Tax Hikes on Carried Interest Hurts Growth Investment

President Barack Obama and various members of Congress apparently believe that taxes can be increased with impunity.

For example, raise taxes on domestic energy producers, and it will not matter in terms of energy production or costs. Increase income taxes on investors and entrepreneurs, and it will not matter in terms of the critical roles that these risk takers play regarding economic growth and job creation.

Such wishful thinking on the effects of higher taxes not only is illogical, but it is, of course, quite dangerous in terms of our economy. Just consider the push to raise taxes on carried interest and enterprise value.

For more than a half-century, partnership tax law has recognized that carried interest -- ownership returns for investment partnerships – is subject, obviously, to all the risks of ownership, and any returns are forms of capital gains, and certainly not ordinary income. For good measure, the returns on investments made by partners to increase enterprise value are correctly treated as capital gains, and are not and should not be treated as ordinary income. Build your business over many years, and upon selling all or part of that business, the returns plainly are capital gains, not ordinary income.

Nonetheless, the President and some in Congress have pushed relentlessly for taxing carried interest and enterprise value for partnerships as ordinary income, which would jack up the top tax rate from 15 percent to 35 percent, with that rate potentially hitting 43.4 percent by 2013. That would be a near tripling of the tax rate. Clearly, such an enormous tax increase would punish risk taking, that is, entrepreneurship and investment.

Keep in mind, as noted by John Rutledge in a Wall Street Journal piece last year, that the returns on private equity, venture capital and real estate investment partnerships are made up mainly of long-term capital gains. While the effort to increase carried interest taxes are billed as being meant to hit hedge funds – another case of political demonization attempting to trump economics – in reality, since much of the returns for hedge funds are short term, they are taxed as ordinary income anyway. This proposal negatively affects long-term investment.

Rutledge drove home the ills of this tax increase on entrepreneurial ventures and investment:

“In 2007, real estate made up the largest category (48%) of partnerships, representing $4.4 trillion in investments by 6.8 million investors. Most of those are small, one-or-two property partnerships where one partner puts up the money to buy a dilapidated building and the other is the general partner who manages the work to improve the property. If you triple the tax rate on the general partner, many of the small deals simply will not happen and fewer buildings will be renovated. Venture capital also will be hit. According to the National Venture Capital Association, more than 27,000 venture-backed companies in the U.S. had revenue of $2.9 trillion. Venture capital (like other investment partnerships) competes for pension fund money based upon after-tax returns. The drop in after-tax return caused by the carried interest tax hike means less money steered their way, and so promising biotech, software or clean-tech ventures may not get funded.”

Taxes cannot be raised with impunity. If you increase taxes on investments in new or expanding businesses, and in real estate, for example, that will negatively impact such investment. And the resulting diminishment in risk taking, in turn, will be felt throughout the economy. That’s simply the harsh economic reality if those pushing for increased taxes on carried interest and enterprise value actually succeed.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council

The Entrepreneur: Creator of Wealth, and Social Justice

The first World Entrepreneurship Forum was held November 13-15 in Evian, France. As a member of the first global think tank dedicated to entrepreneurship, I am excited about this new initiative. After all, if political leaders and larger corporations can have their annual global gatherings, why shouldn’t entrepreneurs? On a global basis, we are responsible for the bulk of wealth creation, new jobs, innovation, and remain the best hope for easing the world out of its current economic woes.

It seems that excessive time and resources are being spent on cleaning up the messes of larger companies and institutions. While work and reforms are certainly needed to bring stability to our financial systems, markets and economy, politicians and existing institutions seem to be overly focused on the wrong targets. At the World Entrepreneurship Forum, there was no bitterness or whining about this current state of affairs – only optimism and solutions. Our job was to develop a common agenda – an actionable list of recommendations – to accelerate global entrepreneurship. And that we did.

While we are fine-tuning the wording of this list of twelve recommendations, the general themes focus on building a more enabling environment – from education to government policies; improving support institutions, and increasing a cultural appreciation for entrepreneurs; and creating an inclusive framework to expose entrepreneurship as an option to more women, minorities and disadvantage groups.

Indeed, enabling business start-ups and entrepreneurship is critical to the economic future of our globe. But the entrepreneur, quite naturally, is a creator of social justice. Their innovations have greatly improved the lives of people around the world; their wealth-building capacity has lead to a better way of life and economic opportunity for untold millions; and their passion is unmatched for giving back to their communities, their causes and their countries.

Upon return from the forum, I stumbled upon an “open letter” on the business wires written by Philip Verges, Founder and CEO, NewMarket Technology Inc. While the letter was directed to “Fellow Shareholders and Small Equity Investors” its message certainly is one that needs to be read by political, social, education and business leaders.

In essence, Mr. Verges believes that the current global economic situation is an opportunity to “bring attention to a long overlooked business sector – a business sector that happens to account for the majority of economic activity around the world with historically little attention from Wall Street.” Of course, this would be the small business and entrepreneurial sector.

In his letter, Mr. Verges writes that he is optimistic that “this previously overlooked business sector will finally get the attention it deserves as institutions search for strength in the market.”

The letter is quite deep and thoughtful. (I hope he puts it on his company’s website as I only have a printed copy.) He concludes that “a new Wall Street” that emerges from the financial crises will do so “with a new appreciation for investment in the small businesses filling the gaps in the continuing market segmentation and the ongoing production fragmentation.”

According to Mr. Verges, “all of us share a vested interest in an improved investment environment surrounding the small business community.” He is confident that small firms will benefit in the new era.

Entrepreneurs are the solution to the global economic crises. This is the message from members of the World Entrepreneurship Forum. It certainly is the belief of thoughtful CEOs such as Philip Verges.

Karen Kerrigan
President & CEO