U.S.
dominance, this Congress is considering a proposal that would go in the
opposite direction.
Migration Of Capital Activity: A third possible consequence is that
private equity activity will increasingly move overseas. There has been
considerable misunderstanding about this risk, with some dismissing the
prospect of major U.S. PE firms relocating. However, the concern is not
that PEC members or other well-established U.S. private equity firms
will relocate their U.S. operations--indeed, I think this is not highly
likely. Rather, the question is whether the U.S. will be the home for
the next generation of PE entrepreneurs, who will have discretion to
start their businesses wherever the climate is most favorable. Will the
``center of gravity'' migrate to Europe, Asia, the Middle East, or
Eastern Europe, where firms will tend to seek first investment
opportunities in their own regions? Will the U.S. see growth capital
now invested to strengthen American companies shifting to help foreign
firms better compete against U.S. businesses? And are the perceived
benefits of this change in tax policy worth taking that risk?
Tax Treatment of Publicly-Traded Partnerships
I do want to address an issue that has received considerable
attention recently. Although the focus of this hearing is not on the
tax treatment of publicly traded partnerships, I would like to provide
the committee with a few observations regarding legislation which would
deny partnership treatment to certain publicly-traded partnerships that
derive income (directly or indirectly) from services provided as an
investment advisor or from asset management services provided by an
investment advisor.
We oppose the bill on several grounds. It inappropriately singles
out our industry for exclusion from the general rules for qualification
as a PTP. In doing so, it will discourage private equity firms from
going public in the U.S., impeding potential benefits both to such
firms and the U.S. capital markets. Those PE firms which do go public
will be subject to a ``triple taxation'' regime, with the same income
potentially taxed at the portfolio company level, at the public entity
level, and at the investor level. And, despite all of this dislocation,
the incremental tax revenue produced by the change is unlikely to be
meaningful.
Virtually all private equity firms are organized as partnerships or
other ``flow through'' entities today. Thus, going public as a PTP
simply preserves the status quo for tax purposes. There is no abuse or
tax evasion involved. In fact, public PE firms would generally conduct
a portion of their operations through a corporation, thus subjecting to
corporate taxation income which is not subject to such tax under
private ownership.
Under the current law, there is a general standard for PTP
qualification: 90 percent of income must be qualified income, such as
dividends, interest and capital gains. The private equity industry is
not seeking ``special treatment'' but simply the ability to use a
structure that is made available to, and used by, other sectors, such
as oil and gas. There is no justification for singling out PE firms for
adverse treatment.
Indeed, exclusion of PE firms is particularly inappropriate given
that their activities center around investments in corporations that
are themselves taxable entities.
Thus, income earned by these firms would be subjected to three
levels of taxation: (i) the first level of corporate tax would be paid
by the investment funds' portfolio companies on their operating income;
(ii) the second level of corporate tax would be paid by the PE sponsor
on its share of the gain from the sale of the portfolio companies or on
distributions received from such companies; and (iii) the third level
of tax would be paid by the public owners of the PE sponsor when they
sell their shares.
Because of the overall structure, the dividends-received-deductions
would generally not be available to ameliorate the three levels of tax.
Thus, the PTP bill appears to impose a penalty on publicly-traded PE
firms that corporate enterprises in foreign jurisdictions do not bear,
and which most other corporate enterprises in the U.S. do not bear (by
virtue of consolidation or the dividends-received-deduction).
This penalty will constrain the ability of mature private equity
firms to raise capital in the U.S. public markets that may be required
to compete in an intense and increasingly global business. In turn,
U.S. public market investors may be deprived of an opportunity to
participate in the next phase of growth of this sector, and the
competitiveness of the U.S. capital markets will suffer.
We understand that the bill was driven at least in part by a
concern over erosion of the corporate tax base. However, as noted
above, conversion by private equity firms to PTPs would simply preserve
the status quo. Other financial firms organized as C corporations have
not shown an inclination to organize as PTPs despite the opportunity to
do so. Financial corporations contemplating a change to PTP status
generally would face significant corporate taxes upon conversion, which
will often be prohibitive.
Finally, the transition to public ownership may be important in
succession planning and allowing a mature PE firm to survive beyond its
founders. By discouraging and possibly precluding such steps, the bill
imposes unfair limits on the ability of these firms to fully realize
their potential.
I would like to thank Chairman Rangel and Ranking Member McCrery
again for the opportunity to present our views on these important
issues. We look forward to working with you and the other Members of
the Committee in the weeks ahead. I would be happy to answer any
questions you might have regarding these issues.
Chairman RANGEL. Thank you, Mr. Rosenblum. Members are
waiting to ask questions. I just want to confine mine to Mr.
Silver.
Mr. Silver, are there people in the corporate world that
manage funds and do the same thing as equity partners do in the
private sector, and you might say they put in sweat equity
because they are working hard in order to protect and expand
the profitability of the funds.
I want to make it clear to this panel, no matter what the
testimony is, if at the end of the day we can reach the
conclusion that the system as it exists is equitable because
one group formed a partnership, the other group formed a
corporation, we have to find some reason, and I am not
convinced by your testimony, Mr. Silver, that what you are
doing is that much different from what somebody in the
corporate investment banking business is doing, especially if
we are talking about no direct money investment being made.
Could you share with me why there should be this difference
in how the fee that is received by the person that is doing the
work, the good work for venture capital, should be different
from your competitor whose fee is treated as ordinary income
and your group's fee would be considered as an investment and
return on capital?
Mr. SILVER. Yes, Mr. Chairman. I would be happy to try to
address that. I assume by your question that you are actually
referring to in the case of venture capital, corporate
venturing as opposed to investment banking, per se.
Chairman RANGEL. Those that you normally consider a
competitor, that you are doing such extraordinary work that
your clients would believe that is so different, and one would
assume that you are entitled to a different type of
compensation.
It has been difficult for a lot of Members of this
Committee, without targeting you or anyone else, to see how you
feel comfortable in distinguishing your work from the corporate
work and deal with the same type of thing.
Mr. SILVER. I think there are a number of important
distinctions. I will simply in the interest of time identify a
couple.
One was mentioned here among the panelists' remarks, and
that is the general partners of individual venture funds are
significant investors in their own funds. A substantial portion
of the net worth of the individual general partners is
generally also in the pool of capital that is being invested.
Chairman RANGEL. Do you have to make any investment at all
as a partner in order for your fee to be treated as capital
gains? Do you have to put any money at all in the venture?
Mr. SILVER. Every general partner at Core Capital and every
general partner in every venture fund I am aware of has made a
significant personal financial investment.
Chairman RANGEL. I thought you spoke a lot about sweat
equity in terms of the value of the investment.
Mr. SILVER. I did. I was trying to originally answer the
question you asked about the distinction between independent
venture funds and corporate venture funds.
The first and most obvious distinction is that----
Chairman RANGEL. I do not think there is much difference in
how those who invest their funds are treated as capital gains
or the return on investment. That is not a problem. You
understand that? It is not a problem that the partner is
investing capital, how the return on the capital they invested
is treated, that is not a problem.
What I want you to address is those services that are
provided that are not direct financial investments, how that,
too, is treated as capital gains. That would help me.
Mr. SILVER. In the day to day practical world of venture
capital, it is almost always the case that independent venture
funds are in fact the lead investors in starting new companies,
and the corporate venture funds, to the extent they
participate, tend to be follow on providers of capital.
The actual work, the sweat you are referring to, the sweat
equity you referred to----
Chairman RANGEL. You referred to.
Mr. SILVER. That I referred to that you were making
reference to, is largely undertaken by firms like mine. We work
side by side along with the entrepreneurs to build these
companies from scratch. We are involved from the outset in
doing everything that an individual does who puts a company
together.
We hire management teams. We build strategic plans.
Chairman RANGEL. People who come from the corporate world,
they do not do these things that you do?
Mr. SILVER. Corporations do. The venture arms of
corporations, which is what I think you are referring to, are
generally providers of capital to invest in ideas and emerging
companies which generally have some potential strategic
importance to the corporation.
Chairman RANGEL. I am only talking about services rendered
that are not direct investments. I want to make it clear. You
invest, whether you are a partnership, a corporation. To
someone like me, it makes sense they should get the same return
on their investment.
I just want you to try to help me to distinguish between
people who make no direct capital investment, they are just
concerned about going into minority communities and taking
projects on that no one else would take, bringing people
together, reforming the system, putting in sweat equity, at the
end of the day, somebody gets an ordinary income and somebody
else gets capital gains.
The person that gets the capital gains, for purposes of our
discussion, did not put up any equity other than sweat equity.
That is the problem as to whether or not there is some
other reason----
Mr. SILVER. I do not know of any venture fund in which the
partners do not as part of the pool of equity being invested
participate themselves directly--who do not participate
themselves directly, and I do not know of any venture fund
where it is not true that the investment is going into the
creation of a capital asset.
The creation of the company is the creation of the capital
asset.
Chairman RANGEL. Mr. McCrery.
Mr. MCCRERY. Thank you, Mr. Chairman.
I want to ask about two things, because we have talked
about this some already today. Number one is risk. Several of
you talked a good bit about risk and how general partners have
inordinate risk compared to say somebody working for UBS or
CitiBank or whatever.
Number two, if the Levin bill were to pass, are there not
ways that businesses, Mr. Stanfill, like yours, or Mr.
Rosenblum, like yours, could reorganize and get around this, to
get the same capital gains treatment?
Mr. ROSENBLUM. I think the most fundamental point here is
not that we are harder working or smarter or more deserving in
some general sense than anybody else. We are owners. We form
businesses. We take risks, both with our capital and with our
time, and with being a manager with residual liability for the
business, and with worrying on occasion of going out of pocket
to swage the limited partners that we have raised money from.
We are not asking to be treated better or worse than other
businessowners, but we are asking to be treated like
businessowners. I think risk is certainly part of that.
In terms of alternate ways of approaching it, I think one
of the striking things about the bill that has been proposed
here is that it changes taxation only on a particular type of
structure and a particular type of financing.
It does not change the taxation on the underlying activity
that we are performing, which is going out, buying a business,
improving it, and selling it.
You have to ask yourself is there a different way to
conduct that business? Is there a different way to raise that
financing? Of course, there is.
We have not studied all the alternatives that may be
available.
Mr. MCCRERY. But you probably would, would you not, if this
bill were to pass?
Mr. ROSENBLUM. I am sure we would have many accountants and
lawyers on our door step if a bill is passed to talk to us
about it. There are very simple things that have already been
mentioned by some of the other panels, taking debt financing
and pursuing it that way.
What we are getting from limited partners is a form of
financing. It has been very beneficial for them because they
get to participate in the vast majority of the profits that are
created by this business, but there are other ways to obtain
financing.
Mr. IFSHIN. Representative McCrery.
Mr. MCCRERY. Quickly, because I want to give Mr. Stanfill a
chance.
Mr. IFSHIN. I will be very brief. As it relates to risk, in
a real estate setting, the general partner frequently takes on
risk that if a project runs into difficulty or fails, can cause
them to incur actual dollar losses.
I think it is important to understand that because in many
fund settings, that may or may not be potentially possible. I
do not know. If a real estate developer sets out to develop a
project, gets his entitlements, gets his limited partners lined
up and gets a construction loan, he probably is going to have
to personally guarantee that construction loan. If that deal
goes bad, that developer could very well lose millions of
dollars against a potential profit that may have been a
fraction of what he actually loses.
Mr. MCCRERY. Mr. Stanfill, do you have any thoughts on
this?
Mr. STANFILL. Just a quick comment, sir. It strikes me that
the biggest risk that my partners and I take is making poor
judgments in our investments and not earning a good return for
our investors, and therefore, not earning a carried interest
for ourselves.
We are well compensated whether--I have been well served by
capital gains, clearly. I do not think--it is a fairness issue
with me. I do not think I pay a particularly heavy price by
paying the same rate on my compensation that other people pay.
Mr. MCCRERY. Mr. Stanfill, if you take this conclusion to
its logical extension, the conclusion that Mr. Rosenblum
reached, that of course, we will organize in some different
business set up to get the same treatment, because the
underlying--the treatment of the underlying asset and sale of
the asset is not changed by this bill, so the logical extension
of that is we will chase that next form of business
organization, and then the next form, until we do not have any
preferential treatment for capital gains any more.
Is that your desire? Would that solve your fairness problem
if we just did not have preferential treatment for capital
gains?
Mr. STANFILL. Not capital gains that apply to compensation,
sir.
Mr. MCCRERY. No, I am talking about capital gains for the
sale of a capital asset. Do you want to keep that preferential
treatment in the Tax Code or not?
Mr. STANFILL. I have no trouble treating all income, be it
dividends, capital gains, ordinary income, at the same rate. We
are talking in that case about a total revision of the Tax
Code, and I think that is unlikely.
Mr. MCCRERY. Right. That is a totally different question.
We have had a couple of witnesses today who have suggested that
there should not be preferential treatment for capital gains,
and that discussion we have not really explored very well in
this Committee. I am hopeful that is not the intent of the
authors of the legislation that we are discussing.
Chairman RANGEL. Mr. Crowley from New York.
Mr. CROWLEY. Thank you, Mr. Chairman. Let me thank the
panel for their steadfastness and remaining and contributing to
the discussion today.
I have been following this issue, as many of you know, for
some time now, and listening to all sides, and have had an
opportunity to meet with some of you privately.
Mr. Rosenblum, you stated previously that private equity
investments, and I quote, ``Will not wither up and die,'' if
the Tax Code is changed, but that ``Rather, there will be deals
that won't get done. There will be entrepreneurs that won't get
funded, and there will be turnarounds that won't be
undertaken.''
Additionally, Mr. Ifshin, you have stated ``If current law
is changed to tax carried interest at the ordinary income rate,
then the investment viability of real estate projects will
surely be brought into question.''
Both of these comments appear to indicate that investors
make economic decisions based on tax law as opposed to a profit
potential.
Would you agree with that statement that I just made and
the observation I just made, and would altering the tax rate on
investment fund managers alter the tax treatment of investors?
Mr. ROSENBLUM. What I would say is that entrepreneurs and
people who fund enterprises like a private equity firm, like a
private equity fund, make decisions based on a risk/reward
basis. Certainly, the tax cost of doing business is part of
that risk/reward equation.
I think it is just simple economics that there will be some
contraction of the pool of activities that will be attractive
to both the general partners trying to run these funds and the
limited partners who are being asked to invest in them or other
sources of capital, that will in the end result in fewer types
of deals getting done.
I agree with Mr. Ifshin that probably the place that
happens first is at the margins with the deals that are viewed
as a bigger risk, a bigger stretch, a longer time commitment,
in some way more speculative and further out on the risk/reward
scale.
Mr. CROWLEY. Mr. Ifshin.
Mr. IFSHIN. Certainly. Since Congress first adopted
partnership tax treatment some 50 plus years ago, private real
estate investment has utilized that format with a flow through
of capital gains treatment from the appreciation of a capital
asset. That has led to substantially the overwhelming majority
of all development, redevelopment, from New York City to San
Francisco.
I do not know of any sophisticated real estate owner or
developer who looks at project profitability solely on a pre-
tax basis. Tax considerations have been embedded in real estate
investment and developer go forward or not go forward or take
risk or not take risk decisions as long as I have been in the
business and certainly for two generations before me.
The use of the partnership as a vehicle, and embedded in
that capital gains treatment for the general partner, has been
embedded in real estate transactions since the law was enacted,
and in fact, the partnership form had been used by two
generations of real estate developers before anybody ever
created the concept of a hedge fund or a private equity fund.
Mr. CROWLEY. It is safe to say that profit is still a
mighty incentive?
Mr. IFSHIN. Profits are always important, but the net
profit after tax is what at the end of the day as an
entrepreneur you can take and re-invest in another project and
create more jobs, or take home and feed your children with the
proceeds.
Mr. CROWLEY. I thank you both. Mr. Stanfill, you previously
stated that a lower tax rate for carried interest is neither
fair nor equitable and that venture capitalists get ample
compensation, ``financial and psychic'' for the work they do.
As venture capitalists are the ones providing their own
capital for innovations, the more they are taxed, the less
funds they have to re-invest back into innovations.
Could that lead to what Mr. Rosenblum has stated
previously, that some deals simply will not get done?
Mr. STANFILL. I think it is possible that some deals will
not get done, but it strikes me as marginal. I may be missing
something. I just do not see this as a serious----
Mr. CROWLEY. I am asking in light of the results of a study
that show that in approximately 62 percent of all venture
capital deals, people either lose money or just break even.
There is apparently tremendous risk in terms of that.
Mr. Silver, you might want to make a comment on that.
Mr. SILVER. Yes, Congressman. I think you are exactly
correct. The most important idea to take away from venture
capital is that you must have winners to offset your losers,
and you do not know which investments are going to be the
winners when they start. You hope they all will be. They are
not.
The study statistics that you cite are common knowledge. I
think they are right. The vast majority of investments that
venture capitalists make fail or fail to return significant
enough sums to cover and return capital to the general partners
and to their investors.
Consequently, I believe what will happen as you move
capital gains tax rates up is you will force the general
partners in venture funds to make decisions about kinds of
investments which alter those investments. We will move to
later stage, less risky, shorter term kinds of investments, and
consequently will not make investments in earlier stage,
riskier kinds of companies, which are themselves the companies
that have been the greatest engines of economic growth in the
United States.
Mr. CROWLEY. Thank you. Thank you, Mr. Chairman.
Chairman RANGEL. Thank you. Mr. Becerra.
Mr. BECERRA. Thank you, Mr. Chairman. Again, thank you all
for your patience. It has been a great hearing.
Let me ask a quick question of all of you. It is obvious
that everyone here indicated that you do participate in
investment activities and therefore carried interest would
apply.
If by chance we were to enact legislation similar to the
House bill before us and it would affect the issue of carried
interest and its treatment as ordinary income as opposed to
capital gains, would any of you leave your business?
I just want to hear from those who would leave.
[No response.]
Mr. Ifshin, you talked about real estate and how you deal
with a physical asset, real estate or a structure that you
develop on that real estate. You talk about some of the risks
imposed.
I will ask you two questions. First, can you continue to
provide this Committee with as much information as you can
about that risk, where you distinguish between that hard asset
versus money or security which is the asset in other private
equity investments?
Secondly, a more direct question and a quick answer, and
then you can follow up with written testimony if you want to
elaborate, should we treat real estate investments where
carried interest is a form of--you do not want to call it
compensation--there is a reward in carried interest, should we
treat real estate differently than we do other types of
investments, private equity investments?
Mr. IFSHIN. We will follow up with written testimony. The
short answer is--I am certainly not a tax lawyer and do not
purport to be one--the way it has been explained to me, if we
are using the same form of partnership, then there is not a way
to distinguish between the two.
Mr. BECERRA. If there were a way to distinguish, should we?
Mr. IFSHIN. I am not intimately familiar with their
business. I do not know intimately whether or not I can make a
qualified judgment for you.
Mr. BECERRA. That is fair. I appreciate your trying to
respond. Mr. Rosenblum, you mentioned something about pension
funds might receive or see a lower return on investment if we
were to pass this House bill.
I believe there was testimony today by Mr. Russell Reed,
the Chief Investment Officer of the California Public Employees
Retirement System, indicating that he had no great concern if
we were to make moves to tax the carried interest or at least
propose a different tax treatment for the general partners in
some of these arrangements.
If you could follow up with us and provide any information
that led you to make the statement that the pension funds might
suffer lower returns, which obviously would be a concern to a
number of us because many pension funds obviously are based on
what employees/workers, who do by the way pay ordinary income
rates, what their returns would be for their retirement
accounts.
If you could provide anything in writing subsequently, that
would be very helpful.
Mr. ROSENBLUM. Certainly.
Mr. BECERRA. Mr. Hindery, you heard the testimony from some
of the individuals who do raise concerns about changing the
treatment of carried interest. If you could comment, and again,
if you could try to be specific and brief, for example, I am
interested in any comments you have with regard to the issue of
the real estate industry and where currently some general
partners in the real estate industry actually have to carry
paper if the investment falls down and they are stuck with the
paper, which the banks ultimately want payment, if they run
into an issue of environmental clean up, comment.
Mr. HINDERY. Congressman, I will try to be brief. Some on
this panel would have you believe there is somehow a direct
correlation between their personal taxation as a hedge fund or
private equity manager and the vitality of these underlying
activities.
We hear about Google and FedEx, and I am thoroughly
impressed. There is no correlation. If there was a correlation,
when Mr. Bush had his tax cut and reduced capital gains rates,
we should have cut our management fees. There have been six
distinct rate changes in the last 20 years in capital gains.
These rates have not adjusted. If you take Mr. Rosenblum,
an extremist, in a perfect world, we should pay no taxes
because then we would be extremely vital. It is apples and
oranges, Congressman.
On the real estate side, to Mr. Ifshin, if Mr. Ifshin in
fact does put capital into his project, he has become a capital
investor in it, and is entitled to capital gains treatment,
capital gains loss and gain.
We are talking simply about the management fee of those of
us who have the privilege of running other people's moneys. On
that one point, none of us came up here and offered to debate
with you and talk with you about cutting our fees when the
capital gains rate went down.
Now you are trying to simply move us to a level of taxation
that every other regular American pays on his or her management
fees, and to tie the vitality of these three industries, now
four, in Mr. Ifshin's case, to this issue is one of the great
obfuscations I have ever confronted.
Mr. BECERRA. Mr. Chairman, I know my time has expired. Can
I just make one clarification? I think, Mr. Chairman, when you
had a colloquy with Mr. Silver, Mr. Silver mentioned the fact
that most general fund managers that he is aware of made an
investment, their personal investment, in these investments.
I think we have to be clear. I think the legislation that
Mr. Levin is carrying would treat any personal investment that
a fund manager makes as a capital gain on the sale of that
particular asset, so we have to make sure we are clear.
If you yourself as a general partner or fund manager make
an investment of your own resources into this fund, you will
receive capital gain treatment upon the sale of that particular
asset, not ordinary income treatment.
Thank you.
Chairman RANGEL. Mr. Levin, the author of the bill.
Mr. LEVIN OF MICHIGAN. I will be brief. Mr. Chairman and
Mr. McCrery, this has been, I think, a very long but useful
day.
We are determined under the leadership of our Chairman to
have these kinds of hearings, to open up these kinds of issues,
to not simply look the other way, because our constituents are
insistent that a Tax Code works when there is fairness, when
there is equity, and when there are distinctions made that are
rational, that are justifiable.
They want distinctions that we can explain to them and that
we can tell them they make good sense in terms of equity and in
terms of growth.
Let others carry on. I just wanted to say to you, Mr.
Silver, and we have had a chance to talk before, and our door
is always open, as everybody's door is here.
When you say we invest our time and lots of it, we work
with the management team often on a daily basis developing
strategy, introducing the company to customers and suppliers,
identifying and hiring key managers, and leveraging our past
experience to address competitive and operating issues, that
strikes a lot of people as the kind of work they do. In the
real estate business, they may well be doing some of this when
they are selling a house.
You talk about risk, I do not think you can base a tax
policy basically on risk because there is so much risk in what
everybody does.
You mentioned the person who takes the stock option. There
is immense risk and you can try to distinguish it if you want,
or others, and there has been reference here to people who work
on commissions or who work on bonuses. There are lots of
people, and this relates to your question, Mr. Chairman, who
are in the stock industry, who make more from the bonuses than
they do from their other pay. They have immense risk as to what
they are going to earn. Immense risk.
We have to be able to tell our constituents who risk a lot,
who work hard, who do lots of things more or less as you have
described here, why there should be a differentiation, a
distinction.
The gist of this effort is to try to have a Code that has
fairness, equity, and draws distinctions that are sustainable
to our constituents. As Mr. Rangel has said, our Tax Code in
terms of compliance is based more on the people's feeling of
equity, of balance, of legitimate distinctions than anything
else. If it is not there, it collapses.
I will yield the rest of my time so others can carry on. I
am going to have to leave to talk about this issue with a
colleague of mine in another setting.
This has been a vitally useful effort. I just want to echo
what Mr. Rangel has said. This is not an effort to soak
anybody. This is a search for a Tax Code that really makes
sense and makes distinctions that we can defend.
Mr. SILVER. Congressman, I appreciate your comments. You
and I did have a chance to have a very productive conversation
privately at an earlier date. You have spoken eloquently about
the issue of fairness, and it is clearly a very important
question.
I would like to leave you and Members of the Committee with
a better understanding than perhaps I have of the unique role
that the venture capital community plays in here and with
respect to fairness, we play the same role in building
companies that the founders and entrepreneurs do.
The question about fairness, we invest our time and our
money like an entrepreneur does. The entrepreneur receives
capital gains for that work. The question of fairness that you
are addressing is a broader macro level question, which is much
warranted and ought to be examined, I think, in a much more
holistic fashion.
The fairness issue here is really a question of the tax
treatment of the kind of work done between the venture
capitalist as investor/co-founder and the entrepreneur, not a
question at the more macro level of tax fairness within the
Code.
Mr. LEVIN OF MICHIGAN. You can shape it that way.
Mr. Stanfill, you do not seem to agree with that.
Mr. STANFILL. I respectfully disagree. I have bright,
young, well educated partners, sometimes we lead deals.
Sometimes we follow on deals and others lead, and our tax
treatment is the same. It simply does not strike me as fair or
equitable.
Mr. LEVIN OF MICHIGAN. The red light is on. Thank you.
Chairman RANGEL. Thank you, Mr. Levin. Mr. Tiberi.
Mr. TIBERI. Thank you, Mr. Chairman. That is a tough act to
follow. I just want to thank you and Chairman Levin for your
sincerity, not only in this legislation, but in this hearing.
I want to thank Mr. Ifshin for putting a different face on
this. Let me tell you about a different face that I saw on this
issue in August in my district.
Mr. Rangel and Mr. Levin's legislation gets a lot of
attention in the media about how it affects Wall Street. My
district is far from Wall Street. Let me tell you a little bit
about some of the interaction that I had.
In Ohio, we have five public employee pension systems. My
mother-in-law, a single mom, a grandma, was a school secretary.
She is on one of those systems. She has great returns compared
to Social Security. In fact, all of our five pension systems do
much better than Social Security does, and they all love their
systems. Teachers, firefighters, police officers, local and
state employees.
In talking not to the political people but a few of the
folks that run a couple of these pension systems, the comment
to me was do not think that returns are not going to be
impacted by tax treatments.
That is something my mother-in-law has concerns about. This
is not from any Republican or Democrat or Union official or
state official. People who are involved in the funds
themselves.
More important than that, I talked to a guy who is an
Italian immigrant. He is a stone maker, along with the brick
layer, and Mr. Pascrell is not here, but my Italian friend, Mr.
Crowley, is, and a carpenter, three guys who came from Italy,
who have formed a real estate partnership. Now they do real
estate development, home building.
They believe that this will have an impact on their
business. A very Main Street issue, not a Wall Street issue,
but a Main Street issue that Mr. Ifshin, you put a face on.
I was at the James Cancer Hospital in Columbus, one of the
ten cancer hospitals in America accredited by the Federal
Government, and met with an inventor that now uses a cancer
device that it took years to get on the market, and if it was
not for venture capitalists, it may not be on the market today.
He said to me be careful what you guys do because this was
hard enough to get, and if you make it tougher to get, what is
the next invention that is not going to be on the market.
What I am saying, Mr. Chairman, is I understand that you
are sincere in trying to close loopholes, but what we do here
does have impact on real people outside of Wall Street, whether
it is a real estate developer who was a stone maker, whether it
was my mother-in-law who was a school secretary, or whether it
was an inventor who could not get something to market without
venture capitalists, and all believe there is concern there.
What I want to ask all of you, just to make a comment, as I
look at this legislation, and I have talked to a tax lawyer who
said to me you guys are trying to make this more equitable, but
in this legislation, it appears to me you are picking winners
and losers.
My question to all of you is how do we draw the line here
in Congress? How does the Chairman pass a piece of legislation
with my support and Mr. McCrery's support and bipartisan
support when we are essentially saying if you are in real
estate, your capital gain is going to be treated as ordinary
income but if you are in another industry, your partnership is
not, and are we heading down a road of making the Tax Code even
more inequitable than it already is?
Mr. Hindery.
Mr. HINDERY. Congressman, two quick comments. I think the
only way to approach this is across the spectrum of investment
partnerships. I think when you cut to the nub, we are all the
same.
There are six of us that have the privilege of being up
here right now. Only Mr. Kramer speaks for the investor crowd.
The rest of us are managers. I defer to his comments which
makes the point strongly that the investor community is
indifferent, the concerns that your mother-in-law has, I do not
believe deep in my soul, are concerns that she needs to have.
It is not an issue for the investor community. It is simply
a personal taxation issue for those of us who are managers.
I think the answer for this Committee and this Congress is
to treat all of these investor partnerships exactly the same,
that which is by its nature ordinary income, tax as such. That,
to Mr. Ifshin's comment, the concern about real estate,
legitimate. That which is capital, treat as capital.
I think there is very bright lines, Congressman, that can
be drawn to let you and your colleagues make that distinction
for us as we go forward as practitioners.
Mr. TIBERI. Thank you.
Mr. STANFILL. I essentially would agree with that comment.
I think capital should be the key.
Mr. KRAMER. Actually, I respectfully find it scary that I
do believe there probably are people in the public pension
world that you can talk to who actually do think that their
fees are going to go up because tax rates are going to go up
for their managers.
I do find that scary. The irony is if you have
conversations with leading people in the private equity world
and in the hedge fund world, you will find very few people
privately who would possibly agree with that argument. It is
only the people they make it to publicly. Privately, they do
not buy into that argument.
On the broader issue, one of the problems with one way the
Committee might go in this area is obviously there are equity
issues and there is a question, why am I supposed to treat
private equity and hedge funds differently than I treat other
classes.
On the other hand, if you basically said it looks and
smells to me like compensation income, make it real simple, if
I am a money manager at Fidelity, I pay ordinary income. If I
am a money manager and I own the same stocks at Goldman Sachs,
I pay ordinary income.
I actually own stocks. As a hedge fund manager, you know,
then I get this capital gains benefit. There is an inequity and
the obvious argument would be if you can extend it to other
industries and get the votes together to do that, that would
actually be more intellectually coherent.
Mr. TIBERI. Thank you.
Chairman RANGEL. You can make one Member of this Committee
very happy if you share those views with his mother-in-law.
[Laughter.]
Mr. SILVER. Congressman, I think you made several important
points. The first is it is not just a Wall Street issue. It is
a Main Street issue. As you may know, we actually have an
investment in a company in Columbus, Ohio. We also have
investments in companies in Seattle, Golden, Colorado, RTP,
Austin, Texas, and smaller communities scattered throughout the
country, which do not typically see venture capital and which
do not have any venture capital firms.
I think it would be fair to say that a number of those
companies would not have been able to launch without venture
capital.
The second observation that you made which I certainly
concur with is that there is an artificial and intellectually
incoherent inconsistency in selecting or identifying out a
particular not just asset class but sector within the asset
class.
We are looking at a snapshot today. If we were having this
conversation in the late nineties, we might have been talking
about venture capital. If we were talking about it in 2000,
2001, 2002, we might have been talking about hedge funds. If we
are talking about it today, we are talking about mega buy out
funds.
That is because there is a natural evolution and a natural
ebb and flow within the financial industry and every industry.
I do not know real estate as well, but I am certain there are
ebbs and flows in the real estate industry, which also are a
function of time and timing.
My strong concurrence with you is that we ought not to be
in the business of trying to identify a subset of a subset of
an asset class for particular tax identification issues.
Mr. IFSHIN. Congressman, to me, it comes across as you have
to be careful of what unintended consequences emerge from
something like H.R. 2834.
In 1986, when the Tax Reconciliation Act was passed, it
ended up costing the Federal Government over $200 billion in
the form of RTC and FDIC bail outs of S&Ls that went broke
because they lent money to developers who had relied on the tax
treatment that was removed.
Unintended consequences as it relates to this piece of
legislation that I think are most important to consider are
ones that would occur on the local level, as opposed to Federal
tax receipts.
We bought an asset several years ago in your district. We
are working to re-do that asset. If we succeed, one would
assume that (a) we will create construction period jobs and we
will ultimately lease that space to retailers who will create
permanent jobs in what is the second largest Somali community
in the world outside of Somalia.
It is a very, very challenged neighborhood and it is a
challenging project. If we succeed, one logically assumes that
the assessment on that property will go up, and the tax base in
a neighborhood that you well know has a shrinking tax base,
will go up. Therefore, the homeowners in that community will
face less of a relative increase in their property tax burdens
than they would in the absence of our project.
We do this all over the country, not just in your district,
Congressman. That is the impact that we have all over the
country.
If you want to look at the average household income in that
particular portion of your district----
Mr. TIBERI. I know it.
Mr. IFSHIN. I will tell you that the thing that is coming
at your constituents is that their property tax bills are not
going up one or 2 percent, they are going up 8 and 10 percent a
year. Why? Because the tax base is shrinking. Their property
taxes are becoming an ever growing percentage of their
disposable income.
Chairman RANGEL. Mr. Doggett.
Mr. DOGGETT. Thank you very much for staying this late
hour. We have been told really in this Committee for 12 years
that our concerns about fairness and equity in the Tax Code and
fiscal responsibility in the budget were inconsistent with
competitiveness and with economic opportunity.
I think particularly your testimony, Mr. Hindery, just as
with Mr. Shay earlier on international tax, suggests that is
not true and there will be members of the business community
who will come forward and say we have to have both, and that
when a gross inequity exists, we need to correct it.
I do have some concern on the venture capital issue because
I represent an area in which venture capital has been very
important to the growth particularly of our small technology
businesses. I gather Mr. Silver and Mr. Stanfill have worked in
this area.
Are there not some distinctions, first of all, in the
length of venture capital funds versus the length of time
involved in the typical private equity fund?
Mr. STANFILL. You are talking about the timeframe?
Mr. DOGGETT. Is it usually 10 year funds?
Mr. STANFILL. There are 10 year funds. As a matter of fact,
we will exit from an investment we made in 1995. There is no
question that we spend a lot of time, sometimes decades or
more, in bringing a company----
Mr. DOGGETT. I guess my first question to you, you feel
there should be no distinction for venture capital from other
types of equity funds, even though you are in the venture
capital business?
Mr. STANFILL. That is correct.
Mr. DOGGETT. If that is the position that prevails
ultimately, will there be a need for reasonable transition
rules for funds that have already been formed, that have been
going on for seven/eight/nine years and are now down to near
the conclusion of the fund, where people relied on the old
rules before you apply a new approach?
Mr. STANFILL. I think a grandfather provision might make
sense in that case, Congressman.
Mr. DOGGETT. With reference to the role that venture
capital funds play, Mr. Silver, versus other types of private
equity funds, you commented on this to Mr. Rangel earlier, but
do you find venture capital funds much more involved with the
management of what are often start up or fairly new
enterprises?
Mr. SILVER. Yes, Congressman. There are some substantial
distinctions between various kinds of private equity funds. I
leave it to my colleagues in the hedge fund and the private
equity fund business, the buy out business, to describe their
own activities.
The point I have been trying to make repeatedly this
afternoon is that the role that the venture capital community
plays is a co-founding/finance role. You are absolutely right
in identifying longevity as one of the keys to that.
As Mr. Stanfill pointed out in his own experience, we are
involved on a daily basis, for years and years, in growing
these funds. Our first fund at Core Capital was launched in
1999. We made 23 investments in that fund. We have exited 14,
or I should say only 14, in that time, and it will probably
take us another 4 years to get out of all of the other
transactions that we are in.
I should also say because I know Mr. Stanfill and I have
different points of view on this, that I appreciate Mr.
Stanfill's desire to address wealth and equality in this
country, but I do think that the approach he is advocating is
the wrong tool to address those concerns.
I actually think it endangers the structure that has
supported innovation. The point I tried to make to an earlier
question was that if the result of this tax disincentive is to
incentivize venture capitalists to make investments in later
stage companies, then almost by definition we will make fewer
investments in early stage companies, create fewer jobs, and
reap the penalty of that in economic growth.
Mr. DOGGETT. If the Committee does include venture capital
with other types of equity funds on this whole matter, how do
you believe that venture capital funds might reorganize to
avoid that new law?
Mr. SILVER. I cannot answer the question as to how
specifically they will reorganize, but I can assure you that
every venture capital firm and every general partner in every
venture capital firm will examine that issue closely.
Mr. DOGGETT. Mr. Stanfill.
Mr. STANFILL. I would only add if we do not start with our
own house in terms of fairness, where do we start.
Mr. DOGGETT. Thank you very much.
Chairman RANGEL. From Texas asking the witnesses to
identify the next loophole.
[Laughter.]
Mr. DOGGETT. I know there will be one.
Chairman RANGEL. Mr. Blumenauer. Thank you for your
patience.
Mr. BLUMENAUER. Mr. Chairman, I must say that it is worth
sitting through 10 hours of hearing today. I do not know that
since I have been in Congress that I have sat through each of
the panels and enjoyed them as much.
Particularly this panel, I have airplane reading for
tomorrow going home. I will re-read each of the statements. I
found them fascinating.
I personally do distinguish as it relates to real estate. I
have been having these conversations at home with a variety of
people who are in--we do not have a huge hedge fund. We have a
little bit of activity. We have financial advisors. We have
people involved with venture finance. We have lots of people
who want venture investments.
I think this hearing, Mr. Chairman, might look a little
different next year, given some of the froth that is going on
in other aspects of financial markets. I wonder in terms of
when we sort of squeeze out some of the problems we have seen
with some investments and we look into some of the financial
markets, if we might be having a slightly different take about
priorities and what we want to do.
Putting that aside, I have noticed a tiny bit of difference
from left to right here on the panel. I am just speaking as I
am looking. I am very interested in getting reactions, I guess,
in two areas from each of the panelists. I will try to be
brief.
It was my impression that primarily this money followed the
performance of investments, that if hedge funds or venture
capital starts blowing up, people are going to go elsewhere. If
people have goofy fee structures or there is more economic
opportunity somewhere else, regardless of the tax structure,
people are going to follow where there are good investments,
and if there are not good investments, they are not going to be
doing it, and pension funds and university endowments are not
going to be throwing money at the people in question.
I was intrigued, Mr. Hindery, with your point that we did
not see fee structures altered when there have been adjustments
downward. It has been about 40 minutes since you said that. I
would like to start to give you an opportunity to clarify, if
you have changed your mind.
I would like to go down the line with folks in terms of is
that a valid point, and second, I was concerned, Mr. Silver,
you mentioned there are not enough qualified, talented
professionals, that firms are declining, and it is hard to get
good people. I am wondering is that because we are not paying
them enough, there are not people in venture capital or in
hedge funds that you cannot attract the best and the brightest?
If we could just go from left to right briefly, I would be
interested in your observations or amendments.
Mr. HINDERY. Congressman, this is an awful good gig if you
can get it. I just think all of this unintended consequence
plow that has tried to be overhung on this industry today, it
is an obfuscation. This is a good deal, Congressman. It really
is.
I would simply ask my colleague, Mr. Rosenblum, why he did
not adjust his rate down, if he is so anxious about the
consequences to this entire industry, when there is the
prospect of the rates on his personal level going up.
That inconsistency, I think, belies the strength of every
one of the arguments that has been made at the far end of the
table. There has been no rate adjustment in the six times----
Mr. BLUMENAUER. I am sorry. My time is fast going. I really
do want to have people react to this. I think it is important.
Do you have trouble getting qualified people to work for
you in the industry?
Mr. HINDERY. I have no problems at all; none. In fact, it
is quite the opposite. There is no industry that is a richer
environment than ours right now to attract people.
Mr. BLUMENAUER. Mr. Stanfill.
Mr. STANFILL. We have no problem filling slots. We are a
very small firm. We are small potatoes, to tell you the truth.
People seek us out. We do not have room for the people who come
to see us.
Mr. BLUMENAUER. Do you see an issue here in terms of the
relationship between capital gains going down and fee
adjustments? Did you adjust your fees when capital gains went
down?
Mr. STANFILL. We did not adjust our fees. However, the
terms, the partnership terms, after the decline that the
industry went through after the meltdown in 2000, all of a
sudden it became a buyer's market instead of a seller's market.
The terms that were negotiated were more in the investor's
favor than they had been.
Mr. BLUMENAUER. Mr. Kramer.
Mr. KRAMER. Three decades ago when I did work in this town,
actually, I did not know anyone who was talented who wanted to
go into the asset management business. It just was not the
thing. Now, the top people coming out of the top schools, they
want to be in private equity. They want to be in hedge funds.
Nobody thought that way then. There is not any question about
where the talent is going.
In terms of tax rates and fees, that is not a subjective
thing. That is empirically the case, historically. There is no
relationship between what the tax rates were and what the fees
had been. There is not some counter argument that somebody
could make.
More broadly, today, the financial services industry is a
record part of GDP. By the way, to throw more tax subsidies
into it, you will get more of anything.
If at the margin some of the mathematically inclined did
not go to hedge funds, in other words, if there was some
diversion of talent away from what all of us do professionally,
it is not clear to me that as a social matter, America would
suffer if in fact our whole general area of enterprise was
deemed less attractive.
I would also say just a general thing, and I think all of
us think this way, if you have a pool of money, you have $1
million, you have $100 million, you are always thinking the
same way, which is what is the most attractive risk-adjusted
set of places that I can use to do with this money.
Actually, whether you tax me at a lower rate or you tax me
at a higher rate, I am still going to be looking at the best
risk-adjusted after-tax return that I can get, because I do not
know how else to think about the $1 million.
Mr. SILVER. Congressman, I think it is very important that
we not think of the financial services sector that we are
discussing as monolithic. We have been very fortunate to
attract very talented people to our firm, but it is not in fact
easy to do that.
We have several hundred million under management, but we do
not have billions and billions. If you do the math on a 2
percent management fee on several hundred million dollars and
you subtract out rent escalators and legal fees and accounting
fees and everything else, there is not there what you might
think there is.
I would answer your question slightly differently and say
yes, we are in a constant search for good talent because there
are other places for prospective young venture capitalists to
go, including within this sector, but the sector is not
monolithic, and that is what causes that movement to occur.
You do not want to lose those people because what makes
venture capitalists, successful venture capitalists unique, is
an unusual combination of technology background and business
building skills. That is hard to come by.
Mr. IFSHIN. Congressman, we have a terrible time attracting
talent such to the point that we have actually started a
training program for recent college graduates. The reason is
that there is a huge draw of those people to Wall Street and
what they pay.
As it relates to fees, we do not charge investment
management fees. It is not applicable.
Mr. ROSENBLUM. Let me just say on this fee issue, I am not
sure where Mr. Hindery gets his data, but I think it is
important to have some data when you talk about this.
There has been a trend over the last 10 years in the
private equity industry, certainly at our firm, to have lower
fees as a percentage of capital under management. I do not
think that you can fairly attribute that to any one particular
factor, but I think taxes are part of the mix there.
Mr. BLUMENAUER. I will stop. I would like to request that
be submitted in writing. I think it is a little different than
what I heard. I do not want to debate it, but I would like it
clarified in terms of percentage of assets under management,
the fees, as opposed to the fees that are charged related to
the tax. I just need help clarifying that. I heard two
different things.
Thank you. Thank you for your patience.
Chairman RANGEL. Ms. Schwartz.
Ms. SCHWARTZ. Thank you, Mr. Chairman. Thank you for your
patience and for the panel as well. As is sometimes said, if I
am standing between you and dinner, I suppose I should be
brief. I hope we are standing between you and dinner anyway. It
is getting about that time.
I also think that today's hearing, and your panel in
particular, really expresses a lot about what is great about
America, the willingness to invest and take risks and support
bright ideas and entrepreneurs and make money off that. That is
part of what we do in this country. It is a good thing.
We are also looking at here, of course, how we can be fair
about how we tax those winners, and I guess sometimes those
losers.
Thank you for what you have done. I know some of you I have
met with individually, and I appreciate that, and hopefully we
will sort this out in a way that allows a continuation of
investment in the brightest ideas.
One of the questions I asked the previous panel, I wanted
to give you the opportunity to respond to as well, and it has
to do with the concern about our public pensions. If you were
here before, I mentioned that previously when I was a state
senator in Pennsylvania, I authored the law that moved our
retirement systems in Pennsylvania, both for the teachers and
for public employees, to a prudent person standard from a legal
list.
That created an enormous opportunity to invest in different
ways and to get much better returns on those investments.
Certainly those investment managers have made good profits off
that, and I think much of that is fair.
There has been a scare put out. I think it was a good idea.
It has worked out well, I think, for the pensions and for
taxpayers in Pennsylvania and other states where we have done
it.
The concern is if we make a change in the way we handle the
taxation for the managers in terms of carried interest, that we
will see a real change in not getting those kind of returns,
that we will not see investment managers willing to do this,
they will have to charge much higher fees, that it will disrupt
what is working.
Mr. Kramer, I think I will start with you because you were
very clear about the fact that would not happen, I think is
what you said. The previous panel agreed with you, by the way.
They said that would not happen. Most of the pension funds have
said they did not believe that would happen.
I just want to give you the opportunity, Mr. Kramer, to re-
affirm that, and then anyone else who wants to really disagree,
that this change could really be damaging to the retired, the
pensioner, in any of our districts, who are really worried
about that, or our taxpayers who have also been very pleased
not to see taxes go up for school districts in particular
because it has worked.
We do not want to disrupt what works. Mr. Kramer, would you
start, and then if anyone wants to disagree with you.
Do you think we will see a negative consequence?
Mr. KRAMER. Yesterday I agreed to join with your State
Treasurer. She is putting together a group of seven people to
initiate reforms on the investment side in Pennsylvania, and I
will be part of that, helping your state.
Ms. SCHWARTZ. Thank you.
Mr. KRAMER. Two things. Number one, one of my erstwhile
private equity friends called yesterday, why am I in this
position. That is the world, alternative managers, that I come
from socially. He wanted me to at least make the point that
hedge funds and private equity are appropriate investments for
pension systems, and actually, I have in fact strongly
supported that view.
I went and took this particular assignment in New Jersey,
because New Jersey had never done any of this stuff. They never
used any outside managers. They never had a private equity
investment. They never had real estate. They never had venture
capital and they never had hedge funds.
I went there in order to change it. I do believe in the
activity. I would simply say that what Congressman Tiberi
expressed undoubtedly is true of the sentiment of some of the
people on the pension side. I would not want to accuse anyone
of public hypocrisy, but I have a lot of friends in the
alternative management business, and it is difficult for me to
find people in the alternative management business who actually
believe that fees are automatically going to go up because the
tax rates go up.
If basically the returns are great over the next 5 years,
then people are going to be able to charge even more for what
sort of everybody collectively does.
Ms. SCHWARTZ. Anyone else want to disagree with that? Mr.
Rosenblum.
Mr. ROSENBLUM. I would say this is not a black and white
issue and it is not consequences that are going to happen
overnight or be uniform across different managers.
There clearly are investors who are concerned about it.
Obviously, there are some who are not. I think the concerns are
genuine and I think the economic likelihood is that pressured
by additional costs, the firms that can extract something more
are going to try to extract it. It will not be everybody. They
will not be able to pass all the costs through.
I think you will see a shift over time, and I am very
surprised that folks think they have the crystal ball that
tells them that will not happen.
Ms. SCHWARTZ. Thank you.
Mr. HINDERY. Congresswoman, in the prior panel, if there is
an absolute one to one correlation, I believe there is none, as
seemingly does Mr. Kramer, I believe there is none, but in the
prior panel, it was proffered to this Committee that if in fact
it passed through, it would have a two basis point impact on
the returns of the public investor community. That is if it is
a 100 percent correlation, two basis points. That is my point.
Ms. SCHWARTZ. Let me thank you very much. I guess I would
say my assumptions, one of the reasons we are spending the time
that we are is because there will be consequences. There will
be changes. There will be effects.
We want to make sure, as we often do, we have to make sure
that the risks, as you do in the work you do, that the benefits
outweigh the risks that we are taking in terms of the
consequences, and that all of those really very smart people
who work for you, and actually, we have a lot of smart people
working for us as well, will figure it out so that we get the
greatest benefit to Americans, both the taxpayers and the
investors.
Thank you.
Chairman RANGEL. Let me thank this panel for its patience.
I think Mr. Blumenauer said it. It certainly was illuminating
listening to your testimony. I know no matter how many times I
say it, it would appear as though we are targeting public/
private investors, equity investors, or hedge fund operators.
I would just like to conclude by saying this Committee
started these hearings with the sole purpose of seeing how we
could eliminate the alternative minimum tax. We made it
abundantly clear that where we saw in the Tax Code unfairness,
something that did not encourage economic growth, that would be
used as one source of revenues in order to compensate for the
dramatic loss we would have in alternative taxes.
Orin Kramer knows I live in Harlem. I have not had an
overwhelming number of constituents come to me because I said
fairness and equity and they said you are taking something away
from me.
There is no one here that can find anything that the Chair
has said that would indicate that we are looking at these
issues for the purpose of raising revenue.
I am amazed that fairness and equity as a guideline for
this Committee has caused so much concern. Having said that, I
would assume that you will have time to tell your constituents
that there is a valid case made for the difference in the way
people are taxed.
This Committee would like to hear it. This has been a great
Committee. I want to give a special thanks for Orin Kramer
because I know some of the people he associates with, and they
are not going to be very nice to you tomorrow or the next day
or the next day.
This has been illuminating. As we have said before, we hope
that you may have time to come back and to clear up some
things. If you read things in the paper that you believe that
you wish you had time to talk about while you had this time
with us, please feel free to share that with us. We want to
make certain at the end of the day, we can have a bill that the
people believe in.
You have been an extraordinary panel. I want to thank you
so much for your patience and being with us at this very, very
late hour.
Thank you. Before I adjourn the Committee, I ask unanimous
consent that the statement submitted from Mayor Blumberg's
office on the question of the expansion of the ITC be submitted
in the record.
The Chair hears no objection.
[The document referred to follows:]
[INFORMATION NOT AVAILABLE AT THIS TIME]
Chairman RANGEL. I want to thank Mr. McCrery for his
patience and being with us. The Committee will stand adjourned
subject to the call of the Chair.
[Whereupon, at 7:30 p.m., the Committee was adjourned,
subject to the call of the Chair.]
[Submissions for the record follow:]
Statement of American Prepaid Legal Services Institute
I am John R. Wachsmann, President of the American Prepaid Legal
Services Institute. The American Prepaid Legal Services Institute (API)
is a professional trade organization representing the legal services
plan industry. Headquartered in Chicago, API is affiliated with the
American Bar Association. Our membership includes the administrators,
sponsors and provider attorneys for the largest and most developed
legal services plans in the nation. The API is looked upon nationally
as the primary voice for the legal services plan industry.
I offer this written testimony in support of employer-paid group
legal services for working families. Employer-paid group legal services
provide a vital safety net for middle-income families.
The hearing today deals with the economic challenges and inequities
in the Tax Code facing America's working families. Committee Chairman
Rangel noted in calling the hearing that ``One of the fundamental
duties of the Committee on Ways and Means is to conduct oversight of
the Tax Code and ensure that our tax laws promote fairness and equity
for America's working families.''
One effective and inexpensive part of tax relief for working
families should be the restoration of the tax exempt status of
Employer-Paid Group Legal Services. This is targeted tax relief that
works two ways:
It reduces the tax burden on working families and
businesses
It seeks to prevent or amerliorate the consequences of
calamitous events that without legal assistance can quickly snowball
into disaster
For example, one of the economic challenges facing working families
is surviving in an increasingly complex financial environment.
Currently working families are in an extremely precarious economic
position. A perfect storm of adjustable rate mortgage increases, credit
card interest rate increases, layoffs and cutbacks have put many
families on the edge of economic collapse. Many working families are
living paycheck to paycheck with very little cushion in the event of
illness or injury.
A single event, such as a divorce, job lay-off or illness that
interrupts cash flow is enough to trigger defaults on mortgages,
evictions or collection lawsuits. Now is the time when working families
need access to the legal system, through employer-provided legal plans,
to save their homes, deal with debt and keep their families intact.
Group legal plans help working Americans in financial distress.
Plans provide preventative assistance with mortgage and refinancing
document review, as well as advice on sub-prime loans and exotic
financing instruments. Group legal plans help American families
understand the economics of their mortgages to avoid entering into
transactions likely to result in future defaults.
If a default has occurred, plans will review the documents for
compliance with existing laws and advise on workouts that allow
reinstatement of the mortgages. The result is not only saving the
family's place to live, but safeguarding the family's primary
investment.
Group legal plans also provide employees with low cost basic legal
services, including assistance with the preparation of a will, probate,
and domestic relations issues, such as child support collection. Other
issues plans address are:
Protecting spouses and children in the event of death
Anticipating the need for long term care, as well as
Medicare and Medicaid issues
Informing medical professionals on how they want to be
treated in the event of a serious illness or a life threatening
accident
Instructing family members on how they want their
property handled in the event of incapacitating illness or accident
Addressing financial management and investment issues in
the face of a decreased income
Educating clients on how to avoid identity theft and what
steps to take if a client is a victim of this crime
Legal plans provide the advice and legal documents to accomplish
these tasks through wills and trusts, powers of attorney, living wills/
medical directives, guardianship and conservatorships, nursing home
contract review, Medicare and Medicaid appeals and home refinancing
document review.
Yet now, when the need is at its greatest, fewer Americans have
access to inexpensive, preventative legal assistance. Since the loss of
the benefit's tax-preferred status in 1992, existing plans have been
forced to cut back and few new plans have been added.
As employers seek to limit expenses by reducing or eliminating
benefits in general, targeting benefits that are not tax-preferred is
high on employers' lists. Recently this trend toward reducing benefits
has taken a toll on existing group legal plans. Large employers such as
Rouge Steel, Delphi and Visteon have either dropped the benefit
entirely or created a two-tier benefit system that eliminates group
legal for their newest employees. The lack of a tax preference for
group legal plans makes the benefit vulnerable for reduction or
elimination by employers, effectively barring access to justice for
millions of working Americans.
Section 120 was originally enacted in 1976 and extended on seven
separate occasions between 1981 and 1991. This Congress has the
opportunity to reinstate Section 120 of the Internal Revenue Code of
1986 and restore the exclusion from gross income for amounts received
under qualified group legal services plans. This will provide an
incentive for existing plans and tax relief for working families and
businesses.
Bills have been offered in the past several Congresses, including
this year's bill, H.R. 1840, introduced by Congressmen Stark and Camp
and co-sponsored by 31 Members of Congress, 15 of whom are on the Ways
and Means Committee. The identical Senate version of the bill, S. 1130,
has similar bi-partisan support on the Finance Committee.
Reinstatement of the benefit's tax preference will provide direct
and immediate tax relief to employees. When this exclusion expired, it
triggered a tax increase for millions of working Americans whose
employers contribute to such plans. Currently more than 2 million
working families with legal plans offered by such national companies as
Caterpillar, J.I. Case, Mack Truck, John Deere, Ford Motor Company,
General Motors, and thousands of small businesses are taxed on the
employer's contribution, whether or not they use the benefit.
Businesses will also gain direct and immediate tax relief.
Employers must pay an additional 7.65 percent of every dollar devoted
to a legal plan as part of its payroll tax. Employees pay the payroll
tax plus income tax on the cost of the benefit whether they use it or
not in any given year.
Encouraging this benefit is also an efficient and low cost way of
offering economic protection and education to middle class working
families. Employers can provide a substantial legal service benefit to
participants at a fraction of what medical and other benefit plans
cost. For an average employer contribution of less than $100 annually,
employees and retirees are able to take advantage of a wide range of
legal services often worth hundreds and even thousands of dollars,
which otherwise would be well beyond their means.
In conclusion, reinstating Section 120 would repeal a tax increase
on middle class Americans and businesses and restore equity to the tax
treatment of this benefit. Reinstatement will also insure access to the
legal system for millions of middle-class families who might otherwise
be priced out of our justice system. Restoring the tax-preferred status
will demonstrate to millions of hard-working low and middle-income
workers, not only that this Congress supports them, but that the Tax
Code can be fair and equitable.
Statement of Chamber of Commerce
The U.S. Chamber of Commerce, the world's largest business
federation representing more than three million businesses and
organizations of every size, sector, and region, is pleased to have the
opportunity to express its views on the proposal to increase the tax
rate on the general partner's share of a limited partnership's profits,
known as carried interest, from the long-term capital gains rate of 15
percent to ordinary income tax rates of up to 35 percent.
The Chamber opposes this change. Advocates of this tax increase
have sold the increase as targeting a few wealthy hedge fund managers;
however, it stands to impact over 15.6 million individuals that are
invested in 2.5 million partnerships. Carried interest is a core
element of partnership finance in every sector of the U.S. economy
engaged in capital formation, including real estate, private equity,
hedge funds, healthcare, and retail. Raising the cost of doing business
with these entities would make the capital markets less efficient at a
time when the U.S. is facing fierce international tax competition.
This changes would undo decades of established tax law and lead to
wholesale alterations in the structure of partnership agreements
including loan-purchase arrangements and shifting general partner costs
to investors and portfolio companies.
The incidence of a tax increase on carried interest would be spread
across all the players in the partnership--general partners through
lower after-tax gains, limited partners and their beneficiaries through
higher partnership costs and lower returns, and owners and employees of
portfolio companies as lower business valuations.
Selectively raising tax rates on the long-term capital gains of
limited partnerships will drive capital offshore and reduce the
productivity of American workers and the ability of U.S. companies to
compete in global markets. In the long term, 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. Reducing partnership
returns by raising tax rates would encourage investors to put their
money elsewhere.
Background
The Chamber recently commissioned a study by economist Dr. John
Rutledge on the use of partnerships and carried interest throughout the
entire economy. Key findings of the study are summarized below. The
full report can be found on the U.S. Chamber's website,
www.uschamber.com/publications/reports.
A half-century ago, in order to encourage entrepreneurship and
capital formation, Congress created a flexible investment vehicle that
these parties could use to work together. That vehicle is the
Partnership, in which each partner contributes their unique assets, the
partners have great flexibility to divide up the gains from their
investment in any way they deem appropriate, and all income to the
partnership flows through the partnership to be taxed to the individual
partners, based solely on the character of the income--ordinary income,
short-term capital gains or long-term capital gains--that the
partnership receives.
Since its inception, the partnership structure has been a
resounding success, giving American investors and entrepreneurs the
tools to create and grow businesses, build shopping centers, build
hospitals, explore for oil and gas, found new technology companies, and
finance mergers and acquisitions. In 2004, more than 15.6 million
Americans were partners in 2.5 million partnerships investing $11.6
trillion through the partnership structure.\1\ The assets held by
partnerships grew from over $2 trillion in 1993 to $11.6 trillion in
2004, providing capital for the growth of the U.S. economy during that
period. The partnership structure is, in no small measure, responsible
for the innovation, entrepreneurial activity and growth that have made
the U.S. capital market and economy the envy of every country in the
world.
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\1\ Internal Revenue Service, 2007, Data Book 2006, (United States
Department of the Treasury, Washington, D.C.).
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When creating and structuring partnerships that have a life of 5-10
years, investors work hard to make sure that the interests of the
various partners are aligned to avoid potential conflicts later.
Limited Partners may put up 90-99 percent of the financial capital but
lack the intangible entrepreneurial assets to carry out a successful
project, typically agree to carve out a portion--usually 20 percent--of
the ultimate gains of a project for the general partner, who may
contribute only 1-10 percent of the financial capital, in recognition
of the fact that the reputation, network, know-how and other intangible
assets of the general partner are extremely valuable. To further align
their interests, the partners often agree that the general partner must
wait until the end of the partnership, after all of the limited
partner's capital, partnership expenses and fees, and usually a
preferred return have been paid, before the general partner receives
their portion of the gain. These delayed payments--carried on the
partnerships capital accounts until the end of the partnership--are
referred to as the general partner's ``carried interest.''
In addition to carried interest, the general partner collects an
annual management fee from the partnership--usually 2 percent of total
committed capital per year--as compensation for the work of managing
the partnership's activities. Such management fees are treated as
ordinary income and taxed at ordinary income tax rates. According to a
recent study by Andrew Metrick and Ayako Yasuda of the Wharton School,
management fees for a typical private equity fund make up 60-67 percent
of the total value received by general partners, with the remaining 33-
40 percent comprised of carried interest.\2\
---------------------------------------------------------------------------
\2\ Metrick, Andrew, and Ayako Yasuda, 2007, The Economics of
Private Equity Funds.
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Under well-established tax principles, all partnership income is
passed through to the individuals making up the partnerships based on
the character of the income received. To the degree the partnership
receives fees or interest payments, all partners--general partners and
Limited Partners--will be taxed at ordinary income rates. To the degree
the partnership receives long-term capital gains or short-term capital
gains, the partners will pay taxes on that income in the appropriate
way.
According to the Internal Revenue Service, fees and short-term
capital gains income, which are taxed at ordinary income rates (up to
35 percent), accounted for 49.8 percent of total partnership income.
The remaining 50.2 percent of partnership income consisted of long-term
capital gains tax at 15 percent. A weighted average of the two tells us
that the blended average tax rate paid by partners in 2004 was 25
percent.\3\
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\3\ Internal Revenue Service, 2007. The weighted average calculated
as [(49.8)(.35)+(50.2)(.15)]/100=24.96 percent.
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Review of Academic Literature
Over the past 30 years there has grown a vast academic literature
on partnerships in general and private equity partnerships in
particular. Although there are many different opinions on various
aspects of the private equity markets, the vast majority of research
agrees on several key points:
First, private equity is a large and extremely important part of
the U.S. economy that has played an irreplaceable role in the
restructuring of American companies over the last 25 years into today's
strong global competitors.
Second, private equity arises partly in response to a market
failure in the public markets, known as the ``Jensen hypothesis,'' \4\
in which some entrenched managers of public companies fail to look
after the interests of their shareholders. The stronger governance and
tighter control exercised by private equity investors combined with the
closely aligned interests of the private equity investors and the
managers of their portfolio companies through partnership agreements
work to correct this problem.
---------------------------------------------------------------------------
\4\ Jensen, M.C., 1993, The modern industrial revolution, exit, and
the failure of internal control systems,
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Third, private equity is a major and growing source of expansion
capital for family-owned ``middle market'' companies that are too small
or otherwise unsuited for the public markets. These small companies are
the backbone of the American economy, accounting for more than half of
GDP and virtually all employment growth.
Fourth, private equity sponsors and the network of operating
resources they bring to portfolio companies significantly improve the
productivity, profitability, asset management, and growth of the
companies manage. According to Steven Kaplan, Professor at the
University of Chicago School of Business and one of the leading experts
in the area, ``the academic evidence for the positive productivity
effects of private equity is unequivocal.'' \5\
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\5\ The Wall Street Journal, 2007, Trading Shots: Taxing Private
Equity, (The Wall Street Journal).
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Fifth, private equity in the form of venture capital invested in
computers, industrial, energy, retail, distribution, software,
healthcare and consumer products has had an extraordinary record in
creating new businesses, new technologies, new business models, and new
jobs. According to Venture Impact, a study prepared by Global Insight
(2007), venture-backed companies like Intel, Microsoft, Medtronic,
Apple, Google, Home Depot, Starbucks, and eBay accounted for $2.3
trillion of revenue, 17.6 percent of GDP, and 10.4 million private
sector jobs in 2006. Venture-backed companies grow faster, are more
profitable, and hire more people than the overall economy.
Sixth, and finally, private equity in the form of real estate
partnerships has dramatically increased the availability and lowered
the cost of capital to build homes, shopping centers, office buildings,
and hospitals for American families and businesses. In Emerging Trends
in Real Estate (Urban Land Institute (2007)), the study reports that in
2006, investors provided $4.3 trillion in capital to the U.S. real
estate sector, including $3.2 trillion in debt capital and $1.1
trillion in equity capital. Of the equity capital, the bulk was
provided 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).\6\
---------------------------------------------------------------------------
\6\ Miller, Jonathan D., 2006. Emerging Trends in Real Estate (ULI-
the Urban Land Institute, Washington, D.C.). p. 21.
---------------------------------------------------------------------------
Below is a detailed review of several key articles written on this
topic:
1. Cumming, Siegel, and Wright (2007) \7\
---------------------------------------------------------------------------
\7\ Cumming, Douglas, Donald S. Siegel, and Mike Wright, 2007,
Private equity, leveraged buyouts and governance, Journal of Corporate
Finance 13, 439-460.
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In an extraordinarily thorough review article in the September 2007
issue of the Journal of Corporate Finance, Cumming et al. conclude that
``there is a general consensus that across different methodologies,
measures, and time periods, regarding a key stylized fact: [leveraged
buyouts] (LBOs) and especially, [management buyouts] (MBOs), enhance
performance and have a salient effect on work practices. More
generally, the findings of the productivity studies are consistent with
recent theoretical and empirical evidence, Jovanovic and Rousseau
(2002) suggesting that corporate takeovers result in the reallocation
of a firm's resources to more efficient uses and to better managers.''
2. Kaplan (1989) \8\
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\8\ Kaplan, S.N., 1989a, The effects of management buyouts on
operating performance and value, Journal of Financial Economics 24,
217-254.
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In a classic article, Kaplan examines a sample group of 76 large
management buyouts of public companies from 1980 to 1986, presenting
evidence for long-term changes in operating results for these
companies. Kaplan found that in the three years following the buyout,
the sample companies experienced increases in operating income,
decreases in capital expenditures, and increases in net cash flow.
Consistent with these documented operating changes, the mean and median
increases in market value (adjusted for market returns) were 96 percent
and 77 percent over the period from two months before the buyout
announcement to the post-buyout sale. Kaplan provides evidence that the
operating changes and value increases are due to improved incentives as
opposed to layoffs, managerial exploitation of shareholders via inside
information or wealth transfer from employees to investors.
3. Wright, Wilson and Robbie (1996) \9\
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\9\ Wright, M., N. Wilson, and K. Robbie, 1996, The longer term
effects of management-led buyouts, Journal of Entrepreneurial and Small
Business Finance 5, 213-234.
---------------------------------------------------------------------------
The authors examine the longevity and longer-term effects of
smaller buyouts. The evidence presented shows that the majority of
these companies remain as independent buy-outs for at least eight years
after the transaction, and that entrepreneurial actions concerning both
restructuring and product innovation are important parts of
entrepreneurs' strategies over a ten year period or more. Wright,
Wilson and Robbie also provide an analysis of the financial performance
and productivity of these companies using a large sample of buyouts and
non-buyouts. Their analysis shows that buy-outs significantly
outperformed a matched sample of non-buyouts, especially from year 3
onwards. Regression analysis showed a productivity differential of 9
percent on average from the second year after the buyout onwards.
Companies which remained buyouts for ten or more years experienced
substantial changes in their senior management team, and were also
found to undertake significant product development and market-based
strategic actions.
4. Nikoskelainen and Wright (2007) \10\
---------------------------------------------------------------------------
\10\ Nikoskelainen, Erkki, and Mike Wright, 2007, The impact of
corporate governance mechanisms on value increase in leveraged buyouts,
Journal of Corporate Finance 13, 511-537.
---------------------------------------------------------------------------
The authors use a data set comprising 321 exited buyouts in the
United Kingdom from 1995 to 2004 to investigate the realized value
increase in exited leveraged buyouts (LBO). Nikoskelainen and Wright
test Michael C. Jensen's (1993) free cash flow theory, showing that
value increase and return characteristics of LBOs are related to the
associated corporate governance mechanisms, most notably managerial
equity holdings. They also show that return characteristics and the
likelihood of a positive return are related to the size of the target
company and to any acquisitions executed during the holding period.
5. Renneboog, Simon, and Wright (2007) \11\
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\11\ Renneboog, Luc, Tomas Simons, and Mike Wright, ibid. Why do
public firms go private in the UK? The impact of private equity
investors, incentive realignment and undervaluation, 591-628.
---------------------------------------------------------------------------
This paper examines the magnitude and sources of the expected
shareholder gains in United Kingdom Public-to-Private (PTP)
transactions from 1997 to 2003. They show that pre-transaction public
shareholders receive a premium of 40 percent. They test the sources of
value creation from the delisting and find that the main sources of
value are undervaluation of the target firm in the public market,
increased interest deduction and tax savings and better alignment of
owner-manager incentives.
6. Jensen (1989) \12\
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\12\ Jensen, M., 1989, The eclipse of the public corporation,
Harvard Business Review 67, 61-74.
---------------------------------------------------------------------------
Jensen argues against the 1980's protest and backlash from business
leaders and government officials calling for regulatory and legislative
restrictions against privatization (takeovers, corporate breakups,
divisional spin-offs, leveraged buyouts and going-private
transactions). He believes that this trend from public to private
ownership represents organizational innovation and should be encouraged
by policy. Jensen explains that there is a conflict in public
corporations between owners and managers of assets known as the
``agency problem,'' particularly in distribution of free cash flow. He
argues that weak public company management in the mid 1960s and 1970s
triggered the privatizations of the 1980s. He sees LBO firms as
bringing a new model of general management that increases productivity
because private companies are managed to maximize long-term value
rather than quarterly earnings. He argues that private equity
revitalizes the corporate sector by creating more nimble enterprises.
Jensen further asserts that it is important that the general partners
of LBO partnerships take their compensation on back-end profits rather
than front-end fees because it provides strong incentives to do good
deals, not just to do deals.
7. Jensen (1993) \13\
---------------------------------------------------------------------------
\13\ Jensen, M.C., 1993, The modern industrial revolution, exit,
and the failure of internal control systems, Journal of Finance 48,
865-880.
---------------------------------------------------------------------------
Jensen describes the problems that accompany the ``modern
Industrial Revolution'' of the past 20 years, citing that ``finance has
failed to provide firms with an effective mechanism to achieve
efficient corporate investment.'' He explains that large corporations
today do not follow the rules of modern capital-budgeting procedures,
most specifically succumbing to agency problems that misalign
managerial and firm interests--damaging managers' incentives to
maximize firm value instead of personal gain. The classic structure of
private equity buyouts helps to realign incentives through increased
managerial equity holding, increased monitoring via commitment to
service debt, and the active involvement of investors whose ultimate
returns depend on the firm's value upon exit. Jensen provides a
framework for analyzing expected longevity and improved performance in
the long-run, arguing that financial sponsor involvement in companies
that have previously been wasting free cash flow and under-performing
can permanently improve the company's performance through improved
organization and practices.
8. Knoll (2007) \14\
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\14\ Knoll, Michael S., 2007, The taxation of private equity
carried interests: Estimating the revenue effects of taxing profit
Interests as ordinary income, Social Science Research Electronic Paper
Collection (Philadelphia, PA).
---------------------------------------------------------------------------
Knoll presents the first academic analysis to quantify the tax
benefit to private equity managers of the current treatment of carried
interests and the additional tax that the Treasury would collect if
current tax treatment were changed in accord with recent proposed
legislation. He points out that it is misleading to look at one party
in isolation because private equity investments involve several parties
including general partner, limited partner, and portfolio company
owners and managers who are joined by negotiated business agreements.
Knoll uses a method for estimating tax impacts that was developed 25
years ago by Merton Miller and Myron Scholes (1982). Using the Miller-
Scholes methodology, he estimates the tax implications of raising tax
rates on carried interest for all parties in the private equity
transaction.
The fund's investment capital comes from its limited partners--
wealthy individuals, charitable foundations with large endowments,
pension funds, and corporations, and insurance companies. Each limited
partners has a different tax status. Using estimates of the composition
of limited partners, Knoll calculates estimates of net tax revenue gain
from the proposed tax increase.
Knoll estimates, based on assumed $200 billion of annual limited
partner investments and with no change in the composition of the
partnerships or structure of the fund agreements, that the change in
tax treatment as a combination of ordinary income tax rates and
accelerating taxation of corporate entities would generate an
additional $2 to $3 billion per year. He notes, however, that it is
highly likely that the structure of private equity funds will change in
response to the tax treatment revisions, shifting some portion of the
burden of increased taxes to limited partners and to the portfolio
companies. Assuming that companies are generating taxable profits, and
can use the additional expense deduction, shifting carried interest to
portfolio companies would virtually cancel out any additional taxes
paid by the general partners, with the result that increasing carried
interest tax rates would generate little or no net increase in tax
collections.
9. Fleischer (2006) \15\
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\15\ Fleischer, Victor, 2006, Two and Twenty: Partnership Profits
in Hedge Funds, Venture Capital Funds and Private Equity Funds,
Colloquium on Tax Policy and Public Finance (NYU School of Law).
---------------------------------------------------------------------------
Fleischer proposes a ``cost-of-capital'' approach under which the
general partners of investment partnerships with more than $25 million
in capital under management would be allocated an annual cost-of-
capital charge (e.g. 6 percent of the 20 percent profits interest times
the total capital under management) as ordinary income. The limited
partners would then be able to deduct the corresponding amount (or
would capitalize the expense, as appropriate). Fleischer argues that
this tax treatment more closely reflects the economics of the
arrangement, explaining ``in the typical fund, the general partner
effectively receives a non-recourse, interest-free compensatory loan of
20 percent of the capital in the fund, but the foregone interest is not
taxed currently as ordinary income.''
Fleischer claims that his cost-of-capital approach also provides a
reasonable compromise on the character of income issue: ``as when an
entrepreneur takes a below market salary and pours her efforts back
into the business as `sweat equity,' the appreciation in the value of a
private equity fund reflects a mix of labor income and investment
income. A cost-of-capital approach disaggregates these two elements,
allowing service partners to receive the same capital gains preference
that they would receive on other investments, but no more.''
10. Weisbach (2007) \16\
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\16\ Weisbach, David A., 2007, The Taxation of Carried Interests in
Private Equity Partnerships.
---------------------------------------------------------------------------
Weisbach argues that the arguments behind the Levin bill (H.R. 2834
in the 110th Congress) are misplaced for two reasons: 1) the labor
involved in private equity investment is no different than the labor
that is intrinsically involved in any investment activity, and should
be treated no differently; and 2) even if there were good reasons for
taxing carried interest as ordinary income, the tax changes would be
``complex and avoidable, imposing costs on all involved without raising
any significant revenue.''
To support his first point, he compares private equity investment
to purchasing stock through a margin account. In both situations,
investors combine their capital with that of third parties, and labor
effort is requires to make the investment. The only difference between
the two scenarios is that private equity funds issue limited
partnership interests as a means of financing their investment instead
of margin debt. Weisbach argues that there are no valid reasons to
change the way that these sponsors are taxed simply because they have
chosen a different method of financing their activities or because they
use a partnership.
The problem of complexity and avoidance that Weisbach describes is
independent of the issue of what is appropriate according to tax law,
and is concerned mostly with practicality. In order to change the tax
treatment of carried interest as proposed, one would first have to
define carried interests. In addition, if that were accomplished
satisfactorily, fund managers would have little problem avoiding the
bulk of these new taxes by acquiring non-recourse loans from limited
partners.
Weisbach concludes that the decision of private equity fund
managers to use limited partnerships instead of debt to finance their
investments does not warrant such a significant change in tax law; and
that even if it did, the small increases in tax revenues (after
investors have avoided the bulk of the impact of the tax rate increase
with simple changes in financing structure) would not outweigh the
difficulties and costs that the new laws would present.
11. Abrams (2007) \17\
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\17\ Abrams, Howard E., 2007, Taxation of Carried Interests, Tax
Notes.
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Abrams discusses current issues surrounding carried interest tax
changes, concluding that while current tax law was drafted largely out
of administrative convenience, it is in fact a fairly good compromise
between the many conceptual and practical difficulties of fashioning a
proper tax treatment for investment activities. He argues that while
surely some portion of the returns could be considered compensation for
services, it is not valid to classify all of the carried interest
received by the general partner as compensation since a large part of
carried interest is in fact the risky return on a capital investment
and should qualify for capital gain treatment.
Abrams considers Fleischer's (2006) proposed cost-of-capital
approach as a compromise, arguing that though much of the logic is
sound, the proposal has very little effect on tax revenues since with
every cost-of-capital charge the general partner pays, the limited
partners are allowed a corresponding deduction, except for non-profit
tax-exempt entities for whom the deduction holds no value. Because of
the small impact this system would have on tax revenues, Abrams
suggests that even if Fleischer's approach were the correct one, the
transaction cost of changing current tax law is greater than the
ultimate benefits of such a change, due largely to undesirable
complexity and avoidance issues.
12. Fenn and Liang (1995) \18\
---------------------------------------------------------------------------
\18\ Fenn, George W., Nellie Liang, and Stephen Prowse, 1995, The
Economics of the Private Equity Market, Staff Series (Board of
Governors of the Federal Reserve System, Washington D.C.).
---------------------------------------------------------------------------
This thorough review of the history and structure of private equity
and venture capital was published as a staff study of the Federal
Reserve Board. The report traces the historical positive role
regulatory and tax changes have played in fueling investment activity
through the widespread adoption of limited partnerships as the dominant
form of organizing private equity ventures.
Fenn and Liang describe the rise of the partnership as the most
effective structure for dealing with issues of information and
incentive structure between the general partner, institutional
investors, and portfolio companies. Fenn and Liang emphasize that the
expansion of the private equity market has increased access to outside
equity capital for both classic start-up companies and established
private companies.
Relevant to the current proposed regulatory and tax changes, Fenn
and Liang describe the abrupt slowing of venture capital investment in
the late 1960s and early 1970s due to a shortage of qualified
entrepreneurs, a sharp increase in the capital gains tax rate, and a
change in tax treatment of employee stock options. These changes not
only discouraged investments in start-ups but drove fund managers to
shift to other strategies for private equity investing. The result,
they note, was an increase in leveraged buy-outs of larger, more
established companies and very little investment in new ventures.
Public concern about the scarcity of capital for new ventures
prompted another round of regulatory changes in the late 1970s,
changing the guidelines for public pension fund investing to include
private equity and venture capital investments. The initial impact of
these changes was to reinvigorate the new-issues market; its long-run
impact has been to encourage pension fund investments in private equity
partnerships. The evolution of the limited partnership in combination
with favorable regulatory and tax changes led to early notable start-up
successes such as Apple Computer, Intel, and Federal Express.
Conclusion
Since its inception, the partnership structure has been a
resounding success, giving American investors and entrepreneurs the
tools to create and grow businesses, build shopping centers, build
hospitals, explore for oil and gas, found new technology companies, and
finance mergers and acquisitions. In 2004, more than 15.6 million
Americans were partners in 2.5 million partnerships investing $11.6
trillion using the partnership structure.
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. If a group of financial investors came together to form a
partnership with no general partner to engage in exactly the same
investment activities, 100 percent of the profits from the partnership
would be taxed at long-term capital gains rates. The partnership
structure simply assigns a slice of those capital gains to the general
partner to induce them to contribute their intangible assets--brand,
reputation, deal flow network, and experience--to the venture. The fact
that limited partners do so willingly, through arms-length negotiations
with general partners, serves as a measure of the value that a good
general partner brings to the table.
The incidence of a tax increase on carried interest would not hit
just the fund managers but would be spread across all the players in
the partnership--general partners through lower after-tax gains,
limited partners and their beneficiaries through higher partnership
costs and lower returns, and owners and employees of operating
companies as lower business valuations.
U.S.-based companies are facing fierce international tax
competition. In today's global economy, countries have to compete for
the capital they need to grow. 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.
Higher tax rates would reduce the amount of long-term capital available
to the U.S. economy and undermine investment, innovation,
entrepreneurial activity, and productivity.
Statement of National Association of Publicly Traded Partnerships
The National Association of Publicly Traded Partnerships (NAPTP) is
pleased to have this opportunity to submit a statement for the record
with respect to the ``Hearing on Fairness and Equity for America's
Working Families'' held by the Committee on Ways and Means on September
6, 2007. NAPTP, formerly the Coalition of Publicly Traded Partnerships,
is a trade association representing publicly traded partnerships \1\
(PTPs) and those who work with them. Our current membership includes
sixty PTPs and thirty-five other companies.
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\1\ Publicly traded partnerships are also referred to as ``master
limited partnerships'' or MLPs.
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PTPs are provided for under section 7704 of the Internal Revenue
Code. This section generally provides that a very limited universe of
companies--those engaged in active natural resource or real estate
business as well as those generating passive investment income--can be
publicly traded partnerships.
I. Publicly Traded Partnerships and Carried Interest
A primary focus of this hearing is the fact that certain private
equity and hedge fund managers, among others, are compensated for their
services via a ``carried interest''--a partnership profits interest--
and that this compensation is received and taxed as capital gains.
Awareness of and concern about this practice escalated early this year
when a few such funds went public as PTPs or expressed the intention of
doing so. It is important to remember, however, that the ability of
these managers to receive carried interest in the form of capital gains
arises not because their companies are publicly traded partnerships--
the vast majority are not--but because they are partnerships whose
investments produce capital gain. The tax treatment of carried interest
is based on long established rules of Subchapter K regarding the tax
treatment of partnership interests received in return for services
provided to the partnership, and not on the publicly traded partnership
rules of section 7704.
Moreover, it is important to recognize that not all carried
interests, nor all partnership profits interests, pass through capital
gains to the holder of the interest. The rate at which the income from
``carried interest'' is taxed is dependent on (i) the organizational
nature of the company receiving the carried interest (C corporation,
partnership, etc.) and (ii) the character or nature of the underlying
income. If the recipient is a C corporation, the income will be taxed
at ordinary income tax rates. If it is a partnership, then it is not
taxed at the entity level and the rate at which it is taxed is
dependent on the nature of the income. The nature of the income
received by the partner will depend upon the nature of the income
generated by the business. Typically, the private equity funds receive
the bulk of their income when they sell the companies in which they
invest, and the proceeds from a sale are usually characterized as long-
term capital gains. In contrast, the business of ``traditional'' PTPs,
i.e., those PTPs clearly and purposefully treated as partnerships in
1987, generates ordinary income.
The general partners of many PTPs (ten of which are themselves
PTPs) have profits interests known as an incentive distribution rights
(IDRs), under which the general partner receives a 2 percent interest
in the PTP's income. This percentage share increases in steps as
distributions to the limited partners reach target levels. This profits
interest, however, gives rise to ordinary business income and is taxed
as such in the hands of the general partner.
While private equity firms are not part of NAPTP, we take no
position on whether the carried interest rules for investment
partnerships should be changed. However, as an association that was
organized in the 1980s when the tax treatment of PTPs was a subject of
debate, and which played a role in the enactment of the current law
that preserves partnership treatment for certain PTPs, NAPTP is happy
to provide its perspective on the history and intent of section 7704
and to provide information on the PTPs that we represent.
As we do so, we strongly urge that Congress avoid changing the law
that for two decades has governed the ``traditional'' PTPs. Those PTPs
operating in the energy industry in particular are a long-established
segment of that industry and play an important role in the development
of the national energy infrastructure needed to insure our continued
economic growth and security. This role is widely recognized by
observers ranging from FERC to energy analysts on Wall Street. There is
no policy reason to overturn twenty years of settled and successful tax
law by changing the tax treatment of these traditional PTPs.
II. Early History of PTPs
The first publicly traded partnership was Apache Petroleum Company,
which was created in 1981 by Apache Oil through the roll-up of several
smaller partnerships. It was soon followed by a number of oil and gas
exploration and production PTPs as well as by real estate PTPs. Some,
like Apache, were formed by partnership roll-ups; some by spin-offs of
corporate assets; some (until the Tax Reform Act of 1986 repealed the
General Utilities doctrine) through corporate liquidations; and a few
through IPOs for new business operations.
The energy and real estate industries had traditionally used
limited partnerships as a means of raising capital and conducting
operations. The pass-through structure of partnerships allowed
investors to share directly in both the profits and the tax attributes
of these industries. Traditional limited partnerships, however, could
attract only a limited pool of investors. They required investors to
commit large amounts of money and were very illiquid. Thus, only very
affluent investors could afford to participate.
By dividing partnership interests into thousands or tens of
thousands of units which were affordably priced and could be traded on
public exchanges, PTPs were able attract a far broader range of
investors than private limited partnerships, providing a new flow of
equity capital to the energy and real estate industries. Unlike many of
the limited partnerships that were formed during the 1980s as tax
shelters aimed at providing investors with a tax loss, PTPs were
created to be income-generating investments. Companies with energy,
real estate, or other assets providing positive income streams over a
number of years were able to attract investors seeking steady cash
distributions.
As the 1980s progressed, PTPs began to emerge in other industries,
e.g., the Boston Celtics and the Cedar Fair amusement park company.
This became a source of concern to tax policymakers.
A. Development of the 1987 Legislation
Until 1987 there were no provisions in the Internal Revenue Code
specifically addressing publicly traded partnerships. However, the
growth of PTPs led to fears on the part of the Treasury Department and
some Congressional policymakers that the expansion of PTPs would cause
a substantial loss of corporate tax revenue. In addition, the 1980s
were the decade of tax reform, and some felt as a policy matter that
the fact that public trading of securities was an inherently corporate
characteristic--an idea with which we have always disagreed.\2\
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\2\ The vast majority of corporations are never publicly traded.
---------------------------------------------------------------------------
After several years of debate over the issue of whether large and/
or publicly traded partnerships should continue to receive pass-through
tax treatment, the Treasury Department and Congressional tax writers
determined to address the issue in 1987. It was clear from the
beginning that while there were varying views on the degree to which
PTPs should be restricted, there was considerable support for the idea
that the natural resources industry, which had always raised capital
through partnerships, should continue to be able to do so through PTPs.
Hearings on publicly traded partnerships were held by this
Committee on June 30 and July 1, 1987, and by the Senate Finance
Subcommittee on Taxation and Debt Management on July 21, 1987. At both
the House and Senate hearings, Assistant Treasury Secretary for Tax
Policy J. Roger Mentz, one of the primary advocates of restricting the
use of PTPs, testified that partnership tax treatment should be
retained for PTPs engaged in natural resources development:
If Congress changes the classification of MLPs for tax purposes, we
suggest that it consider extending the current statutory pass-through
models to include activities such as natural resource development.
Thus, as with REITs, RICs, and REMICs, entities engaged principally in
developing timber, coal, oil, and gas, and other natural resources
serve a relatively passive function, generating income from wasting
assets and distributing it to investors. Given the importance of
natural resource development in the nation's security, Congress should
consider carefully whether such traditionally noncorporate activities
should be subjected to corporate level tax. . . . [Emphasis added]
B. Final Legislation
The provisions that we now know as section 7704 of the Code, which
were enacted as part of the Revenue Act of 1987, originated in this
Committee. This Committee retained partnership tax treatment for PTPs
generating the type of income, such as interest and dividends, that one
would receive as a passive investor, explaining in its report,
If the publicly traded partnership's income is from sources that
are commonly considered to be passive investments, then there is less
reason to treat the publicly traded partnership as a corporation,
either because investors could earn such income directly (e.g.,
interest income), or because it is already subject to corporate-level
tax (in the case of dividends). Therefore, under the bill, an exception
is provided . . . in the case of partnerships whose income is
principally from passive-type investments.
This Committee did not allow interest to be treated as qualifying
income if it was earned in conducting a financial or insurance
business, ``as deriving interest is an integral part of the active
conduct of the business.'' Dividends, unlike interest, were not
specifically restricted in the statutory language, but this Committee's
report states, ``Similarly, it is not intended that dividend income
derived in the ordinary conduct of a business in which dividend income
is an integral part (e.g., a securities broker/dealer) be treated as
passive-type income.''
Importantly, this Committee also retained partnership tax treatment
for PTPs engaged in two types of active businesses: real estate and
natural resource activities, noting in its report that these activities
``have commonly or typically been conducted in partnership form'' and
that it ``considers it inappropriate to subject net income from such
activities to the two-level corporate tax regime to the extent the
activities are conducted in forms that permit a single level of tax
under present law.'' Natural resources activities were purposely
defined very broadly to include ``income and gains from exploration,
development, mining or production, refining, transportation (including
through pipelines transporting gas, oil or products thereof), or
marketing of, any mineral or natural resource, including geothermal
energy and timber.'' \3\ This is essentially the rule that Congress
adopted in the final bill.
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\3\ ``In the case of natural resources activities, special
considerations apply. Thus passive-type income from such activities is
considerably broader. . . .''
---------------------------------------------------------------------------
In summary, Congress' intent in 1987 was to allow partnership tax
treatment for PTPs generating investment-type income, i.e., income such
as interest and dividends which a passive investor might earn without
directly participating in a business. Partnership tax treatment for
active business operations was also allowed to continue for two
industries which had traditionally used the partnership structure, real
estate and natural resources. Importantly, however, the evidence is
that Congress also intended that qualifying income should include
dividends received by PTPs from taxpaying corporate subsidiaries.
C. Non-Qualifying Income and Corporate Subsidiaries
As noted above, while the legislative history of section 7704
clearly indicated that interest and dividends earned as part of a
financial business should not be considered to be qualifying income, it
did not state or imply that dividends from corporate subsidiaries of
PTPs would not be qualifying income to the PTP. To the contrary, it is
apparent that Congress condoned the use of corporate subsidiaries.
The 1987 Treasury testimony noted above, which suggested that
partnership tax treatment be retained for entities engaged principally
in developing natural resources, also acknowledged that if this
exception was enacted into law, many ``downstream'' operations such as
milling, processing, refining, or marketing activities would remain in
corporate form. Thus Congress was aware of the potential use of
corporate subsidiaries for this purpose and did not exclude or restrict
dividends from such subsidiaries as qualifying income in enacting
section 7704.
In addition, as the legislative history makes clear, section 7704
was resulted from the concern that the widespread use of PTPs would
lead to a loss of corporate income tax revenue. Thus, there could be no
objection to a PTP receiving dividend income from a subsidiary earning
non-qualifying income that had been subject to corporate tax. Finally,
the transition rules provided by Congress for existing PTPs with non-
qualifying income allowed them to remain in existence after the
transition period ended if they were able to change their income stream
to meet the qualifying income test of 7704, and placed no restrictions
on PTPs' ability to place operations in corporate subsidiaries for this
purpose.
Some NAPTP members form corporate subsidiaries for related
activities that generate non-qualifying income.\4\ This is done to
ensure that the qualifying income test is met. Although the amounts
involved are usually quite small, it is important to remember that the
penalty for exceeding the 10 percent limit on non-qualifying income is
extremely severe--the conversion of the PTP into a corporation, with
resulting adverse tax consequences to the company and its investors. We
therefore feel it is entirely appropriate to use a corporate
subsidiary, which is not afforded flow-through treatment, to act as a
``safety valve'' for the qualifying income test.
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\4\ Some members also have corporate subsidiaries which generate
qualifying income, as part of an acquisition or joint venture, or for
other reasons.
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Since 1987 no additional restrictions have been placed on the
activities of publicly traded partnerships and there have been some
small liberalizations in their tax treatment. For example, in 1993 the
rule enacted in 1987 which treated all income from a PTP as unrelated
business income for tax-exempt investors, regardless of the nature of
the income, was repealed; and in 2004, with bipartisan support,
Congress added PTPs to the list of qualifying income sources for mutual
funds.
III. PTPs Today
A. PTP Businesses
The PTP universe today looks very different from the one in 1987.
Most of the PTPs doing business in 1987 are gone, eliminated not by
Congress, but by the marketplace. Changes in economic conditions for
the energy and real estate industries in the latter part of the 1980s
led to a wholesale change in the composition of the PTP universe.
Gradually over the course of the 1990s and early 2000s, the
exploration and production PTPs were replaced by companies in the
``midstream'' sector of the energy business: pipeline and marine
transportation, processing, refining, gathering, marketing, etc. This
sector is much less affected by oil and gas prices, receiving a
contracted fee for services regardless of the price of the commodity,
and thus is better able to maintain steady distributions through the
ups and downs of the markets. Companies with these types of assets,
particularly regulated pipelines, found that they were able to attract
more capital in PTP form than in corporate form.
Today, by the Association's count, there are some 80 publicly
traded partnerships trading on the major exchanges, including the
Fortress and Blackstone entities. The great majority of these are
energy-related partnerships, as demonstrated in Table 1. The total
market capital of these 80 PTPs is about $163 billion as of August 31,
of which about $134 billion or 82 percent comes from the energy-related
sectors.
------------------------------------------------------------------------
Table 1 Publicly Traded
Partnerships on Major Exchanges
---------------------------------
Percent Market Percent
Capita
l
Number* of Total ($B) of
Total
------------------------------------------------------------------------
Oil and Gas Midstream Operations 39 48.8% $91.7 56.2%
Marine Transportation 6 7.5% $3.8 2.3%
Propane & Heating Oil 9 11.3% $23.6 14.4%
Oil & Gas E&P 7 8.8% $7.6 4.6%
Coal 5 6.3% $7.4 4.5%
------------------------------------------------------------------------
All Energy 65 82.3% $134.0 82.2%
------------------------------------------------------------------------
Other Minerals, Timber 2 2.5% $2.2 1.4%
Real Estate--Income Properties 3 3.8% $8.5 5.2%
Real Estate--Mortgage Securities 3 3.8% $1.8 1.1%
Miscellaneous 6 7.5% $16.5 10.1%
------------------------------------------------------------------------
All PTPs 80 100% $163.0 100.0%
------------------------------------------------------------------------
ANumbers include 10 PTPs which are publicly traded general partners of
other PTPs. This includes 6 in Midstream Operations, 2 in Propane &
Heating Oil, and 2 in Coal.
B. PTPs in the Energy Industry
Of the various sectors of the energy industry in which PTPs
operate, the largest by far, representing over half of the PTP market
capital, is the midstream sector: PTPs which gather oil and natural gas
in gathering pipelines; compress natural gas for transportation; refine
or process crude oil and natural gas into natural gas liquids; fuels,
and other products; transport oil, gas, and refined products in intra-
and interstate transmission pipeline systems; and store them in
terminals. Another group of PTPs, currently six in number, transports
petroleum products by water to areas not reached by pipelines.
In other energy niches, several PTPs are engaged in the
distribution of heating oil and propane. In addition, seven to date
have returned to the place where PTPs originally started--exploration
and production of oil and gas. For various reasons, these PTPs are
considered by analysts to be more conservative and less risky than
their 1980s counterparts. Finally, three PTPs and two PTP general
partners are in the coal industry; one engaged in active production;
the others as lessors of coal reserves.
As midstream energy operations have become an increasingly
important part of the businesses conducted by PTPs, PTPs have
conversely become an increasingly important part of the midstream
energy industry, and particularly the ownership and operation of oil
and gas pipelines. As shown below in Figures 1 and 2, the midstream
energy PTPs dominate the PTP world in both numbers and market capital.
MISSING GRAPHICS
Why has so much midstream energy capital moved into PTPs? Over the
past decade, many corporate energy companies have realized that they
had a good deal of capital tied up in pipeline assets which, although
dependable generators of cash, produce only a modest return,
particularly for those pipelines subject to rate regulation. By selling
these assets to PTPs, they could monetize them and reinvest the capital
in areas closer to their core business and with higher returns. PTP
unitholders, meanwhile, would receive the benefit of the steady cash
distributions generated by pipeline fees.
PTPs, for their part, have proven to be a highly efficient means of
raising and investing capital in pipeline systems. Their structure
affords such PTPs a lower cost of capital, allowing them to spend more
on building or acquiring pipelines. PTPs need to pay out most of their
earnings as cash distributions due to their pass-through tax status,
which requires the unitholders to pay tax on their shares of
partnership income regardless of whether they receive a corresponding
amount in cash; therefore, PTPs cannot retain earnings for building or
acquiring pipelines and other assets. The need to go to the equity or
credit markets to raise capital lends discipline to their capital
expenditures, helping to ensure the most efficient use of capital.
For these reasons, the proportion of oil and gas pipelines owned by
MLPs has steadily increased over the years. We estimate that PTPs today
own over 200,000 miles of pipelines--gathering and transmission,
onshore and offshore, carrying natural gas, natural gas liquids, crude
oil, and refined products, as shown in Table 2. Of the $163 million of
PTP market capital, $102 million is in pipeline PTPs. To an increasing
extent, PTPs are building and maintaining the pipeline infrastructure
on which we depend for energy security.
------------------------------------------------------------------------
Table 2 PTP-Owned Pipeline Mileage as of August
2007
-------------------------------------------------
PTP-Owned
Mileage (1)
------------------------------------------------------------------------
Crude Oil 29,496
Refined Petroleum Products 37,527
Natural Gas 123,942
Natural Gas Liquids \(3)\ 20,641
------------------------------------------------------------------------
TOTAL 211,606
------------------------------------------------------------------------
(1) Sources: PTP 10-Ks and websites. When a PTP owns a partial interest
in a pipeline, the mileage included is equal to (pipeline miles) x
(percentage interest).
This fact has been increasingly recognized by, among others, the
Federal Energy Regulatory Commission (FERC), which oversees a number of
pipelines owned and operated by PTPs. Most recently, on July 19, 2007,
FERC Chairman Kelliher issued a policy statement stating that PTPs will
henceforth be included in the proxy group for calculation of returns
under the discounted cash flow model for natural gas pipelines.
Kelliher noted that PTPs have been included in oil pipeline proxy
groups for a number of years due to the lack of corporate owners and
stated:
The reality is that both sectors have increasingly adopted the MLP
structure as the framework for the pipeline business. This raises a
policy question: have we reached a tipping point, have we reached the
point where the natural gas pipeline sector has adopted the MLP to such
an extent that it is perverse to exclude MLPs from the proxy group? In
my view we have reached that point. It seems clear we reached that
point with respect to oil pipelines some time ago.
It was in recognition of this fact that the Senate Finance
Committee this year included in its energy tax provisions a measure
that would include transportation and storage of blended ethanol,
biodiesel, and other renewable fuels in the definition of ``natural
resource activities'' under section 7704. If the Federal policy of
dramatically increased use of these fuels is to be achieved, pipelines
will have to be built or converted to carry them. The past decade has
shown that if large amounts of capital are to be put into pipelines, it
will be PTPs that will do it.
The energy PTPs are doing exactly what Congress intended them to do
in 1987, including building and maintaining the pipeline infrastructure
on which we depend for energy security. Accordingly, the PTP provisions
are working well and should be allowed to continue doing so.
IV. Conclusion
Twenty years ago Congress and the Treasury Department undertook a
lengthy and careful consideration of the issue of publicly traded
partnerships and who should have access to this particular business
structure. The result was the enactment of section 7704 of the Tax
Code. It is clear from the legislative history that those in Congress
and the Executive Branch who participated in the development of section
7704 intended that--
Activities generating passive investment income such as
interest and dividends should be able to use publicly traded
partnerships. However, companies for whom interest and dividends were
their business income, such as those in the financial services
industry, should not qualify as PTPs.
Two types of active businesses, natural resources and
real estate, which had traditionally raised capital through
partnerships and whose existence was important to the national economy,
should continue to be able to access the capital markets in partnership
form.
As long it is not ``business'' income to a PTP, dividend
income, including income received from a corporate subsidiary, is
qualifying income.
Over the ensuing years, the economics of the midstream energy
transportation and storage industry and the interest of many integrated
energy companies in finding more lucrative investments for their
capital, have led to an increasingly important role for PTPs in this
sector. The PTP rules have worked well in allowing capital to be
channeled into the infrastructure needed to move traditional energy
sources out of the ground, process them into useable products, and
transport them from production areas to the areas where they are
consumed. As the country moves to alternative forms of energy, PTPs
will continue to play a central role. The ongoing debate on the pros
and cons of carried interest should not be allowed to change this fact.
Statement of National Center for Policy Analysis
Mr. Chairman and Members of the Committee, thank you for this
opportunity to submit testimony on methods to achieve a fair and
equitable tax system. My testimony draws heavily from research
conducted by scholars at the National Center for Policy Analysis
(NCPA), particularly from NCPA Brief Analysis numbers 537, 571, and
588--all of which can be found at the ncpa.org website.
The Alternative Minimum Tax (AMT) enacted in 1978 was intended to
tax the small number of wealthy individuals who, in any given year,
legally owe no personal income tax due to the many exemptions allowed
by the U.S. Tax Code. The AMT has its own set of rules, which limit
deductions. Individuals with incomes above a certain level calculate
their taxes under both sets of rules and pay whichever amount is
higher.
However, the exemption levels are not indexed for inflation. Thus,
as incomes have risen, more and more middle-class Americans have been
forced to pay the AMT. Congress has addressed this problem by passing a
series of temporary increases in the exempt amount, but when these
temporary fixes expire, millions of middle-income citizens will be
forced to pay a tax intended only for the super-rich. Rather than
creating another temporary fix, Congress should use this opportunity to
permanently restructure the tax system.
Problems with the AMT
In addition to the burden that awaits middle-class families when
the AMT extensions expire, there are other problems.
Uncertainty for Taxpayers. By continuously setting back the date
when the 2000 exemption levels return, legislators create uncertainty
in the economy. In any given year, if Congress cannot agree on
legislation to temporarily extend higher exemption levels, the middle
class will be hit by the AMT. Furthermore, should Congress allow a
return to 2000 exemption levels, the complexity of the AMT creates
uncertainty for individual tax filers as to how they will be affected.
Thus, even in the years when Congress is successful in extending higher
exemptions, middle-class taxpayers may reduce their investments in
order to protect themselves against a possible future rollback.
Future Dependence. Because of the growing number of taxpayers
filing the AMT every year, the Federal budget will increasingly depend
on it for tax revenue. Though repealing the AMT will cost an average of
$74.5 billion annually over the next decade, if it remains in place,
the costs increase over time. Every year, over two million more
taxpayers will file AMT. By 2008, the AMT will be more expensive to
repeal than the income tax--$100 billion versus $72 billion--according
to the Tax Policy Center.
Unfairness. Currently, the AMT taxes individuals a flat 26 percent
of gross income minus deductions for mortgage interest and charitable
contributions. Therefore, the brunt of the AMT falls on taxpayers
earning between $200,000 and $500,000. This is because they are most
likely to fall under the AMT, but have lower mortgage interest and
charitable deductions than higher-income taxpayers. While 43.4 percent
of these individuals filed AMT in 2005, only 26.4 percent of taxpayers
with incomes of more than $1,000,000 did, according to the Tax Policy
Center. Ironically, the AMT does not achieve its original goal. Even
with the AMT, 5,650 tax filers with incomes over $200,000 owed no
income taxes in 2002.
The Regular Income Tax versus the AMT
In the 1970s and 1980s, supply-side economists and journalists
noted that high marginal tax rates create a large ``tax wedge'' between
the after-tax income workers receive and the value society places on
their output--and between the after-tax return on investment and the
value of the production that investment makes possible. A big tax
wedge, and high marginal tax rates, stunt economic growth by
discouraging work and investment. For a given amount of tax revenue
raised, the lower the marginal tax rate the better.
The supply-siders' insight wasn't novel. In the United Kingdom, the
top marginal tax rate in the 1970s was 83 percent on earned income and
98 percent on interest and dividends. James Mirrlees, a ``left-wing''
economist and Labour Party adviser, concluded that the optimal top
marginal tax rate was only about 20 percent and that rates for other
income groups should be close to 20 percent. An optimal tax rate would
generate substantial government revenue while not greatly reducing
individual incentives to work and invest.
In other words, Mirrlees provided an economic rationale for a
``flat tax,'' such as an income tax that imposes the same rate at all
income levels. Although such a reform is desirable, the odds that such
a flat rate will ever be implemented are small. But it is possible to
get much of the way there by flattening the AMT.
The AMT versus a Flat Tax
Most flat tax advocates want a zero percent tax rate on a minimum
level of income and a tax rate of about 19 percent on all additional
income, with few, if any, deductions allowed. The current AMT differs
from this flat tax system in three main ways: (1) The basic exemption
is higher, (2) the marginal tax rates are substantially higher, and (3)
the expenses that are deductible are more numerous than under a flat-
tax regime. All three aspects of the AMT could be modified easily,
while raising the same amount of revenue for the Federal Government.
MISSING GRAPHIC
Under the AMT, instead of basic deductions, the first $45,000 of
income is exempt for a married couple filing jointly. The tax rate on
this income is zero. As the figure shows:
On income above $45,000 the marginal tax rate is 26
percent, up to $150,000.
Above $150,000 the marginal tax rate is 32.5 percent up
to $206,000.
Above $206,000 the marginal rate is 35 percent up to
$330,000.
Above $330,000 the marginal tax rate falls to 28 percent.
Although the IRS publishes AMT tax rates of 26 percent and 28
percent, in practice there are 4 rates since the exemption on the first
$45,000 is phased out at higher income levels. After the exemption is
completely phased out, the rate falls back to 28 percent.
AMT reformers usually advocate raising the amount of income that is
exempted, which has been done in past years. Instead, Congress could
reduce the exemption, further limit deductions and cut the AMT marginal
tax rate to 24 percent, or even 20 percent. As recently as 1986, the
AMT marginal tax rate was 20 percent. (The 1986 Tax Reform Act raised
the marginal AMT rate to 21 percent, the 1990 tax bill raised it to 24
percent and the 1993 tax bill imposed the current nominal rates of 26
percent and 28 percent.)
Is a Flat Tax-Rate Desirable?
As supply-siders have emphasized, a low flat tax-rate has a
positive effect on the incentives to earn, save, invest and become more
productive, whether through training, education or experience. The
lower the marginal rate, the stronger the incentives.
Critics of supply-side economics have admitted that the marginal
dollars taxpayers are allowed to keep are an incentive to earn more
income. But they also argue that since cuts in tax rates make taxpayers
better off, they may use this higher real income to ``buy'' leisure--
that is, work less. But this criticism warrants little attention unless
the choice to work less resulted in less government revenue. Instead,
the tax system could be changed to keep the Federal Government's
revenues constant by reducing AMT deductions in exchange for lower
marginal tax rates. In economics jargon, the system could be changed so
that there is a substitution effect (working harder in response to
higher after-tax incentives), but no income effect (that is, working
less hard because of the tax break on nonmarginal dollars). The net
effect would be more work and more output.
Long-Term Solutions: Flat Tax or Consumption Tax
As it is currently imposed, the AMT is complex and ineffective in
ensuring that the wealthy pay taxes on their incomes. But even if it
were repealed this year (while leaving the rest of the income tax
system in place), by 2010, over 9,000 high-income filers would pay zero
income tax, due to exemptions.
Congress should create a system that taxes everyone fairly and
efficiently, and simplifies the entire Federal Tax Code. One solution
is to replace the bloated, complex income tax system with a flat income
tax. Another, purer, solution would be to implement a national sales or
consumption tax.
A Lower Rate Flat Tax
A lower-rate flat tax can be structured in a way that:
Ensures the rich continue to bear more of the burden than
they currently do; thus, the plan can be more progressive than the
current system.
Taxes income only once (when it is earned), and does not
tax savings or investments; thus, the plan promotes efficiency and
economic growth.
Does more to help low-income families by providing
incentives to purchase health insurance and invest for retirement.
Steve Forbes has proposed a flat rate of 17 percent, with generous
personal exemptions for all families, so that a family of four would
not pay taxes until its income exceeded $46,000. Moreover, the Forbes
plan encourages growth by exempting income that is saved and invested.
Which means that the Forbes plan approximates a consumption tax. It
taxes people based on what they take out of the economy, not on what
they put in. It is a good plan, but can be improved upon.
The tax rate can be lowered further--14 percent as opposed to 17
percent--and at the same time do more to help low-income people. With
the assistance of Boston University economist Laurence Kotlikoff, an
advocate of a national retail sales tax, the NCPA put together a plan
that works in the following way.
First, it would eliminate the across-the-board $9,000-per-person
exemption in the Forbes plan. Why should billionaires like Bill Gates
get an exemption? Forbes' plan gives too much money away to rich
people. Eliminating the across-the-board exemption would allow the
money to be rebated to the bottom third of earners, those who bring
home roughly less than $25,000 for a family of four.
Second, Forbes doesn't address the 12.4 percent Social Security
payroll tax (split between employer and employee), although the payroll
tax is an example of a pure flat tax. Currently, income over $90,000 a
year is not subject to the tax. It is a regressive feature of the
current tax system that a $50,000-a-year autoworker has to pay payroll
taxes on all his income while a million-dollar-a-year auto executive
does not. Under the NCPA proposal, the income ceiling would be lifted
and all wages would face the same income and payroll tax rates.
These changes should make a flat tax plan more politically
appealing. Politicians are unlikely to adopt a new system that taxes
the paychecks of the rich at a lower rate than those of blue-collar
workers. Under the NCPA proposal, all wages would face the same income
and payroll tax rates. And they would be taxed only once. All savings
would accumulate tax free and be taxed only when withdrawn.
A More Progressive Flat Tax
This plan allows a lower flat-tax rate and produces results that
should appeal to liberals as well as conservatives. What conservatives
most want is an uncomplicated system that taxes income only once (when
it is earned) at one low rate. Liberals are more concerned about
progressivity. They want the rich to bear more of a burden than the
poor.
The left objects to most consumption tax proposals because they
mistakenly believe they aren't progressive. Low- and middle-income
people would pay a greater share of what they earn than rich people.
This proposed system is more progressive than the Forbes flat tax. It's
also more progressive than the current system. Using economic modeling,
Kotlikoff found that under the NCPA flat tax the rich would bear more
of the burden than they currently do.
Health Care and Pensions
Most flat-tax proposals ignore health insurance and retirement
saving. Yet the failure to insure or save--especially for low-income
families--is a social problem. For that reason, the rebate of tax
dollars to the bottom third of taxpayers would be used to help solve
these problems. For example, as a condition of receiving the 14 percent
rebate, low-income families would be required to show they have health
insurance and a retirement pension. Specifically, to get one-half the
rebate (7 percent), they would have to produce proof of health
insurance. This would encourage millions of people who qualify to
enroll in Medicaid or in their employer's health plan. Barring that,
families could apply the tax rebate to health insurance they purchase
on their own. The other half (7 percent) of the rebate would be
contingent on proof of a pension, an IRA, a 401(k) or some other
savings account. So instead of national health insurance and more
government spending on the elderly, this flat-tax proposal would
encourage people to solve these problems on their own.
A Higher Rate of Economic Growth
GRAPHIC MISSING
The tax system itself drags down the economy with the cost of
keeping mountains of records and filling out voluminous forms. It also
distorts economic decisions--everything from whether a spouse works to
how much families save. The U.S. Government Accountability Office
recently published estimates of these economic costs by various
researchers. They found the efficiency cost of the tax system--the
output lost over and above the amount of taxes collected--is 2 percent
to 5 percent of gross domestic product. [See the figure.] In short, we
lose between $240 billion and $600 billion every year just collecting
taxes.
A post-card-sized tax return would slash compliance costs. A single
tax rate applied to all wages would make the system more equitable and
transparent. By improving economic efficiency, it would raise
productivity and hence the rate of economic growth.
National Consumption Tax--The Fair Tax
Another innovative tax reform proposal that deserves consideration
is the national sales or national consumption tax, more recently called
the Fair Tax. The Fair Tax would build on these fundamentals of
taxation:
Only people pay taxes.
Consumption tax rates are self-limiting.
Uniformity of taxation wards off special interest
manipulation.
As described at fairtax.org, the Fair Tax proposal would replace
all Federal income and payroll taxes with a progressive national retail
sales tax. The Fair Tax would also incorporate a tax credit to ensure
no Federal taxes are paid on spending up to the Federal poverty level.
The Fair Tax would replace Federal personal and corporate income taxes,
gift, estate, capital gains, AMT, Social Security, Medicare, and self-
employment taxes and it would be administered primarily by existing
state sales tax authorities.
Based on work done by Boston University economist Laurence
Kotlikoff and Beacon Hill Institute, a Fair Tax rate of $0.23 out of
every retail dollar spent on new goods or services would generate
Federal tax revenues of approximately $2.6 trillion--about $350 billion
more than the revenues generated by the taxes it would repeal. The Fair
Tax would likely lower the lifetime tax burden for most Americans and
would greatly simplify Federal tax compliance. The Fair Tax would also
obviate the need for the Internal Revenue Service.
Conclusion
The AMT has not achieved its intended goals. It is inefficient
because it discourages investment. At the same time, the AMT is
ineffective in taxing the super-rich. Left unabated, it will cause a
major tax increase for middle income filers starting in 2007. Congress
could use this problem as an opportunity for restructuring the Federal
Tax Code.
Both the flat tax and the consumption tax are big improvements over
the current mess. A low-rate flat tax would help the economy. A rebate
to the poor would enhance progressivity. Making the rebate contingent
on the purchase of health care and saving for retirement will improve
the quality of life. A national consumption tax--with a provision
exempting spending up to the Federal poverty level--would dramatically
shrink the costs of tax compliance and would promote an efficient,
transparent means for Federal revenue generation.
President Bush said that he wants to reshape our tax system. Many
in Congress agree on the need for change. But an oft-repeated objection
is that tax reform benefits high-income taxpayers at the expense of
low-income taxpayers. With the ideas presented here, that objection
need not apply.
Statement of National Taxpayers Union, Alexandria, Virginia
Introduction
Chairman Rangel and distinguished Members of the Committee, thank
you for the opportunity to submit written comments on behalf of the
American Taxpayer regarding the important issues of tax fairness and
tax equity. My name is Andrew Moylan, and I am Government Affairs
Manager for the National Taxpayers Union (NTU), a non-partisan citizen
group founded in 1969 to work for lower taxes and smaller government at
all levels. NTU is America's oldest and largest non-profit grassroots
taxpayer organization, with 362,000 members nationwide.
I write to offer our comments on the issue of tax fairness in
private equity and the Alternative Minimum Tax (AMT). Few citizen
groups in Washington can match NTU's 38-year history of participation
in the national debate over tax fairness and simplification. We have
established a principled stance in favor of lower, simpler taxes on all
individuals and businesses, not just those who are politically in
fashion at a given moment. You can find further research into these
topics on our website at www.ntu.org.
Any discussion of tax fairness ought to begin with some context, by
examining IRS data. Tax returns filed in 2005 indicate that on the same
dollar, the wealthiest 1 percent of Americans paid an effective income
tax rate nearly eight times higher than those in the bottom 50 percent.
This picture does not change significantly even when taxes often
thought of as ``regressive'' are included in the analysis.
A December 2005 study by the Congressional Budget Office (CBO)
provides some illuminating statistics to prove the point. It accounted
for ALL Federal taxes, including income, payroll, and social insurance
taxes, and broke the burden down by income quintile. CBO found that
Americans in the lowest income quintile (who made an average of
$14,800) paid 4.8 percent of their income in ALL Federal taxes.
Meanwhile, the highest quintile (situated at an average of $184,500)
paid 25.0 percent of their income in taxes. Additionally, the top 1
percent of all income earners (who bring in an average of more than
$1,000,000) pay 31.4 percent off the top in taxes.
This is hardly the picture of a Tax Code that is insufficiently
progressive. The richest among us pay the most in taxes, in both
absolute and relative terms. Yet, in spite of that fact, some Members
of Congress persist in poisoning the tax policy debate with false
rhetoric about the Tax Code being tilted toward the wealthy.
Private Equity Taxation
In the rush to find ``pay-fors'' to fund other priorities, some in
Congress are now eyeing so-called ``carried interest'' taxes on private
equity managers to raise additional revenue. These managers are
compensated using the ``2-and-20'' method, which means that they get a
salary worth 2 percent of the fund's assets and receive 20 percent of
any capital gains the fund earns (also known as carried interest). If
the fund suffers a loss, its manager receives nothing from the ``20''
portion and is compensated solely by the 2 percent portion.
That 2 percent is taxed at normal income rates while, under current
law, the ``20'' component is taxed at the capital gains rate of 15
percent. One proposal, H.R. 2834 introduced by Representative Levin (D-
MI), seeks to change the treatment of the ``20'' share so that it is
taxed at ordinary income rates as well. This would have the effect of
raising taxes more than 230 percent on the capital gains of fund
managers. Simply stated, the concept embodied in H.R. 2834 is a bad
idea motivated by the quest for more revenue, not tax fairness.
It is NTU's belief that the ``20'' portion should continue to be
taxed at capital gains rates. Historically speaking, this portion of a
fund manager's compensation has long been treated as a capital gain
(and NOT ordinary income) because it represents the return on, or loss
from, an investment. It is subject to the same risk factors as any
other and receives capital gains tax treatment. It is only now that the
capital gains tax rate has been lowered to 15 percent that attacks have
been leveled at the ``fairness'' of this system. This suggests that the
true complaints rest with the lower tax rate, not the supposedly
improper treatment of the compensation.
Indeed, it is notable that other ``fairness'' aspects of capital
gains tax policy have so far not merited Congress's attention, even
though their implications are wide-ranging for all investors. For one,
current law does not allow a taxpayer to adjust the value of an asset
for inflation when declaring a capital gain. Moreover, even though the
government subjects the full computed value of a capital gain to
taxation, only $3,000 of a capital loss on a jointly filed return is
deductible for income tax purposes in a given year. Because these
limits aren't even inflation-adjusted, any ``carryover'' loss amounts
for future years are being taken against a deduction that's losing
value.
Congress established the lower capital gains and dividend tax rates
because it wanted to relieve the double-taxation and market distortions
that high rates impose. When individuals invest their dollars, they do
so after having already paid income taxes on them. The 15 percent rate
was intended to alleviate this double-taxation and encourage the kind
of bullish financial outlook for which Americans are renowned. Raising
the capital gains tax rate on a small but convenient segment of the
economy will only establish a foothold for higher capital gains taxes
on everybody in the future.
Higher capital gains taxes will discourage much-needed investment
in many segments of our society. Thousands of colleges, pension funds,
and charities invest their dollars in private equity plans so as to
leverage scarce resources. Raising taxes would harm them immensely.
Public employees, in particular, are heavily invested in the kind of
plans that would be hurt by such a tax hike. It is difficult to believe
that Congressional supporters of new tax treatment for carried interest
intend to load an additional levy onto the pensions of teachers, police
officers, and other public service workers. Such a policy would be all
the more ironic, in light of the American Federation of State, County,
and Municipal Employees' (AFSCME) official position that the 2003
capital gains tax cut ``mostly benefits wealthy stockholders.'' If
Congress travels further down the road toward taxing carried interest,
AFSCME's members will learn a hard lesson about how harmful their
union's stance is.
In addition, higher capital gains taxes would be a significant step
in undermining the advancements in savings and growth that have taken
place in the last few years. Since 2001, an additional 12 million
people have joined the investor class. Since 2003, household net worth
has increased by an astounding $12 billion.
Such trends were evident several years before George W. Bush took
office. In 1997, Congress enacted and President Clinton signed the
Taxpayer Relief Act. This law actually led to a much steeper decline in
capital gains rates than the Jobs, Growth and Tax Relief Reconciliation
Act of 2003. The long-term maximum capital gains tax rate was reduced
from 28 percent to 18 percent in most instances, while an even lower 8
percent rate was put into place for certain taxpayers. Although
President Clinton expressed some ``concerns'' with the Taxpayer Relief
Act, he predicted that the bill would ``encourage economic growth.'' He
was right. According to a detailed analysis by Standard & Poor's DRI,
the new law helped to trigger a bull market for stocks that led to the
rise of the ``investor class.''
Finally, it bears mentioning that even with higher capital gains
taxes, revenues may not increase substantially. A 2002 CBO study
pointed out that because such taxes are paid on ``realized rather than
accrued gains, taxpayers have a great deal of control over when they
pay their capital gains taxes.'' This makes the capital gains tax
particularly subject to revenue fluctuations resulting from changes in
the rate. In recent history, every capital gains tax cut has resulted
in additional revenue and every capital gains tax hike has resulted in
less revenue. Any revenue gained from such a tax hike would be far
outweighed by the damage done to pensions, universities, and charities
across the country.
Alternative Minimum Tax
Much of the talk of raising private equity taxes would not be
happening if it weren't for the Alternative Minimum Tax disaster. Like
a parallel universe in the twilight zone of IRS rules and regulations,
the AMT forces taxpayers to calculate their taxable income and
liability under a different set of allowable exemptions, deductions,
and credits. Because Congress designed the system so poorly and did not
index the AMT threshold for inflation, it ensnares an ever-greater
number of taxpayers each year.
In 2006, 4 million unlucky taxpayers paid the AMT. If Congress
doesn't act, there will be 23 million equally unlucky Americans in
2007. These figures do not include millions of additional taxpayers who
expended significant time either in tax planning to avoid being trapped
by the AMT, or on IRS worksheets to determine whether they should
complete Form 6251.
Despite promises to ``fix'' this problem every year, neither the
former Republican Congress nor the current Democratic Congress has
enacted a truly lasting solution. As a 2004 National Taxpayers Union
Foundation study noted, ``Continued delay will merely result in further
losses to the economy and further corrective costs. It will also lead
to a political motivation to design a solution which is `revenue
neutral' and thus cause further damage to the fiscal stability of the
nation.'' Since that time, Congress has done little more than ``kick
the can down the road'' by enacting one-year AMT patches.
Unfortunately, the new pay-as-you-go budget rules (PAYGO) make
fixing the AMT highly unpalatable because of future revenue losses.
Despite the fact that it was never intended to reach down into the
middle class, the AMT now brings in substantial amounts of revenue each
year. Under PAYGO, those ill-gotten receipts must now be offset so as
not to violate its strictures.
Yet, PAYGO itself violates the very principles of ``fairness and
equity'' around which this hearing has been designed. Under current
rules, any tax cuts or new direct (mandatory) spending programs
relative to the official revenue and outlay growth baseline are
required to be funded through tax increases or spending reductions
elsewhere.
But not all baselines are created equal. The mandatory spending
baseline is assumed to be perpetual for entitlements such as Social
Security and Medicare, while the 2001 and 2003 tax cuts are on a
baseline that terminates in 2011. This double standard allows massive
expansions in programs like Medicare Part D to be added directly to the
deficit, while tax reductions are allowed to vanish unless they are
extended with offsets.
Federal revenues have zoomed 28 percent over the past six years,
and 2006's inflation-adjusted total exceeded the amount brought in
during President Clinton's last year in office. During that same
period, when Republicans controlled both branches of elected
government, expenditures rose by an astonishing 49 percent. Recently
enacted PAYGO rules create an inexcusable bias toward boosting Federal
outlays while denying relief to taxpayers--thereby guaranteeing that
this disparity will worsen.
While NTU would argue that budget process reforms should favor
shrinking government, in the interests of ``fairness and equity''
Congress should, at the very least, force spending-hikers to play by
the same rules as tax-cutters. Rigging the process to grow already
imperiled entitlement programs is not the kind of ``new direction''
that Americans were expecting from the 110th Congress.
Conclusion
Congress ought to repeal the AMT outright. It is a confusing,
economically destructive tax that has spiraled wildly out of control
since its inception. It was created in 1969 to deal with 155 high-
income individuals who paid no income taxes. Today, it is a monster
that threatens to grow even larger if it isn't vanquished once and for
all. As it so happens, the encroachment of the AMT also provides a
cautionary tale to those who believe that a ``small adjustment'' in the
tax treatment of carried interest will remain so.
The way to bring down that beast, however, is not to raise taxes
elsewhere. Private equity fund managers, though a convenient political
target, are an important cog in the massive machinery that is the
American economy. Raising taxes on certain forms of compensation will
be highly destructive to America's public employees, unions, college
students, and charities that rely on private equity.
Furthermore, while raising taxes is certain to be economically
harmful, it is far from certain to enhance receipts. History shows that
capital gains taxes constitute a fluid revenue source that fluctuates a
great deal in response to rate changes.
If lawmakers seek tax fairness, they ought to focus on a
fundamental overhaul of the IRS code, not piecemeal reform that only
adds to the problem. With such a commitment, tomorrow's taxpayers will
be most grateful to today's Congress.
Statement of NGVAmerica
Introduction
NGVAmerica appreciates the opportunity to provide the following
statement concerning tax policy and its impact on energy policy,
security and the environment. NGVAmerica is a national organization of
over 100 member companies dedicated to developing markets for NGVs and
building an NGV infrastructure, including the installation of fueling
stations, the manufacture of NGVs, production and use of renewable
natural gas, the development of industry standards, and the provision
of training.
The Ways and Means Committee has indicated an interest in reviewing
current alternative minimum tax (AMT) provisions. The primary purpose
is to review the impact of this tax on working families and how it
might be revised or amended to create more equitable treatment for
taxpayers. NGVAmerica would like to encourage the committee to also
consider how the current AMT provision limits efforts to stimulate the
use of new energy efficient, non-petroleum technologies. Our statement
addresses how AMT as currently structured discourages individuals and
businesses from accelerating the introduction of alternative fuel
technologies and ultimately limits efforts to reduce petroleum
reliance.
Impact of AMT Provisions on Incentives for Alternative Fuel Vehicles
and Infrastructure
The Energy Policy Act (EPAct) of 2005 (Pub. L. No. 109-58) includes
incentives to encourage the acquisition of dedicated alternative fueled
vehicles (AFVs) and alternative fuel refueling stations, among other
things. The vehicle and fueling infrastructure incentives are found in
sections 1341 and 1342 of EPAct 2005. The AFV credit expires on 12/31/
2010 and the alternative fuel infrastructure credit expires 12/31/2009.
NGVAmerica previously has submitted comments to the committee
recommending that the credits be extended since the short timeframe for
this incentive sends the wrong message to businesses and consumers
about the government's support for AFVs, and is inconsistent with
petroleum replacement goals espoused by the Administration and
Congress. Congress has recognized this shortcoming and has introduced
several measures that would extend these incentives.
Simply extending these tax credits, however, will not address
another major shortcoming, namely, the fact that, as currently crafted,
these tax credits are subject to AMT. The recently passed energy bill
(H.R. 3221) partially addresses this shortcoming but only with respect
to vehicles acquired by individual consumers. There is no adjustment
for businesses that buy these vehicles, and there is no change at all
with respect to the fueling infrastructure credits. The EPAct 2005 tax
credits have been largely successful in accelerating the introduction
of hybrid electric vehicles like the Toyota Prius and Honda Civic.
Modifying the vehicle credits so that they are not subject to AMT will
make it possible for more people to take advantage of these new
technologies. We applaud Congress efforts to expand these incentives
for consumers. However, the proposed adjustment of the AMT provision
for consumers is unlikely to help advance the use of AFVs among
business fleets.
As currently structured, the corporate AMT provisions significantly
limit the benefit of the AFV and alternative fuel infrastructure
incentives. The tax credits for vehicles and fueling infrastructure are
general business credits that are subject to AMT limitations. This is a
major stumbling block to encouraging business fleets to buy large
numbers of AFVs. Based on our analysis, the majority of fleets that buy
large numbers of new AFVs will only be able to take advantage of the
tax credits for a limited number of vehicles (if these businesses are
not currently paying any AMT) or not be able to take advantage of any
tax credits (if they currently are paying an AMT). This means that most
fleets cannot make a major commitment to AFVs (i.e. acquiring large
number of AFVs) without shouldering the additional financial investment
associated with these vehicles. Given that these vehicles can cost tens
of thousands of dollars more than petroleum fueled vehicles, most
businesses have been reluctant to make the necessary investments
without government assistance.
The most efficient way to commercialize AFVs is to encourage the
purchase of these vehicles by large centrally fueled fleets. Focusing
on large, centrally fueled fleets also is more efficient in terms of
servicing and maintaining these vehicles (which may require special
training), and providing alternative fuel infrastructure.
Unfortunately, the Tax Code favors a strategy that requires industry to
sell one or two AFVs to thousands of individual fleets in order to take
advantage of the AFV incentives. This limitation also is likely to be a
stumbling block for selling medium and heavy-duty hybrid vehicles to
businesses as such vehicles become commercially available.
The incentives are also similarly limited with respect to the sale
of vehicles and fueling stations to tax-exempt entities. The tax
credits for vehicles and refueling stations (EPAct Sec. Sec. 1341-1342)
include provisions allowing the tax credits to be taken by the seller
of the vehicles or fueling stations instead of the purchasers if the
purchaser is a tax exempt entity. This provision was intended to ensure
the Federal, state and local governmental agencies benefit from the tax
incentives. This was viewed as an important provision in the law
because government entities (e.g., municipal fleets, port authorities,
transit agencies, school districts) in many cases are taking the lead
in introducing AFVs. Congress provided this provision with the
expectation that the seller would pass back some or all of the
incentive to the buyer in the form of a lower purchase price. The Tax
Code as modified by EPAct 2005 allows the AFV and alternative fuel
infrastructure credits to go to the seller in the case of an
acquisition by a tax-exempt entity. However, dealerships also are
subject to AMT provisions and are, in most cases, only able to benefit
in a limited way, if at all, from the sale of AFVs. Based on our
discussions with numerous dealerships, we believe that most are not
able to benefit from these incentives due to their tax status and,
therefore, will not be able to pass any savings back to their tax-
exempt (i.e., primarily government) customers. This means that state
and local government acquiring AFVs will not benefit from these
incentives.
Conclusion
NGVAmerica urges the committee to amend the Tax Code so that the
incentives for AFVs and alternative fuel infrastructure are exempt from
all AMT limitations. The current AMT provisions limit the ability of
large fleet customers to acquire AFVs and also limit the ability of
governmental fleets to benefit from the incentives. Modifying the
incentives so that they are not subject to the AMT provisions will
encourage businesses to invest in these new technologies and reward
them for promoting practices that reduce petroleum reliance. When
Congress passed these incentives, it believed they would encourage
investments in AFVs and refueling infrastructure. However, the
limitations addressed in our statement indicate that these incentives
are not being fully utilized and are not having the intended impact. We
urge Congress to correct this situation.