The realities of Romney’s taxes

DAVID ROBINSON DURHAM

As we reach the last few weeks of the U.S. presidential election and the debates between President Barack Obama and Governor Mitt Romney reach a crescendo, it is increasingly likely that the subject of private equity taxation will continue to garner attention. Many Americans were shocked this fall to learn that Mitt Romney’s effective personal tax rate was 14.1 percent. How could a captain of industry pay less than half the marginal tax rate that an upper middle-class American family would pay? It is certainly fodder for populist tax reform. The fact that management fees are taxed as ordinary income – essentially about 50 percent once Medicare, state and local taxes are factored in — while carried interest is taxed at the capital gains rate of 15 percent, creates a giant wedge favoring the wealthy. Clearly we need to close this egregious loophole and get these guys to pay their due. Right?

Wrong. The issue is not whether it is morally outrageous for Romney to face a low effective tax rate because most of his money is generated through equity investments as opposed to ordinary income. Suppose it is outrageous. Nor is the issue the inherent difficulty in singling out private equity general partners for this special treatment, which seems to be the desire of everyone who is trumpeting such policy proposals. Suppose it’s easy to treat private equity general partners differently than other equity investors. Nor is the issue the fact that the capital gains have already been taxed once at the corporate level, although that’s certainly true.

The issue is who will actually end up paying the tax at the end of the day. When gasoline, or cigarettes, or alcohol, or anything else is taxed, the tax is ultimately shared by both the producers and the consumers of the product being taxed. When gasoline taxes go up, the driver pays part of the tax in the form of more expensive gasoline and the oil company pays part of the tax in the form of less gas sold.

The same dynamic is at work in private equity. General partners are, after all, middlemen. If they face higher taxes, they will pass some of the costs on to limited partners in the form of higher fees
and they will also pass some of the costs onto portfolio companies in the form of more stringent
contracts and less overall capital available. As a result, the extra tax imposed on private equity general partners will be borne by general partners, limited partners and portfolio companies alike, all to differing degrees.

So, before we respond to this moral outrage by raising taxes on carried interest, we should ask ourselves a few questions. Do we really want to raise taxes on pension funds? They are, after all, major investors in private equity. Is it fair to raise taxes on the retirement earnings that ordinary Americans receive? This is, after all, what will effectively happen. Do we really want startups to bear the cost of this tax by taking capital out of the venture market? Is it good for the economy if fewer underperforming companies are restructured through private equity transactions? These will be the side-effects and hidden costs that occur when political points are scored by raising taxes on private equity.

We should think seriously about how large and how painful these side effects are likely to be before we go on a crusade to correct a wrong that is so widely known only because it is so politically convenient to talk about - not because it is so economically important to correct.