Republican presidential candidate Mitt Romney's tax returns have prompted a new wave of press attention to the tax treatment of private equity managers and of other investment partnerships. There are few other issues about which there is so much misinformation afoot. Here is an attempt to correct some of the myths.
Myth No. 1.: This is an issue about the treatment of the little guy versus billionaires. Not so. Those pressing this issue include Warren Buffett, Rupert Murdoch, and Michael Bloomberg, all of whom are a lot richer than Mitt Romney. It's a case of some billionaires wanting to raise taxes, not on themselves, but on other billionaires and multi-centimillionaires who compete with them for deals, for investment capital, for talent, and in the contest of wealth accumulation.
Myth No. 2.: Hedge fund managers and private equity guys get a special deal. Not so; they get the same deal as managers of venture capital funds, of real estate partnerships, and of oil and gas partnerships, who have gotten this treatment for generations. Those who want to change the tax treatment need to be prepared for negative effects not just on hedge funds or private equity managers but also on real estate, energy, and venture capital investment.
Myth No. 3. All hedge fund managers benefit from paying the 15% long-term capital gains rate on their "carried interest." Again, not so. A lot of the hedge funds, including some of the largest ones, hold most stocks for shorter periods of time than the full year required to get the long-term capital gains rate. Or they invest in other things, such as gold or options, that don't qualify for the 15% rate. Again, it's not a special deal; the managers just pay the same capital gains rate that their investor-partners do on investments that qualify for the long-term capital gains rate.
Myth No. 4. Applying the long-term capital gains rate to carried interest is a government subsidy. Nope.
If an individual investor buys $1 million of IBM and the stock doubles in two years, there is a $1 million gain and it is taxed at 15%, or $150,000.
If an individual investor invests $1 million in a hedge fund and the hedge fund invests that $1 million in IBM and the stock doubles in two years, there is a $1 million gain and it is taxed at 15%, or $150,000. In this case, if the hedge fund manager earns 20% of the profit, the individual investor makes $800,000 and the hedge fund manager makes $200,000. The individual investor pays 15% x $800,000 = $120,000 and the hedge fund manager pays 15% x $200,000 = $30,000. The total tax paid is $150,000, the same as in the initial case.
So, there is no special tax rate and there is no tax loss. There is simply an allocation of profit and taxable income between the investor and the hedge fund manager.
Myth No. 5. The deductibility of interest expense is another government subsidy to private equity. Critics focus on the deductibility of interest expense. But they forget the other side of it — that interest income is taxable to the recipients. Don't worry, the government is getting a piece of the action. It almost always figures out a way to do that.
Myth No. 6. The private equity and hedge fund managers are the only ones who get compensated for their labor and pay the long-term capital gains rate. Founder's stock that entrepreneurs get as sweat equity in their companies is also, if held for more than a year, taxed at long-term capital gains rates, and then only when sold. If the critics taking aim at carried interest have their way with their insistence on imposing ordinary income tax rates on items now taxed as long-term capital gains, it would also hit job creators like the founders of Google and Microsoft. The effect would be to reduce the rewards for risk-taking entrepreneurs.
Myth No. 7. This is a really important issue to fix right now. Given all the attention devoted to the issue — two Bloomberg View editorials in less than a week (here and here) together with a Bloomberg View column by William Cohan, Twitter campaigns by Mr. Murdoch and by Jim Cramer, a New Yorker article by James Surowiecki — you'd think that the secret to balancing the federal budget, reducing the unemployment rate, and igniting strong economic growth is figuring out a way to more than double the taxes on a few entrepreneurs creating profits for themselves and their partners. Come on. If there's a tax issue in this election year it's not targeting a successful few for punitive and steep tax increases, but instead figuring out how to lower corporate rates and simplify the code, or at the very least lock in the current rates while averting scheduled tax increases.