Even as the union representing Stella D’Oro factory workers in New York City is fighting the private equity firm that wants to shut it down, lobbyists for equity firms and other big investors are swarming over Congress to keep the tax breaks that helped fuel such buyout-driven closings. Related tax breaks also helped spur the global meltdown resulting, in part, from taking on too much debt to pay for shady investment instruments such as credit-default swaps.
As a result of these tax breaks, the Service Employees International Union (SEIU), among other reform groups, has urged Congress to “close tax loopholes that encourage buyout kings like KKR’s Henry Kravis and Carlyle’s David Rubenstein to utilize risky debt-laden business models to earn hundreds of millions a year while allowing them to pay a lower tax rate on their huge investment incomes than nurses have to pay on a $50,000 salary.”
SEIU estimated — based on public figures — that Henry Kravis’ creative use of tax loopholes cost taxpayers as much as $96 million in 2006, when private-equity funds were raking in investments to take over companies, then forcing them to pay off the loans the take-over titans used to purchase the companies.
Essentially, the tax system rewards companies and executives that pile up enormous amounts of debt either to use “leveraged buyouts” to take over other companies before reselling them, or to speculate in such near-worthless investments as subprime-based “mortgage-backed securities.”
Then, critics say, the executives line their pockets by paying as little as 15 percent in capital gains taxes on their income when they resell companies bought with other people’s money, rather than the higher 38 percent they’d normally owe on income.
Last year, Bob Greenwald’s Brave New Films produced an animated cartoon, “Larry the Loophole,” explaining how this lowered capital gains tax windfall fits into private equity funds’ schemes to take over companies:
This low taxation rate on resale profits is formally known as “carried interest,” derived from a long-ago era when, as financial blogger Dana Chasin observes, “private fund managers customarily did take equity positions in the funds they managed. Such positions were referred to as a “carried interest,” – an interest they held as long-term (carried) investors.”
But that’s no longer the case, and while investing 10 percent or less of their own money, these same partners still receive huge capital gains breaks on their funds’ profits.
“It’s ridiculous,” says John Adler, the director of private equity for the capital stewardship program of the SEIU. “Our tax system favors borrowing over [equity] investment.”
Private equity firms are run by partners who not only take millions in management fees, but divvy up the 20 percent of the profit from reselling companies that they gained by using primarily other investors’ money (the investors get the other 80 percent of the profits).
So the equity partners are getting a huge tax windfall to promote their own maximized profit, regardless of the impact on workers or the public.
“Millions of Americans are worried about losing their homes to foreclosure…and states are facing record deficits,”
observed Stephen Lerner, director of the Service Employees International Union’s
financial reform project.
“Yet buyout execs will file their income taxes this year and again, many will pay a lower tax rate than nurses and doormen. There is going to be increasing pressure on Congress to take a hard and serious look at how the buyout industry uses the tax code to transfer billions into their pockets and away from the needs of the country.”
The Obama administration has proposed in its new budget to close this loophole, but the financial industry and Big Business — fronted by benign-sounding venture capitalists who are seeking to distance themselves from rapacious equity funds — say that ending this preferential tax treatment would choke off new investment. Their slogan? “Don’t Shatter America’s Bright Ideas.”
(But this noble campaign to preserve investment is also being championed by the likes of the Chamber of Commerce, which generally opposes any more taxes, while also leading the fight against the Employee Free Choice Act and opposing most of the leading social reform legislation since the New Deal.)
As the New York Times explained this arcane but important capital gains issue driving fierce financial industry lobbying:
The venture capital industry is gearing up to fight against raising the tax on carried interest. A key battle is differentiating itself from the private equity industry.
Carried interest, known as “carry” in the industry, is the share of profits that venture capitalists receive after they successfully cash out of portfolio companies and return money to their investors. It is on top of management fees, which venture capitalists get each year for investing the money.
Carry is now taxed at the capital gains rate of 15 percent. It could potentially be taxed as ordinary income at a rate of 38 percent, said Mark Heesen, president of the National Venture Capital Association, the industryís lobbying group in Washington.
On top of all that, the taken-over companies, such as Stella D’Oro, that drain revenues, lay off workers and undermine quality in order to service their new debt can then deduct all those payments from their business taxes.
That robs the government of revenue in yet another way, in addition to the lowered capital gains loophole.
Even pro-business columnists realize that these perverse incentives to pillage companies and wreck the economy through reckless investment vehicles are, essentially, nuts. Hugo Dixon of the Breakingviews financial newsletter labeled this deductible interest tax break “barmy.” He noted that the tax advantage “allure has helped bring the world to the brink of crises in leveraged buyouts and commercial real estate.”
Now, with investments and revenues plummeting in the wake of the financial crisis, the private equity funds’ debt-laden companies are increasingly collapsing — and laying off workers.
Nearly 50 companies with private equity funding filed for bankruptcy in the first half of this year. Indeed, as International Union of Food, Farm and Hotel Workers (IUF) equity expert Peter Rossman notes in his “Buyout Watch” blog:
It should come as no surprise that private equity-owned companies make up over half of the 293 entries on Standard & Poor’s recent “weakest links” list of corporations facing credit downgrades (reported in the June 2 Financial Times) or that private equity funds were involved in 78 of the last 140 corporate defaults. The suffocating weight of high leverage on company balance sheets has been regularly documented on this site.
Unfortunately, as Rossman and Adler observe, the Obama administration isn’t interested in ending one of two major loopholes: the deductible interest loophole for private equity firms. Adler concedes that there is also a legitimate use of that deduction for companies that need to borrow money for genuine investment and expansion.
Even so, Rossman argues, “This massive regulatory subsidy, which encourages financial pillage while costing taxpayers billions of dollars in lost public revenue, is an open invitation to poison the books.”
And given the clout of the financial industry in beating back far more visible reforms this year, such as allowing bankruptcy judges to help homeowners stay in their homes, the obscure capital gains tax reform could easily be defeated.
So Robert Greenwald’s assessment last year of the current tax system’s impact on destructive investing still applies: “Private equity is an intricate and complex money-making tactic, but it comes down to a very simple bottom line: greedy financiers make a killing, while taxpayers get screwed.”