The Private-Equity Scam

This week, Senators Max Baucus and Charles Grassley, the chairman and ranking minority member of the Senate Finance Committee, have been holding "informal meetings" to consider whether the stratospheric incomes of private-equity partners ought to be treated as compensation rather than as capital gains, for tax purposes.

Way back in the 1970s, newly-minted MBAs with dollar-signs in their eyes wanted to be CEOs. Then, in the 1980s, they wanted to go into investment banking, because the money was even better there. In the 1990s, they went into high-tech venture capital and dot coms. Now it’s private equity. Becoming partner in a private equity firm is also the new dream of every CEO in America.

That's because the average big-company CEO has to make do with a measly $7 million a year, taxed at 35 percent. But private equity partners are raking in hundreds of millions a year, taxed at 15 percent -- less than the tax rate paid by middle-class Americans.

What exactly do private-equity partners do? They use the investment money of pension funds and college endowments and wealthy investors to buy up publicly-held companies and turn them briefly into privately-held companies. Then they do what you might do when you want to resell your home -- redecorate, refurbish, knock out some walls, apply fresh paint, sell the furniture.

Sometimes they keep the same CEO of the publicly-held company, give him some private equity too, and tell him to apply the good ideas he’s stored up but never implemented when he was just earning $7 million a year as CEO because now he can really cash in.

Then, a few years later, the private-equity partners resell the company to the public, usually at a big profit. And they take 20 percent of the profits for themselves.

We’re talking billions of dollars here, folks. And it’s only taxed at 15 percent because even though it’s most of their compensation, it’s treated as a capital gain. And courtesy of the Bush tax cuts, capital gains are taxed at 15 percent. Of course, those billions are what these guys pay themselves for their work. It's their compensation.

When capital gains are taxed at less than half the tax rate the rich pay on their incomes, you can expect this sort of gamesmanship.

Now that the tax-writing committees of Congress are taking a look at this giant loophole, they’re besieged by private-equity partners who are, of course, screaming: No! You can’t do this to us! If you treat the money we’re making as compensation, you’ll reduce our incentives. We won’t work as hard if we’re taking home only 60 million dollars a year instead of 80 million!. And that will cripple the American economy.

Baloney.

This column is adapted from Professor Reich's weekly commentary on American Public Radio's Marketplace.

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