Rubinstein discusses what this might mean for the industry.
In 1922, the United States Congress said that there is a reason why we should encourage people to invest capital, because investing capital creates jobs and makes the economy better. And as a result, in 1922 for the first time, the Congress said we will have a lower rate for capital gains or for capital that is invested in terms of its taxation than we do for ordinary income. And from that point forward, it was recognized in the United States and many other countries of the world that it was an advantage to capital being invested. It creates jobs. It’s good for the economy. When we invest in private equity, we are investing capital on behalf of investors. And we are hopefully creating jobs, hopefully making companies better, and hopefully making a profit. When we invest money on behalf of investors, the capital that we invest is treated as a capital gain when there are profits, and that is not in dispute. The issue that is in dispute is how the professionals who invest the money get compensated. Historically we’ve been compensated by having the profits that we get a share of the profits earned by our investors taxed as capital gains. In other words, typically our money is other people’s money when we’re investing it. Eighty percent of the profits goes to the investors. It’s taxed at capital gains rates. And 20 percent comes to the people who do the transactions. That 20 percent is known as a “carried interest” or a “promote”. Historically that’s been taxed at capital gains rates as well. Of late, Congress and others have said, “Well what we’re really doing is providing a service to our investors, and that service enables us to get this 20 percent. And for providing this service, we’re really providing ordinary working kinds of services. And therefore that should be taxed as ordinary income at a higher rate than the capital gains rate.” And that’s a dispute that’s now going on in Congress. My own view is that what we do is take enormous risks. We are like the people putting up capital. We could lose it all. We could get no compensation at all if we do not succeed. And so we do take the kind of entrepreneurial risk that was envisioned in 1922 when Congress set up the capital gains system. So my own view is that the capital gains treatment is appropriate for people in our system; but I recognize that we have to explain this to members of Congress. This is an issue that’s relatively new to members of Congress. It wasn’t one they’d ever focused on before. And so it’s not as if we can sit in our offices and just say intellectually what we’re doing is the same as investing our own capital. We have to go to members of Congress. We have to go to the press. We have to go to the public and explain why we’re adding value, why we deserve to be treated this way. And I should add that this system has worked quite well. Capital gains treatment for private equity has worked quite well in producing the kind of private equity industry we have today. It’s made our country and economy much more efficient. In the 1980s it was thought that Japan would have a better economy than ours by this time, and that Japan would be a bigger economy. That didn’t happen. Because of private equity and other forces like private equity, our economy has been transformed, and transformed into a more productive economy. And I think before Congress changes things, they should think twice about whether they’re going to tinker with something that works quite well. There’s an old saying: “If it’s not broke, don’t fix it.” There’s also a concern about a law of unintended consequences. Sometimes when you try to change a law, you get consequences you didn’t intend. For example it was reported in the 1970s – late ‘60s, early ‘70s – that some people were paying no tax on their income. There were about 10 people in the United States in those days who had a million dollar income and they paid no tax because of various loopholes. Should Congress pass the AMT – so called the Alternative Minimum Tax – which made it possible . . . or impossible for people to avoid tax at all, everybody has to pay some tax. It was designed to affect about 10 people. It now affects about 50 million people. The law of unintended consequences applied, which is to say Congress tried to have a fix on a limited number of people. It didn’t quite work. I’m afraid if Congress tries to change the tax structure here, not only will they upset a very good thing for our economy; but I think they could have an unintended consequence that might be very adverse for our economy. If the private equity industry stops doing what it does – if the private equity industry doesn’t feel that it can invest as efficiently as before – we might find that people move offshore to do investments. We might find that the private equity industry doesn’t yield the kind of returns that pension fund investors have come to expect. Remember pension funds are investing a lot of money in private equity. They’re getting very good returns. The best returns they’re getting are coming from private equity. And so we shouldn’t do something that is working for pension funds and working for economy without fully understanding whether the consequences are really worth it. I don’t really believe if this were done, we would pick up all that much revenue for the United States government. And in fact I think there are many ways that the government could pick up revenue much more readily.
Recorded on: 9/13/07