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July 15, 2007

Cash and Carry

If you at all follow the start-up industry, you have heard the taxing news.  Congress wants to raise taxes on VCs and private equity executives.  Blackstone's IPO and the perceived excessive economics reaped by the firm's principals appears to have been the impetus for the new legislation proposed by representatives Charles Rangel (D-NY) and Barney Frank (D-MA).  As a side note, it is ironic that the sponsoring representatives are from two of the three states (California being the obvious third) whose local economies benefit the most from the private equity industry.  Talk about putting national (albeit populist) politics ahead of local interests!

At any rate, the economic impact involved is quite considerable.  Currently, we VCs get taxed at the long-term capital gains rate - that is, 15% - for our carried interest of 20-30% in a fund.  The new legislation would result in taxing the carry as ordinary income, typically 35%.

Just a reminder, the "carry" in a fund is the portion of the gain that the VC reaps as part of their compensation.  That is, if a $200 million fund returns 2x, or $400 million, a "20% carry" on the $200m gain is $40 million, which goes to the VC managers of the fund.  A 10x performance on a $200 million fund would yield $360 million in carry ($2 billion in returns, $1.8 billion in gains x 20% carry).  The tax difference for these two funds would be 20% points in incremental taxes paid by the principals, or $8 million and $72 million, respectively.

Some entrepreneurs have asked me to justify why VCs should get the capital gains treatment in the first place and I confess to being hard-pressed.  On the one hand, we do put capital to work and it is truly risk capital.  On the other hand, the capital we put to work is either other people’s money (our LPs) or our own money (our “co-invest”), which under any circumstances would be treated as capital gains – that’s not a part of the debate.  The carried interest is a more complicated portion to analyze because the carry isn’t really capital at risk – it’s a share of profits, not unlike what a sales VP or a stock broker might get in commissions, which are taxed at ordinary income rates. 

The industry is obviously aghast at the proposition of paying more in taxes.  The complaints are at both the micro (“you’re going to double my taxes!”) and macro level (“private equity and VC are fundamentally making American business more competitive and critical elements to the economy; increasing their collective tax payments will be deleterious to US growth and global competitive position.”).  Many VCs rightfully argue that the carry can’t be looked at in isolation – it is a single component of a range of components of private equity compensation that the general partners choose to allocate more of their dollars towards as compared to management fees exactly because of the favorable tax treatment.  If that were to change, they would simply raise management fees or increase the carry rate.  Increasing the taxes on VCs and private equity and having these costs passed through to the limited partners in the form of higher fees or carried interest payments will, in turn, lower the asset class returns for American private equity funds and result in capital shifting away from this asset class into other vehicles, likely private equity funds outside the US.

How will all this impact entrepreneurs?  Probably very little in practice.  On the margin, if it pushes a few private equity executives out of the business, the impact will be negligible given the current situation of "too much money chasing too few quality deals".  My observation is that entrepreneurs roll their eyes when they hear their VC friends whining about the topic, and probably rightfully so.

I guess in the end, I personally find myself in the unusual position of being a bit wishy-washy on the topic.  On the one hand, it is galling that Steve Schwarzman’s butler pays a higher tax rate than he does.  On the other hand, raising taxes on such a critical part of corporate America that is so intricately linked to our capital markets, industrial competitiveness and technology innovation clearly isn’t going to help our global competitive advantage.  In practice, my VC friends cynically tell me the whole debate is moot.  If Congress passes the contemplated law, an army of lawyers and accountants will begin advising us on intricate loopholes to structurally avoid the whole thing!

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We solve this problem - and the problem of "ROME BURNING," which goes beyond the economic system - by SCRAPPING the income tax system - business and personal - and replace it by enacting the FairTax (HR 25 / S 1025).

While many who are invested in the current income tax system seek to demagog the well-researched FairTax plan (*), its acceptance in the professional / academic community continues to grow (**). Failure to enact the FairTax - choosing instead to try to "flatten" a NON-FLATTENABLE income tax system - will result in an IRREVOCABLE ECONOMIC MELTDOWN. (*** Impossible, you say?)

Here is why the FairTax MUST replace the income tax. It's:

• SIMPLE, easy to understand
• EFFICIENT, inexpensive to comply with and doesn't cause less-than-optimal business decisions for tax minimization purposes
• FAIR, loophole free and everyone pays their share
• LOW TAX RATE, achieved by broad base with no exclusions
• PREDICTABLE, doesn't change, so financial planning is possible
• UNINTRUSIVE, doesn't intrude into our personal affairs or limit our liberty
• VISIBLE, not hidden from the public in tax-inflated prices or otherwise
• PRODUCTIVE, rewards, rather than penalizes, work and productivity

Its benefits are as follows:

FOR INDIVIDUALS:
• No more tax on income - make as much as you wish
• You receive your full paycheck - no more deductions
• You pay the tax when you buy "at retail" - not "used"
• No more double taxation (e.g. like on current Capital Gains)
• Reduction of "pre-FairTaxed" retail prices by 20%-30%
• Adding back 29.9% FairTax maintains current price levels
• FairTax would constitute 23% portion of new prices
• Every household receives a monthly check, or "pre-bate"
• "Prebate" is "advance payback" for monthly consumption to poverty level
• FairTax's "prebate" ensures progressivity, poverty protection
• Finally, citizens are knowledgeable of what their tax IS
• Elimination of "parasitic" Income Tax industry
• NO MORE IRS. NO MORE FILING OF TAX RETURNS by individuals
• Those possessing illicit forms of income will ALSO pay the FairTax
• Households have more disposable income to purchase goods
• Savings is bolstered with reduction of interest rates

FOR BUSINESSES:
• Corporate income and payroll taxes revoked under FairTax
• Business compensated for collecting tax at "cash register"
• No more tax-related lawyers, lobbyists on company payrolls
• No more embedded (hidden) income/payroll taxes in prices
• Reduced costs. Competition - not tax policy - drives prices
• Off-shore "tax haven" headquarters can now return to U.S
• No more "favors" from politicians at expense of taxpayers
• Resources go to R&D and study of competition - not taxes
• Marketplace distortions eliminated for fair competition
• US exports increase their share of foreign markets

FOR THE COUNTRY:
• 7% - 13% economic growth projected in the first year of the FairTax
• Jobs return to the U.S.
• Foreign corporations "set up shop" in the U.S.
• Tax system trends are corrected to "enlarge the pie"
• Larger economic "pie," means thinner tax rate "slices"
• Initial 23% portion of price is pressured downward as "pie"
increases
• No more "closed door" tax deals by politicians and business
• FairTax sets new global standard. Other countries will follow


(*) http://snipurl.com/taxpanelrebutted (.pdf)

(**) http://snipurl.com/econsopenletter (Lists every tax that FairTax will eliminate, together with the power they represent to pol's and lobbyists.)

(***) Listen to an interview where Prof. Kotlikoff elaborates: http://snipurl.com/meltdowninprogress


The time for sitting around, pontificating, is over. We have NO CHOICE but to ACT: http://snipr.com/scrapthecode

Thanks for pointing this out! The tax discussion has been hovering over us for a while too. Love to read your blogs every now and then! You are rarely off base. Glad to see another like minded individual.


The brain is a wonderful organ; it starts working the moment you get up
in the morning, and does not stop until you get to work.


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http://arrongrossqw.easyjournal.com

I'm new here, just wanted to say hello and introduce myself.

For years we have all been listening and reading news reports that USA economy is deteriorating. The dominance of the major industries and big businesses is soon come to an end. The increase of tax is one of the greatest problems that we, the people are facing. The government should think first before doing something because not all the people will agree on it. Some will protest while some other people will just ignore it. The financial problem is one of the challenges that the people are trying to cope up nowadays. And today- we heard another more disastrous economic news. If the taxes will continue to increase many companies will close and it will result to higher unemployment, more home foreclosures, skyrocketing oil prices, obscene gas prices. The present economics is not strong and offers nothing. And the disastrous economic policies of Mr. Bush- policies that benefit the wealthiest among us and multinational corporations that ship jobs abroad and has no qualms about spending billions of dollars on a war while ignoring our domestic economic disaster and our crumbling infrastructure. The American economy continues to deteriorate: consumer spending is bad and likely to get worse; home prices continue to fall; and Wall Street has been unable to shake a credit crisis that keeps hurting big institutions. Stock prices are down too, further eroding household wealth. The main reasons why the USA economy is deteriorating is that a ton of money has been spent on our military budget is so large is largely to do with the level of our technology as well. Look at it this way. We do not have the largest Army in the world. Again there is more information about government transaction. I’m sure you’ll like it because it’s very informative. Just visit this site: http://personalmoneystore.com/moneyblog/

Tax is being considered as the blood of the government. If the people won’t pay tax properly then the government can’t do their duties well and they will not be able to plan and create projects for the people. However, if the government wants to raise taxes I think it would be better to put higher tax to those products that are harmful to human health like cigarettes. Also to those products that are not really necessary to have like beauty products etc. Talking about financial matter is a very complicated one. Articles on this site http://personalmoneystore.com/moneyblog/ also talks financial matter and how to handle it.

Increasing the tax payments will help one’s country a more competitive and productive in the global market. But somehow it will not help the entrepreneurs because increasing in tax payments can be one of the reason of low income to the business. All the people will be affected by it not just the business owners. If they will increased the tax they have to focus to the things hazardous to peoples health. Like the liquors and other hazardous to one’health.


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