The Godfather will See You Now: The War on Private Equity

Had Mario Puzo ever collaborated with George Orwell, one might easily imagine a sinister or otherwise shadowy character brandishing the honorific, “The Intellectual Godfather of Private Equity Tax Hikes.” Sadly, the genius of these two novelists is unnecessary in a world run by Barack Obama, Nancy Pelosi and Harry Reid. Meet the all too real Victor Fleischer who is indeed “sometimes called the Intellectual Godfather of Private Equity Tax Hikes.” The story of his quest for academic tenure is as frightening a plot as any work of fiction.

In 2007, Fleischer authored a paper titled, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” in which he argued that private equity managers had taken advantage of a “loophole” in the tax code to [gasp!] make some money. As Fleischer has said, “It was stunning to me that you had some of the wealthiest people in the country paying a low rate on their labor income.”

Of course, private equity managers are the black-hatted proxy for most partnerships under the tax code, including real estate partnerships and even many “mom and pop” shops. And by “loophole in the tax code,” one can easily conclude Fleischer simply refers a feature of the tax code he doesn’t like because it allows people to “pay a low rate.”

Nevertheless, this isn’t a story about an egghead who wrote a paper that was well received within the brick and mahogany walls of higher education. No, our plot takes a dark turn when Mr. Fleischer’s paper, “landed with some Congressional staff members, who were looking for ways to pay for a rollback in the alternative minimum tax.”

“In 2007, a draft version of my paper on carried interest helped prompt Congress to propose Section 701 of the tax code, which would tax a portion of carried interest as ordinary income rather than a capital gain,” boasted Fleischer on his blog, which he calls – get this – A Taxing Blog. Despite aggressive efforts on the part of many liberal members who have been inspired by Mr. Fleischer’s paper, however, Congress has yet to pass this massive jobs-killing tax increase, which Larry Kudlow has labeled “a war on prosperity.”

Ah, but that hasn’t stopped our restive, tenure-hungry academician; we’re only at the cliffhanger. The sequel is in the works.

This summer Fleischer studied “the tax treatment of founders’ stock and entrepreneurship under an income tax and consumption tax.” Founders’ stock is also known as “sweat equity stock”: Those shares mom and pop grant themselves when their fly-by-night operation achieves success and actually becomes worth something. You see, as far as Prof. Fleischer is concerned, mom and pop are tax cheats because mom and pop’s sweat equity stock hasn’t really been taxed at a high enough rate.

Here’s a quote from the abstract of Prof. Fleischer’s forthcoming paper:

“Founders of a start-up usually take common stock as a large portion of their compensation for current and future labor efforts. Getting paid in founders’ stock allows entrepreneurs to defer paying tax and–more importantly–allows them to pay tax at the long-term capital gains rate. Politicians, entrepreneurs, and many academics claim that the favorable tax treatment of founders’ stock is an effective method of subsidizing entrepreneurship. … Taxing founders at a low rate is a conspicuous loophole in the fabric of our progressive income tax system, uniquely undermining our commitment to equal opportunity and distributive justice. Founders’ stock is often bequeathed to heirs who receive a step up in basis, allowing founders to avoid the income tax altogether, leaving a legacy of dynastic wealth subject only to the rather dodgy application of the estate tax. While it would be desirable to eliminate the tax subsidy and instead tax gains from founders’ stock as labor income, fixing the problem is not easy. I offer a range of possible solutions that policymakers might consider.”

Did you catch that? Distributive justice!? Leaving a legacy of dynastic wealth subject only to the rather dodgy application of the estate tax!? Low tax rates are a “tax subsidy!?” Let us all hope Flesicher’s latest paper doesn’t “land with some Congressional staff members” as his first paper did.

So what’s going on here? As Richard Baker of the Managed Funds Association has observed in the Wall Street Journal, Prof. Fleischer and the Democrats in Congress are engaged in “a stealth attack on capital gains.” To put it in terms unbecoming an “intellectual godfather” or a Wall Street Journal Op-Ed: The government needs money, successful business owners have money and Congress has the power to take it away. Prof. Fleischer sees it as his job to justify confiscatory tax policies that punish success and damage the U.S. economy. When one is stunned that wealthy people are paying such low rates of taxation, the academic studies become just that, academic.

To further the Godfather analogy, Baker argues in the Journal it is the investment services industry that is waking up with a horse head in its bed. Tomorrow the “threat [is] to any business or industry that politicians decide is no longer popular.”