What an Obscure Tax Loophole Means for Future MBAs and JDs

It's rare that I hit on a topic that allows me to write about issues of importance to both MBA folks as well as law school/aspiring policy wonk types. You'd think that not many people would care about the special tax treatment received by partners in private equity firms and hedge funds (in particular, the capital gains treatment for their "carried interests"), but two opinion pieces in today's NYT demonstrate why the issue should matter to many more people, including many who read this blog.

First up: "The Under-Taxed Kings of Private Equity" by Alan S. Blinder, professor of economics and public affairs at Princeton, former vice chairman of the Federal Reserve, and adviser to Democratic politicians. His piece lays out in very understandable terms what that "carried interest" is, why it matters, and what kinds of dollar amounts are at stake for the public treasury.

Next up: "The Hedge Fund Class and the French Revolution," by lawyer, law professor, writer, actor ("Bueller? Bueller? Bueller?"), economist, and Nixon speech writer Ben Stein. Stein takes Blinder's argument one step further and asks about the policy implications behind a tax law that has hedge fund and private equity gazillionaires paying a much lower tax rate on their income than normal people:

We are in a war. We are apparently not winning the war. The military is desperately shy of funds, to the point where our fighting men and women are being shortchanged in training and equipment.

We also need more money for our soldiers' pay, so their families do not have to live like church mice while their spouses are deployed in Iraq or Afghanistan. In these circumstances, is it fitting and morally right for the richest of the rich to be paying either very low taxes or no tax at all?

Is it right or even admissible in the human conscience that while teachers, emergency room technicians, police and firefighters are taxed at full earned-income rates — and often underpaid — that the highest-earning people in this country should pay at either very low tax rates or none at all?

Stein is no class warrior, so coming from him, this argument lept off the page (screen) at me.

Why does or should all this matter to a big chunk of my readership? For the following reasons:

1. For my MBAs and aspiring MBAs, so many of whom are itching to get into private equity: I've written before about how the economics of PE are very possibly about to change, and how that doesn't bode well for their career prospects, or at least their earnings prospects, in PE.

As Blinder puts it, "If we tax Activity A at 15 percent and Activity B at 38 percent, a free-market economy will give us more of A and less of B." If we start taxing private equity incomes at 38% rather than 15%, expect to see less capital and less top talent gravitating towards private equity.

(And the issue of capital gains treatment of their income doesn't even touch the problem of what happens to the buy-out market once interest rates rise, as they inevitably will. Could be a perfect storm brewing.)

2. For my law school types: I would guesstimate that a solid majority of law school applicants seek a law degree because they want to effect change on a policy level and make society better. (And they usually misspell "effect" as "affect," a spelling faux pas from which spellcheck won't rescue them.) In the same breath, when I ask them more specifically what kind of law they want to practice, they start rattling off the kinds of law they're certain they don't want to study. High on that list: tax law. That they don't realize how intertwined tax law is with the fundamental policy choices we make as a society and the give-and-take that happens through the legislative process suggests to me that most applicants have no idea what they're talking about.

Stein's article is a reminder that if you don't know anything about tax policy like carried interests and amortization of goodwill during an IPO, you're going to have a hard time making a rational or convincing argument about whatever activities you would rather have the government encourage, or what programs we should be funding over other ones, in a world of finite treasury resources.

Care about AIDS or cancer research? Global warming initiatives? More subsidized health care? Better life-saving equipment for our soldiers? Fancy technology for national security efforts? Those all take federal dollars, and if you want some of them for whatever your preferred cause might be, better that you start understanding things like the policy argument behind capital-gains treatment for carried interests.

Which leads me to my final point for law school types: Don't graduate from law school without having taken financial accounting and being able to read a financial statement. It could be the most useful class you take in law school, even if -- and I would argue especially if -- you're a policy wonk at heart. And if you retort that you're "just not a numbers person," you're not going to be as effective an advocate for your cause.