Politicians Will Hit Dealmakers--Not Just Yet
From the July 22, 2007 Sunday Times
July 23, 2007
by Irwin Stelzer
Operate internationally and at times you have to fight a war on two fronts. That’s what the private-equity industry, with bases in New York and London, finds itself doing, as politicians in America and Britain attack its tax status. Never mind that the dealmakers, led as if by an invisible hand, have found a solution for one of market capitalism’s problems – the separation of the ownership and control of companies.
That separation is one factor that led to the current battle. The battle between the politicians and the private-equity industry didn’t suddenly flare up because a British dealmaker remarked that he pays taxes at a lower rate than his cleaning lady, or because an American equivalent threw himself a birthday ball costing $2m, or $5m, or $15m, depending on your tabloid of choice.
The controversy began, in part, because company executives, unconstrained by the dispersed and therefore relatively powerless company owners (also known as shareholders), persuaded many supine boards of directors to award compensation bearing little relationship to performance. That created a background in which the public on both sides of the Atlantic began to wonder why inept directors exit the executive suites as multimillionaires. Since those who do not follow Wall Street or the City closely can be forgiven for failing to distinguish between corporate bureaucrats and the inventive, risk-taking entrepreneurs who run private-equity firms, public grumbling became a generalised dissatisfaction with “unfair” compensation. That, of course, attracts the attention of politicians and, when the private-equity operators proved inept at explaining what they contribute to the economy, the stage was set for a battle.
Which is a pity because, by taking over troubled companies, private-equity entrepreneurs cure the problems stemming from the separation of ownership and control. They and their partners now own and control former public companies, and have every incentive to reward only those managers who earn their pay by increasing profits and growth rates. Enter that invisible hand, and the further long-term result might prove to be job creation and enhanced value of the pension funds and other institutional investors who share the profits of these ventures.
Abuse of executive compensation procedures is not the only bit of background noise that has drowned out the defences offered by the private-equity industry. Critics have long argued in both our countries that the prosperity resulting from the Bush tax cuts in America, and Gordon Brown’s economic management in Britain, has not been shared equitably. Globalisation has increased the value of education and management skills in the international market, while the entry into that market of more than a billion unskilled labourers has contained the wages of lower earners. High earners and consumers are winners, but unskilled workers, even those who benefit from low-cost made-in-China T-shirts and trainers, see themselves as losers.
So when the press reports that the hundreds of millions earned by some private-equity entrepreneurs are taxed as capital gains rather than as ordinary income, it should come as no surprise that politicians feel compelled to act. Or at least to seem to act. To an elected official, lectures on efficient tax structures matter less than angry letters from their constituents.
So far, there has been more noise than action. Sir David Walker’s report on Britain’s private-equity industry calls for greater transparency, something the industry can live with more comfortably than a review of its tax status. After all, many of the companies acquired by private-equity firms have publicly traded debt, and are already required to disclose their finances.
In America, Congress seems to have decided to do nothing this side of its summer recess, for the sensible reason that the tax status of the private-equity industry is of concern to many more people than a few bil-lionaires in Greenwich, Connecticut and on Park Avenue in New York City. For one thing, many private-equity firms are quite small, specialising in deals of about $5m.
For another, as New York Senator Chuck Schumer points out, sauce for Wall Street dealmakers – many of whom are his constituents and financial supporters – is surely sauce for the Texas oil men who rely on similarly structured partnerships. Raise taxes on my constituents, Schumer is telling his colleagues in the Senate, and I will raise taxes on yours. For senators who represent neither New York dealmakers nor Texas oil men, that might sound more attractive than Schumer intends.
In Britain, where the decision on tax technically rests with the new chancellor, Alistair Darling, nobody is in any doubt that the final call will be made by Gordon Brown. Brown would love to get his hands on additional tax revenues to spend on more social programmes. But he has to consider whether a crackdown would lead to a flight of high earners from London, taking with them the revenues they now provide for the Treasury, and the jobs their spending creates. The difficulty of doing that sort of arithmetic is as good an excuse as any for doing nothing, at least until the autumn.
On both the American and British fronts, then, we have a phony peace. Private-equity entrepreneurs are gathering ammunition to support an autumn offensive in support of the status quo – continued taxation of the bulk of their profits at low capital-gains rates. Politicians are marshalling forces for an assault on that position, both to appease their constituents and to increase the immediate flow of revenues to their treasuries. Most civilians, meanwhile, are studying their maps, not to follow the battle, but to decide where to spend their holidays.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.