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January 23, 2012
Romney's Other Tax Break

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By Martin A. Sullivan --

Was it creative destruction or vulture capitalism? Whatever you call what Mitt Romney did at Bain Capital, it is now a multi-pronged challenge to his presidential aspirations. Just the mention of investment shops like Bain can stir up resentment with the voters still looking for jobs and seething over the collapse of 2008.

Then there is the tax angle. When he left Bain in 1999, Romney negotiated a retirement package that gave him a share of the company's skyrocketing profits for at least a decade after his departure ("Buyout Profits Keep Flowing to Romney," The New York Times, Dec. 18, 2011). The bulk of those profits were carried interest -- consulting fees paid to managing partners conditioned on upside gain for investors. The payouts were likely taxed at 15 percent. For a man with an estimated net worth of a quarter-billion dollars, a tax rate lower than middle-income families' does not sit well with voters who are daily reminded of increasing inequality, especially when Romney is proposing a plan that cuts taxes on the rich and raises taxes on the poor (Tax Policy Center, "The Romney Tax Plan," Jan. 5, 2012, Doc 2012-249, 2012 TNT 4-28).

Just as many Wall Streeters feared, Romney's rising presidential fortunes are threatening their monetary fortunes. The long-simmering debate about the tax treatment of carried interest is being reignited. On January 18 House Ways and Means Committee ranking minority member Sander M. Levin, D-Mich., announced his plans to reintroduce legislation to treat carried interest as ordinary income rather than capital gains. (For related coverage, see p. 405.) This is just the opening salvo. If Romney wins the Republican nomination, the president's populist reelection campaign will ensure that the carried interest controversy goes prime time.

Despite the media coverage of everything Romney and Bain, there is another significant tax policy issue concerning the business that has been left unmentioned. Like all investment houses that do leveraged buyouts, Bain created value for its investors by increasing debt levels and reducing taxes of its target companies. Bain profited from a dangerous flaw in our corporate tax that subsidizes destabilizing financial structures.

Distribution of $40 Million of Operating Income
Before and After a Leveraged Buyout (LBO)

Source: Example from Joint Committee on taxation, "Present Law and Background Relating to Tax Treatment of Business Debt," JCX-41-11, July 11, 2011, p. 70.

Debt Is the Key

Specialized investment partnerships that do leveraged buyouts like to be called private equity firms. But their deals have more to do with debt than equity. The bulk of funds for their acquisitions comes from debt issued by the target company to outside investors. The smaller portion of funding is equity from partnership investors. Leveraged buyouts that use mostly debt to acquire established firms are very different from transactions entered into by venture capital companies that use mostly equity.

Private equity firms emphasize that they create value by applying their management skills and operating knowledge of an industry. Whether or not these contributions exist in any particular deal, there is always a significant tax component. The injection of debt into leveraged buyout transactions reduces tax payments on income from the underlying business. This occurs for the simple reason that interest payments on debt are tax deductible, while dividend payments on equity are not. A tax system should be neutral. But our tax system favors debt over equity.

We aren't talking small potatoes. A hypothetical example used by the Joint Committee on Taxation illustrates this point ("Present Law and Background Relating to Tax Treatment of Business Debt," JCX-41-11, July 11, 2011, Doc 2011-15103, 2011 TNT 134-14). In the example, a target firm with no debt generates $40 million of before-tax profit annually and pays $14 million of corporate tax (at a 35 percent rate).

The rearrangement of cash flows from a leveraged buyout of this firm is shown in the figure above. Most of the funds for purchasing shares from pre-deal owners come from new debt issued by the target firm. As a result, the target has interest payments of $21.6 million. That reduces before-tax profits from $40 million to $18.4 million. Of the $18.4 million, Uncle Sam gets $6.44 million and the private equity investors keep $11.96 million. Without any change in the operating income of the business, there is an annual reduction in taxes of $7.56 million. Under the assumptions in the example, the private equity firm has increased the market value of the target by over $60 million.

This is all perfectly legal. But it is not good economics. In contrast to the carried interest loophole, which simply allows very rich partners to be even richer, the tax incentive for leverage goes to the heart of the deal and can cause serious economic damage. If we have learned one lesson from the Great Recession, it is that too much debt can be devastating to a business. Higher debt increases the possibility of financial distress for the firm, and that distress imposes real costs, including reduced availability of funds needed during business downturns. It also increases the likelihood of bankruptcy and all the costs associated with it.

And higher levels of debt threaten macroeconomic stability by leaving the economy more vulnerable to small contractions in business activity. Because insolvency and illiquidity can spark a chain reaction, one major bankruptcy can threaten the whole economy. That increases pressure for the federal government to bail out bankrupt firms. And there can also be increased pressure on the Federal Reserve to relax monetary policy, increasing the risks of inflation. After this near-death experience for the economy, you might have expected Congress to give priority to creating a tax system that discourages debt. Unfortunately, it has left in place a tax system that does exactly the opposite.

As Congress desperately searches for revenue to pay for a reduced corporate tax rate, it should consider limitations of interest deductions when there is excessive debt. Even if the Romney campaign convinces you that leveraged buyouts are totally benign, there is still no reason for the United States to maintain a tax system that favors them over venture capital.

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