#PrivateEquity’s Sweet Tax Deal

By MERRILL GOOZNER,

The Fiscal Times

@TheFiscalTimes Washington, DC and New York

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January 9, 2012The Great Recession was preceded by a massive run-up in private sector debt, and not just by overstretched homebuyers snapping up bubble-era priced houses. Corporate borrowing also rose sharply. But even though both forms of borrowing are heavily subsidized by the government through deductions on interest, only one – the home mortgage deduction – is on the chopping block in the tax reform debate. Some experts say both should be.

“There’s no reason in the world not to limit interest deductions for corporations,” said Marty Sullivan, a contributing editor at Tax Analysts. “We have a tax system that encourages corporate leverage. It should be just the opposite.”

No industry has taken better advantage of the business interest exclusion than private equity investors like Bain Capital, which is Republican presidential frontrunner Mitt Romney’s former firm. Private equity is actually a misnomer, since the modus operandi of those investors is no different than the leveraged buyout firms that pioneered junk-bond financing in the 1980s. Private equity firms generally finance anywhere from 60 to 90 percent of their purchases with borrowed cash. Interest payments on those debts are treated just like any other expense, and are therefore deductible from earnings.

President Obama has focused his efforts on repealing the so-called carried interest loophole, which allows private equity investors pay taxes on earnings at a lower capital gains rate.

The business interest deduction distorts economic activity, according to a report issued last year by the Joint Committee on Taxation. It encourages companies to raise capital through debt rather than equity, since returns to stockholders – dividends – come out of after-tax profits (and then are taxed again as part of recipients’ individual tax returns). Payments to bondholders, on the other hand, is a deduction from earnings.

Moreover, many of those interest payments are never taxed, since many of the buyers of bonds from highly leveraged firms are pension funds, which do not pay taxes on income generated by their bond holdings. And if a company uses the debt proceeds to invest in tax-exempt or tax-reduced activities – like oil drilling, for instance – the deduction can be used to offset other earnings that are taxed at higher rates, thus allowing the issuer to use debt payments to lower their overall tax rate.

“Executives receive enormous returns for very modest increases in performance…. They don’t have any skin in the game. Downside shocks are absorbed by creditors.”

The tax break is also a major driver of soaring executive compensation, since many senior managers who participate in leveraged buyouts receive stock options in the newly acquired firms. They can reap huge returns when the purchased company is later resold, either on a public exchange through an initial public offering or to another private firm. “Executives receive enormous returns for very modest increases in performance, simply by virtually of how leveraged the bet is,” said Edward Kleinbard, a law professor at the University of Southern California and a former top tax aide on Capitol Hill. “They don’t have any skin in the game. Downside shocks are absorbed by creditors.”

The Great Recession was preceded by a massive run-up in private sector debt, and not just by overstretched homebuyers snapping up bubble-era priced houses. Corporate borrowing also rose sharply. But even though both forms of borrowing are heavily subsidized by the government through deductions on interest, only one – the home mortgage deduction – is on the chopping block in the tax reform debate. Some experts say both should be.

“There’s no reason in the world not to limit interest deductions for corporations,” said Marty Sullivan, a contributing editor at Tax Analysts. “We have a tax system that encourages corporate leverage. It should be just the opposite.”

No industry has taken better advantage of the business interest exclusion than private equity investors like Bain Capital, which is Republican presidential frontrunner Mitt Romney’s former firm. Private equity is actually a misnomer, since the modus operandi of those investors is no different than the leveraged buyout firms that pioneered junk-bond financing in the 1980s. Private equity firms generally finance anywhere from 60 to 90 percent of their purchases with borrowed cash. Interest payments on those debts are treated just like any other expense, and are therefore deductible from earnings.

President Obama has focused his efforts on repealing the so-called carried interest loophole, which allows private equity investors pay taxes on earnings at a lower capital gains rate.

The business interest deduction distorts economic activity, according to a report issued last year by the Joint Committee on Taxation. It encourages companies to raise capital through debt rather than equity, since returns to stockholders – dividends – come out of after-tax profits (and then are taxed again as part of recipients’ individual tax returns). Payments to bondholders, on the other hand, is a deduction from earnings.

Moreover, many of those interest payments are never taxed, since many of the buyers of bonds from highly leveraged firms are pension funds, which do not pay taxes on income generated by their bond holdings. And if a company uses the debt proceeds to invest in tax-exempt or tax-reduced activities – like oil drilling, for instance – the deduction can be used to offset other earnings that are taxed at higher rates, thus allowing the issuer to use debt payments to lower their overall tax rate.

“Executives receive enormous returns for very modest increases in performance…. They don’t have any skin in the game. Downside shocks are absorbed by creditors.”

The tax break is also a major driver of soaring executive compensation, since many senior managers who participate in leveraged buyouts receive stock options in the newly acquired firms. They can reap huge returns when the purchased company is later resold, either on a public exchange through an initial public offering or to another private firm. “Executives receive enormous returns for very modest increases in performance, simply by virtually of how leveraged the bet is,” said Edward Kleinbard, a law professor at the University of Southern California and a former top tax aide on Capitol Hill. “They don’t have any skin in the game. Downside shocks are absorbed by creditors.”

Given those incentives, it’s no surprise that total corporate debt soared from 38 percent of gross national product in 1994 to nearly 48 percent on the eve of the Great Recession (at the height of the junk bond mania in the 1980s, by comparison, it never got higher than 44 percent). Total corporate interest payments tripled over the same period to nearly $1.2 trillion, according to the JCT report.

The favorable tax treatment for debt-financed takeovers by private equity firms might be more sensible if it ultimately helped create more jobs. Romney claims the successful buyouts created during his tenure at Bain created 100,000 new jobs at firms that were later sold to new investors after being turned around. Critics say job losses at firms that either went bankrupt or downhill after the leveraged buyout more than offset those gains.

Academics who have studied the private equity phenomenon say it’s pretty much a wash on the job creation front, with the takeovers that were funded in the 1980s and 1990s – when Romney was active in the industry – more likely to result in substantial layoffs than the buyouts of more recent years. “The deals which were public companies before being taken private tend to be more cost-cutting deals,” said Steven Kaplan, a professor of finance at the University of Chicago’s Graduate School of Business. “There were fewer jobs at those LBOs than their peers” in the same industry.

On the other hand, companies that were being spun off from larger conglomerates or were simply private takeovers of already private firms tended to increase jobs. “They (private equity firms) make firms more efficient. Sometimes that means cutting; sometimes that means growing,” he said.

The one thing that experts agree on is that the hefty returns to private equity investors were beefed up by the income deduction on the interest they paid while owning the firm. “While the performance (of the purchased firms) is pretty much on a par with their industry peers, we know the returns to the private equity investors are quite stellar,” said Edith Hotchkiss, a professor of finance at Boston College. “A part of that increased return is from the tax yield.”

Kaplan estimated that 10 percent to 20 percent of the returns from private equity transactions came from reduced taxes. One way to level the playing field, he said, would be to grant dividends the same tax benefit. However, that would simply blow another hole in corporate income tax collections, which have been declining as a share of the overall income tax take for decades despite corporations capturing a growing share of national income.

Kleinbard, who previously served as chief of staff for the nonpartisan Joint Committee on Taxation, agreed dividends and debt should be treated equally, but said the deductions for both should be capped. That’s not likely to happen – and it’s doubtful the business interest exclusion will become part of the tax-reform debate during election season. President Obama has focused his efforts on repealing the so-called carried interest loophole, which allows private equity investors and hedge fund managers to pay taxes on their annual earnings at a lower capital gains rate. Romney has said he is for corporate tax reform that lowers rates, but has not indicated how or whether he would make up the revenue.

“At this point, the corporate tax reform debate is limited to what you can stick on a placard,” Kleinbard said. “We’re a long way from debating what would make a sensible system.”