Carried interest, in particular, is clearly a loop hole written into law by the Private Equity industry, for the Private Equity industry. If they wish to be taxed at capital gains rates, then they should invest as LPs. This area is clearly indefensible, but I don't anticipate it changing.
Second is the financial engineering that comes with that tax benefits of leverage. If one is to have a tax on corporations, then there's a good argument for making interest payments on debt tax deductible. Better, though, to stop taxing corporations altogether.
Third, there is Epicurian's defense of the infamous dividend recap, where the PE firm takes cash out of the company as a dividend, and lets the firm take on more debt. If the firm goes bankrupt, the PE company keeps the money they extracted earlier.
One more wrinkle is worth discussing. This is the relatively recent phenomenon of financial sponsors borrowing additional debt through their portfolio companies during the life of their investment, and using the proceeds to pay equity dividends to themselves and their limited partners. These are known as dividend recapitalizations, or “dividend recaps.” Often, financial sponsors can use such recaps to withdraw money equal to or even in excess of their initial equity investment. This leaves the portfolio company with an increased debt burden and the financial sponsor playing with house money. Many people outside the industry, including our friends Messrs. Kwak and Surowiecki, don’t like dividend recaps, because it loads up the portfolio companies with risky debt while appearing to reduce private equity’s skin in the game. This is very true.Epicurious fails to mention whether the lenders in question get paid when they make the loan, or when the loan gets paid back.
However, having participated in or observed a number of such deals, I must strenuously disagree with Mr. Kwak’s contention that the lenders which participate in such transactions are unsophisticated dupes. They lend with eyes wide open, and an impressive amount of company-specific due diligence. Normally, a company is able to take on a bigger debt load because the financial sponsor and company management prove to new lenders that they have improved the company’s earnings power and free cash flow enough to sustain it.
«Better, though, to stop taxing corporations altogether.»
ReplyDeleteThis opens a tax avoidance/evasion opportunity as large as not taxing capital gains. If people are afraid of double taxation, one can allow deduction of corporate tax paid per share from share-owner taxes.
In general the best tax strategy for anti-avoidance is to have a number of relatively low taxes rates on a number of aspects of income generation, so that the income stream be caught at some point, and the incentive of avoiding any single tax be minimized.
This means that when in doubt between taxing A or B at some rate, tax both at a half rate, or tax both at a full rate and allow deduction of tax on A from tax on B.
Tax systems need to take very much into account not the fancy fantasies of economists, but also the practical experience of tax accountants.
The purpose of taxation is to raise revenue or to constrain demand reliably and defensibly, not as a morality tale.