Tax plan misfires on issues dear to growth-driving private equity

Tax plan misfires on issues dear to growth-driving private equity
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America is long overdue for an update to its outdated, overly complex tax code. Our tax system should promote growth instead of punishing it, and recent proposals suggest that both the administration and Congress are committed to this essential outcome.

But, as in most cases of policymaking, the devil is in the details. As lawmakers move forward with a reform framework, they should abide by an important rule when it comes to the way businesses and investments are taxed: First, do no harm.

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In broad terms, the initial tax plans include many smart solutions for a simpler and fairer tax system. But even as congressional leaders attempt to chart a way forward for economic growth, they have left two proposals on the table that would stunt long-term business investment, cost jobs and even undermine retirement security.

 

Here’s the good news: Congress can address these issues by doing absolutely nothing. For all its troubles, the current tax code does get a few things right. Those measures need to be left in place.

The first is the classification of carried interest as a capital gain. Carried interest is a long-standing, standard business practice that has become a popular target for tax hikers, who unsurprisingly misrepresent it for political gain.

Simply put, carried interest is the portion of profits on capital investment shared with those who managed the investment.

Time is money, as the saying goes, and carried interest capital gains treats an investment manager’s time, hands-on approach and expertise as an investment in itself by taxing that portion of the profits at the same rate capital investors receive on their returns.

Since it is usually only triggered if a fund exceeds certain performance benchmarks, it is unlike ordinary income. 

It is also a critical component for growth. Carried interest capital gains are largely realized in the industries of private equity, venture capital and real estate investment. These sectors are some of the greatest drivers of job creation across the entire American economy, helping to grow and turn around companies.

An unwarranted carried interest tax increase would be a significant setback for these critical industries. Without this appropriate incentive to partner with promising our distressed businesses, economic growth would be stifled.

In addition to businesses and workers, the treatment of carried interest as capital gains also has another important and unheralded beneficiary: retirees. Pension funds represent 40 percent of overall investment in private equity. In return, private equity has consistently proven itself as the best performing asset class for pensions.

Over the last 10 years, state pension programs saw a historically low 5.7 percent investment return. Yet, during the same period, private equity investments made by those funds returned 9.7 percent, after all related fees. In 2015, the national average return on private equity investments for pension funds topped 11 percent. 

So despite efforts by some to score easy political points, it is a fallacy that the incentive provided by the carried interest capital gains rate benefits just a few fund managers. Nearly every retired teacher, police officer, firefighter and public employee in the country relies on private equity so their pension fund will be there when they need it.

Congress has also indicated that it will consider limiting the deductibility of interest on debt. This equates to a tax increase on businesses for the simple act of doing business. Interest deductibility allows companies to deduct interest paid on debt from their taxable income.

If a business owner takes out a loan to finance the construction of a new facility or simply manage day-to-day operations, the interest paid on that loan is tax deductible, as it has been for the last 100 years. A massive number of companies, spanning the entirety of America’s private sector, use debt to finance investment and growth.

Congress has proposed replacing this completely logical practice with 100-percent expensing of capital investments and asset purchases. But companies can’t expense what they can’t afford.

Only the minority of companies that don’t have to borrow capital to finance new investments will benefit from this plan in the long run. For everyone else, it means slower growth and higher barriers to access capital. 

Done right, tax reform will unquestionably have a widespread positive effect on American businesses and workers while strengthening our economic position globally. It will benefit millions, from entrepreneurs to employees to retirees. With this once-in-a-generation opportunity in front of us, we can’t afford self-inflicted wounds.

As lawmakers craft a final tax bill, they should bear in mind that some of the most important policies we can embrace are already on the books. They should remain there. 

Mike Sommers is the president and CEO of the American Investment Council, a lobbying, advocacy and research organization based in Washington, D.C., that was launched by a consortium of private equity firms in February 2007.