Hearing of the Senate Finance Committee. Subject: "Carried Interest Part III: Pension Issues"

Interview

HEARING OF THE SENATE FINANCE COMMITTEE
SUBJECT: "CARRIED INTEREST PART III: PENSION ISSUES"

SEN. MIKE CRAPO (R-ID): Thank you very much.

At a time when many of us are raising concerns about the competitiveness of the United States in global capital markets, it seems to me that the last thing we want to do is create a disincentive by increasing taxes and encouraging the movement of business away from the United States to London and other capital markets.

Just yesterday, the U.S. Chamber of Commerce released a phase of a two-part study of the impact of increasing carried interest taxes on the U.S. economy. And the purpose of the study was to better understand how carried interest affects the economy as a whole and how different sectors and industries may be impacted by this proposed tax increase. And this study concluded that the carried interest is an element of partnership finance in every sector of the U.S. economy engaged in capital formation. Increasing the tax rate on carried interest would lead to changes in the structure of partnership agreements. Incremental tax collections would be small.

To the extent that the tax increase could not be avoided by restructuring, the study concluded that the costs would be borne by all the members of the investment process, including general partners, limited partners, and their beneficiaries, as well as owners and employees of portfolio companies. Increasing carried interest taxes, the study concluded, would reduce the amount of long-term capital available to the U.S. economy and undermine investment, innovation, entrepreneurial activity, productivity and growth and, accordingly, the ability of U.S. companies to compete in the global markets.

This study reinforces testimony that this committee heard earlier from the Treasury assistant secretary for tax policy, Eric Solomon, who concluded that the current taxation of carried interest encourages the pooling of capital, ideas and skills in a manner that promotes entrepreneurship and risk taking.

I guess my first question is to you, Dr. Auerbach. Do you agree with those general conclusions of this study?

MR. AUERBACH: Yes, I do.

SEN. CRAPO: In your testimony, you stated that it was difficult to predict the actual costs that the impact of this tax would produce and then you gave us your best prediction. Have you looked at the predictions of others, and, if so, can you give me a range of the kinds of predictions that are out there from other economists and analysts?

MR. AUERBACH: I am not aware of quantitative predictions. The predictions that you mentioned are of a qualitative nature, that is, these are the kinds of effects that would occur, and I agree with those. In my testimony, I tried to nail down to the extent possible what the quantitative effect would be.

The thing I have the most confidence about of those calculations is the size of the increase in cost for hedge funds is about 10 to 20 basis -- not just hedge funds, all of these affected funds -- on the order of 10 to 20 basis points annually. The hard question is the extent to which those increases in cost could be avoided through restructuring of arrangements and, if not avoided, the extent to which they could be passed on to investors.

And of course, the passing on involves a lot of other changes in behavior such as a reduction in activity, which is one of the concerns you mentioned in the report, and lower returns available to investors because there would be less competition in the industry. That's a lot harder to know.

And this is the kind of thing one has to confront whenever a tax increase is considered. We think that all tax increases are going to have deleterious effects on the economy, but the money has to come from somewhere and the question is whether these particular taxes are less advisable than others.

And I think there are two things to weigh here. On the one hand, these seem to be logical taxes to raise because the income in question really does seem to be compensation, and it also is income of very high-income individuals which perhaps makes it more appropriate for taxation. But on the other hand, because of the avoidance possibilities and because of the fact that there's a lot of productive activity going on in these sectors, one has to be concerned. And so it is a difficult policy question.

SEN. CRAPO: Are you familiar -- in terms of the question of how many dollars will this proposed tax increase actually produce for the economy or for the Treasury, are you aware of the Knoll -- K-N-O-L-L -- study?

MR. AUERBACH: No, I'm not.

SEN. CRAPO: All right. That's one that was quoted in the U.S. Chamber's report, which indicated that they predicted about $3.2 billion would be raised assuming that there wasn't any restructuring. But you're not familiar with that?

MR. AUERBACH: I'm afraid I can't comment on it.

SEN. CRAPO: All right. My time's just about up.

I want to just ask you one question, Mr. Trone. You indicated in your testimony that in theory a tax hike would have the deleterious effect of making hedge funds and private equity investments less attractive. I assume that that theory you're talking about there is the same kind of thing that the U.S. Chamber was talking about in terms of the predicted response to this proposed tax increase. But in any event, if I understand your testimony correctly, are you basically saying that there's so much exuberance out there that the managers of these various funds and those engaged in these entrepreneurial activities are just not acting rationally -- is that your testimony?

MR. TRONE: A large number, yes.

Now I'd like to add to that, Mr. Read is a great counterbalance to my testimony today. CalPERS is an example of an excellent investment fiduciary who's making prudent investment decisions into these asset classes.

But they are atypical as opposed to the typical investment fiduciary.

SEN. CRAPO: All right. Thank you.

I see my time's expired. Thank you.

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