Blackstone: Too Rich for Congress

By Justin Fox

On June 22, shares in the private-equity firm Blackstone Group began trading publicly on the New York Stock Exchange. By late afternoon, CEO Stephen Schwarzman's 23% stake in the firm he co-founded was worth almost $9 billion; he also pocketed $700 million cash from the deal.

The same day, several high-ranking members of the House Ways and Means Committee introduced legislation to make Schwarzman and Blackstone pay a lot more in federal income taxes than they do now.

Coincidence? Naah. The astounding riches made public for the first time when Blackstone filed for its stock offering are a big reason this is shaping up to be a hot summer for private equity. Key members of the Senate Finance Committee have also proposed tax hikes, hearings are planned on both sides of Capitol Hill, and private-equity firms are gearing up for a lobbying fight.

But Blackstone-induced "class envy," as TV pundit Larry Kudlow has called it, is not the only reason Congress has suddenly developed an interest in the subject. Nobody proposes touching Schwarzman's big founder's stake, which slipped below $8 billion within days as Blackstone's stock price dropped. At issue instead is the mere $398 million he made as CEO last year, much of it in carried interest on Blackstone's investments. And the manner in which carried interest is taxed is enough to make even a megamillionaire corporate CEO envious.

Carried interest is the main way partners in private equity and venture capital--and some hedge funds--are paid. The outside investors in a fund give the inside partners a share of profits (an interest) as compensation for their work. Compensation, whether the weekly pay of wage slaves or risky executive remuneration like stock options, is usually taxed as regular income at rates as high as 35%. But for reasons having mainly to do with the muddled history of partnership law, carried interest is taxed instead at the 15% capital gains rate.

"When you take a step back and look at the end result, you sort of say, This can't be right," argues Victor Fleischer, a law professor at the University of Illinois. Fleischer explained this conclusion in a paper that he began circulating last year. Since then, his brief for taxing carried interest as ordinary income--what the proposed House bill would do--has won over tax wonks and piqued congressional interest. "It seems like a reasonable argument," says Alan Auerbach, a University of California, Berkeley, economist and tax expert. "I don't think there are many people in the tax-policy community who believe that it isn't." But there's no law that says the tax code has to be reasonable, and the private-equity guys claim to see economic danger in changing the rules.

The proposed revisions could hurt the U.S. venture-capital industry, which helps small companies get big and is the envy of the world. Private-equity firms--which buy companies with mostly borrowed money, fix them up or pare them down, then sell them--are more controversial but have perhaps made corporate America more efficient and competitive. Ramping up taxes on these guys could lead to unpleasant consequences: think about the next Google going unfunded because money was diverted to pay taxes. Losing such opportunities might far outweigh the few billion dollars in annual revenue the tax change would bring in.

That's just a guess, though. What is certain is that when capital gains tax rates drop well below income tax rates, taxpayers react. On the positive side, the lower rate brings more risky, productive investments. On the negative, it prompts more unproductive accounting games. The Tax Reform Act of 1986 tried to end the games without killing entrepreneurship by setting both rates at 28%. (A quirk in the law kept the effective top rate at 33%.) But since 1992, as the chart on the previous page shows, income and capital gains rates have followed very different paths. One inadvertent result has been a pronounced tax bias in favor of private-equity partnerships and against traditional corporations. It's a bias that Stephen Schwarzman has taken great advantage of over the past 15 years. Now he may just have helped end it. THE BIG TAX GAP The growing disparity between capital gains and income tax rates has been a boon to private equity [This article contains a chart. Please see hardcopy of magazine.]