Thursday, January 26, 2012

The Romney tax debate is all wrong

I'm amazed that EVERYONE is missing the real story with the Romney 14% tax rate story.  Here's the deal - we structure our tax code to encourage investment.  Invest over a long enough time and you are rewarded by paying a lower rate.  Since the bulk of Romney's income comes from investments he gets the benefit of that lower rate.

However, this is where it gets interesting.  There has been a long debate over whether people like Gov. Romney who are not the actual investors but rather the managers of the investmens, should have their money taxed like that of the investors. 

Consider this hypothetical example... Let's say Sane Capital decides to raise a new buyout fund.  They raise $98 from wealthy investors and kick in $2 to act as the general partner.

Sane Capital then buys company ABC, strips out inefficiencies, turns a profit and sells ABC to another competitor three years later for $200.  Sane Capital repays their investors their capital of $100 and a hurdle rate return (call it $15 for this example).  Now we're left with roughly $85 of "long-term gain".  The typical Private equity firm gets 20% of the profits, so in this case $68 would go to the investors and $17 would go to Sane Capital.

The great debate is: should that $17 gain on the Sane Capital $2 investment be taxed as "long-term gain" or "operating income" because their operations (fixing the business) is what generated the income?  I'm not a tax expert and I don't play one on TV but every Private Equity guy I've ever talked to agrees that this is really OPERATING INCOME (meaning they should be taxed at normal income tax rates) but they aren't in any rush to change the tax laws. 

I know most eyes glazed over when I started talking investments and tax policy but hopefully I added a little color to the tax debate surrounding Gov. Romney's tax returns.  It's not about the 14%, but rather is the income a gain or income from operating the business?



sharonwue said...

In the 2011 SOTU, I seem to recall Pres Obama calling for an overhaul of the tax code, and one of the examples he used was this one, and how fund managers' incomes get the favored tax treatment because of it.
It IS tough to explain.
Is it possible that no one would manage these investors' money without the advantage of having their earnings taxed at the Cap Gains rate? That is probably not true.

The Artful Blogger said...

The best analogy that I can make is imagine if you had a human stockbroker like we all did in the 1980s. When you invested $100 in IBM at his direction he kicked in an extra $1 or $2 of his own.

Five years later you sell the stock for $200 (those were the days right?!) and you get your profit less his fee which is 20% of the profit.

The tax issue is really a philosophy - was the brokers fee earned by him doing his job (earned income) or was the fee his GAIN on his investment? Obviously gains are taxed at a much lower rate so every manager argues they are gains but the reality is that they earned that money by doing their job, in my opinion.

The risk is that some of these guys make not millions or tens of millions but BILLIONS of dollars and they are global residents. If we change the tax status there could be an exodus of fund managers to Europe, Canada or Asia.

Good question!