Private equity: Hike taxes and we may not play

NEW YORK (CNNMoney.com) -- What happens when you boost taxes on high-income folks who manage $2 trillion that is integral to capital markets and spurs innovation, creating the Googles and Genentechs of the world?

To hear them tell it, nothing good.

A Senate Finance Committee hearing on Wednesday considered the question of whether private equity and hedge fund managers are taxed enough when they're paid "carried interest" and the subsequent consequences if it was taxed more.

Carried interest is the managers' share of a fund's profits. Even though managers don't necessarily invest any of their own money in a fund, their carried interest is taxed as a capital gain at 15 percent instead of at ordinary income rates that can run as high as 35 percent.

Key House Democratic lawmakers contend that managers are providing a service for a fee, and they've proposed doubling the tax on the manager's carried interest by treating it as ordinary income.

At issue during the hearing Wednesday was when labor is like capital and worthy of being taxed as such, and whether a tax increase stifles innovation and economic activity.

Those in private equity contend that while they may not invest much, if any of their own money, they provide industry and business expertise, hands-on management, connections and their reputations to the companies their funds buy, often for long periods of time.

In the case of venture capitalists, they help the person or venture working on the "next big thing" commercialize their efforts. "Our objective is to get the engineer out of Cisco and into the garage to create the next Cisco," Kate Mitchell, managing director of Scale Venture Partners, told lawmakers in her testimony.

What's more, the managers contend, carried interest as a source of income is uneven at best, both because a lot of investments may not turn a profit and even when they do, there are provisions that can prohibit the manager from collecting if they don't meet certain thresholds.

According to Mitchell, 40 percent of venture capital investments lose money, another 40 percent do little more than break-even and only 20 percent are big successes. "We dig many dry wells," she said.

Mitchell likened carried interest to stock received by the founder of a company who puts in years of sweat equity and when he sells his stock, his gains are treated as capital gains.

Raise the tax on carried interest, and you could see a loss of talent in the industry. "We'll be much less incentivized to invest," she said, noting that jobs with steady incomes or less risky investments requiring less commitment will draw them away.

That, she suggested, could dampen innovation since talented venture capitalists are needed to identify the most promising new companies, which in turn, create jobs. Companies backed by venture capital since 1970 accounted for 10.4 million jobs and $2.3 trillion in revenue in 2006, Mitchell told lawmakers.

Peter Orszag, director of the Congressional Budget Office, noted during the hearing however, that there are plenty of other examples of performance-based fees that are taxed as ordinary income and have not had the effect of drying up the talent well.

Among them are fees paid to actors when their movies do well, performance bonuses, many stock options and fees paid to asset investment managers who are not designated as "partners" to their clients.

Other critics of a higher rate contend that taxing managers more could inhibit the flow of capital to U.S.-based private equity and hedge funds.

But Orszag told lawmakers that that's not likely for two reasons: a) the limited partners' gains would still be taxed as capital gains and they're the ones putting in the money; and b) in cases where the limited partner is a taxable entity, the treatment of a manager's carried interest as ordinary income can result in a valuable deduction to the limited partners. "If anything, it could encourage more capital flow," he said.

Mitchell disagreed. While there may be plenty of capital around to invest, she said, fewer managers will be willing to put it to work, since the nature of their work is "cyclical, high-risk and long-term," and a number of other countries are actively trying to attract venture capital.

In her written testimony she noted, "(T)hese foreign economies would be all too happy to grab the brass ring from the United States. The game is ours to lose."