Operate internationally, and sometimes you have to fight a two-front war. That’s what the private equity industry, with bases in both New York and London, finds itself called upon to do as politicians in the United Stated and the United Kingdom launch simultaneous attacks on its tax status.
Never mind that these private deal-makers contribute to the solution of the problem created for market capitalism by the separation of the ownership and control of both nations’ corporations — one factor leading to the current battle.
The battle between the politicians and the private equity industry didn’t suddenly flare up because a British deal-maker commented that he pays taxes at a lower rate than his cleaning lady or because an American equivalent threw himself a birthday ball costing $2 million or $15 million, depending on your tabloid of choice.
The controversy began, in part, because corporate executives — unconstrained by dispersed and therefore relatively powerless owners (aka shareholders) — persuaded many supine boards of directors to award them compensation bearing little relationship to their performance. Ordinary taxpayers soon began to wonder why even inept executives were exiting as multimillionaires.
Since those who do not follow Wall Street closely can be forgiven for failing to distinguish between corporate bureaucrats and the more inventive, risk-taking entrepreneurs who run private equity firms, public grumbling became a generalized dissatisfaction with “unfair” compensation, thus attracting the attention of politicians. When the private equity operators proved inept at explaining exactly what they contributed to the economy, the stage was set for a battle.
Which is a pity. By taking over troubled companies, these entrepreneurs cure problems stemming from the separation of ownership and control. They and their partners, who buy and control formerly publicly traded companies, have every incentive to reward only those managers who earn their pay by increasing profits and growth rates. The long-term result might well be job creation and enhanced value for the pension funds and other institutional investors who share the profits of these ventures.
Abuse of executive compensation is not the only bit of background noise that has drowned out private equity’s defenses. Critics have long argued that the benefits of American prosperity have not been shared equitably. While globalization has increased the value of education and management skills in the international market, the entry into that market of more than 1 billion unskilled laborers has constrained the wages of lower earners.
So when the hundreds of millions earned by some entrepreneurs are taxed as capital gains rather than as ordinary income, it should come as no surprise that politicians feel compelled to act — or at least to seem to act. To an elected official, lectures on efficient tax structures matter less than letters from constituents complaining about disparate tax treatment.
So far, there’s been more noise than action. Congress seems to have decided to do nothing this side of its summer recess, for the quite sensible reason that the tax status of the private equity industry is not only of concern to a few billionaires in Greenwich, Conn., or on Park Avenue in New York. For one thing, we do not yet fully understand the economic consequences of any change in tax treatment.
For another, as New York Sen. Chuck Schumer, D-N.Y., points out, sauce for Wall Street deal-makers — many of whom are his constituents and financial supporters — is surely sauce for the Texas oil men who rely on similarly structured partnerships. Raise taxes on my constituents, Schumer is telling his colleagues in the Senate, and I will raise taxes on yours. For senators who represent neither New York deal-makers nor Texas oil men, that might sound more attractive than Schumer intends.
So right now, we have a phony peace. Private equity entrepreneurs are gathering ammunition to support an autumn offensive in support of the status quo: continued taxation of the bulk of their profits at relatively low capital gains rates. But politicians are marshalling forces for an assault on that position, both to appease their constituents and to increase the immediate flow of revenue to the government.
Like most civilians, you would do well to study maps — not to follow the battle, but to decide where to spend your vacation.
Irwin Stelzer is a senior fellow and director of the Hudson Institute’s Center for Economic Policy.
