Submitted testimony from Lenore Palladino, Senior Economist and Policy Counsel, Roosevelt Institute
March 15, 2018
Dear Senator Martin, Senator Winfield, Representative Lesser and Members of the Banking Committee:
My name is Lenore Palladino. I am a Senior Economist and Policy Counsel at the Roosevelt Institute.
Thank you for the opportunity to testify before you today. I am here to urge you to support S.B. 475, “An Act Studying the Effect of Federal Tax Reform on Hedge Funds and Investment Management Firms in this State.”
The Tax Cuts and Jobs Act (TCJA) has triggered a tremendous increase in corporate profits and shareholder payouts, as the increase in company cash flows directly to wealthy asset holders. It is crucial for Connecticut to study the windfall profits that hedge funds and investment management firms, in particular, will gain in the aftermath of TCJA as these industries play a significant role in Connecticut’s economy. I would urge you, once you have completed this study, to go further and enact policies to place fair tax rates on the earnings of investment fund managers in order to rebalance Connecticut’s economy towards true productivity.
Connecticut can take affirmative steps to treat the earnings of private equity managers the same as the earnings of cashiers and school teachers by changing how it treats ‘carried interest’ earnings in the fund industry. “Carried interest” refers to the profit share earned by general partners in investment funds that are organized as partnerships, such as private equity and hedge funds. This policy means that the managers of such firms—some of the wealthiest individuals in the state—pay a federal tax rate that is roughly 13 percentage points lower1 than the top marginal income tax rate.2 A standard arrangement is for general partners to receive a 20 percent share in profits, representing a large proportion of their total compensation, taxed with capital gains tax upon realization. General partners in investment funds earn this “profit share” through their work managing their fund on a day-to-day basis, as opposed to “limited” partners, who contribute capital but do not have an active management role. In recent work I argued that this compensation should be properly taxed as labor income, finding that taxing this activity fairly would raise between $2 billion and $8 billion in federal revenue annually.3
The rationale given for treating such activity as capital gains rather than labor is that the general partner of such funds should be considered as engaging in entrepreneurial activity rather than service or executive activity. Entrepreneurs pay capital gains, not ordinary income tax rates, when they profit off of the sale of their businesses, even though they have been providing labor services in the normal course of building their business. In the case of private equity and hedge funds, this is not persuasive because managerial service activity in other industries is properly taxed as labor income. Fund managers of the private equity firms are providing a managerial service by helping to restructure firms:
[W]hether one views the service provided as one having positive or negative social value, there is no reason that the provision of this service should be taxed at a lower rate than other managerial services. There is no reason that these managers should be able to avoid taxation… [in order to take] advantage of the favorable treatment of capital gains. (Stiglitz 2014, p. 19)
The TCJA did not take any significant steps towards treating carried interest as ordinary income, which one estimate by Hamilton Lane, an investment management firm, celebrated as “a big win for GPs.”4 They also found that the new tax law will increase deal returns by 30-170 basis points, holding all else constant.5
The tax reform in the “Tax Cuts and Jobs Act” was just the latest cause of the high-profit, low-wage corporate sector we see today. We are living through a decades-long trend in which value is extracted from corporations by shareholders and private owners, rather than creating a virtuous loop of continuous productivity growth, in which multiple stakeholders—workers, smaller businesses along the supply chain, the public—benefit. This trend began in the 1980s, when corporations began shifting away from the idea that their primary purpose was to meet the demands of all their stakeholders, to a narrower conception that their primary purpose is to maximize value exclusively for their shareholders—a shift that was facilitated by a series of changes in the laws that governed corporations.
We can see the stark disparity playing out in the aftermath of passage of the federal tax law, which has resulted in a drastic increase in shareholder payouts by corporations, while working families have seen negligible increase in their paychecks. For example, various estimates have shown that more than $200 billion of new open-market stock buyback programs by public companies have been authorized after the tax bill was passed, as outlined in a special report from the Democratic Caucus of the U.S. Senate (2018). An analysis by Just Capital (2018) found that just six percent of the tax windfall is going to employees, while 60 percent is going to shareholders6. A separate analysis by William Lazonick, Emre Gomec, and Rick Wartzman (2018) found that, so far, companies have announced share buyback programs that are 30 times as valuable as the announcements of increased employee compensation.
In sum, the majority of Connecticut’s residents will not benefit from the tax windfall aimed at the wealthy. That is why it is so important for you to take a close look at how the tax law will directly impact Connecticut hedge funds and investment funds, and further develop appropriate policies to rebalance the economy towards true productivity and shared prosperity.
I urge the Banking Committee to vote in favor of SB 475.
Senior Economist and Policy Counsel
1. Comparing a 37% top marginal income tax rate with a 23.8% capital gains tax rate.
2. Often, fund managers make a separate equity investment into the firm, which is taxed appropriately as capital. It is crucial for policymakers to disentangle the labor service versus capital investment of the general partner. The general rule is articulated in Section 707(a)(1), which provides that if a partner engages in a transaction with a partnership “other than in his capacity as a member of such partnership,” then the transaction shall be treated, for tax purposes, as if it occurred between the partnership and a third party. (Fleisher 2015, p. 20)
3. Lenore Palladino, Reality Check: Raising Revenue for Structural Reform and Large-Scale Public Investment, Roosevelt Institute, July 2017. https://rooseveltinstitute.org/realitycheck/ For more detail on the revenue estimates, please see Reality Check.
4. The TJCA does impose a new three-year holding period on certain carried interest in order for holders to qualify for long-term capital gains rates. Since the majority of private equity holdings are currently in the six-year range, this provision, according to Hamilton Lane, is largely ineffective.
5. Brian Gildea, Here’s How Tax Reform will shape the Private Market. Hamilton Lane.
6. For more information, see Just Capital’s Corporate Tax Reform Rankings, https://justcapital.com/news/tax-reform-rankings/.