There’s been some press recentlyabout potential tax code that will put the hurt in the pockets of your friendly neighborhood private equity partner.  For those who aren’t in the private equity circle, much of earnings currently are taxed at the lower capital gains rate rather than higher individual income tax rate.  Not being in the Private Equity inner circle, I only became aware of this after reading an article in the Economist indicating that Washington was looking into this.  The Economist and I share a similiarly muted opinion on this matter, but before I get into that opinion, let me highlight what the issue is.   I know this probably a matter of little interest to most people given that it certainly doesn’t affect most of us, but it’s interesting issue with regards to the tax code.

Partners at private equity firms typically recieve the bulk of their compensation in what is called “carry” on top of their regular income.  They earn a good income, but it’s really this carry which can easily be millions upon millons of dollars that is their bread and butter.   I don’t have a problem with the money they earn or the work they do.  Private equity and it’s nicer half brother, Venture Capital, have an important place in the financial and economic world.  They along with their nanny, Investment Banking, do make the world go around, well at least the financial world.  We can certainly argue about if these people are excessively compensated.   Given that most of the people reaping rewards are only risking other people’s money, I think they are indeed rewarded quite lavishly.  However that’s a decision of the market.  Ulimately a investment banker or a private equity partner is beholden to how much clients will pay them.  That’s the market.  Taxes, however, are another question.  Does it stand that Private Equity partners deserve to have “special” tax treatment?

The primary purposes of taxes is to generate revenue for the Government.  The seconday purpose to encourage or discourage particular behaviors.  The 1st and 2nd purposes are often in conflict as most taxes disinventvize production.   Income taxes are a prime example of this, but in some regards capital gains taxes might be more important.  Despite what some people may believe of me, I’m very much a capitalist and the most important thing about capitalism is that capitalist are given incentive to reinvest their capital into the economy.   This is the primary reason to have lower long term capital gains rates.   The problem with profits being made by private equity general partners as opposed to limited partners is question of who’s money.  In a private equity firm a the general partners invest the money of the limited partners.   Clearly limited partners should only be taxed at capital gains rate on the profits from the investments they make.   It seems unreasonable to extend this lower tax rate to profits that the general partners earn without putting “skin in the game.”  There is a reasoned argument that the government should tax all income regardless of sourceat the same rate,  as there is an equally valid argument to go to purely consumptive tax system.   I can support all those arguments, but I cannot support giving private equity managers preferential tax treatment over ordinary americans.