Carried-interest tax hike slammed

Pension funds would be adversely affected if taxes on private-equity funds were raised, witnesses said at a Senate Finance Committee hearing today. If the tax on carried interest went up from the 15% capital gains rate to the income tax rate of up to 35%, it would be equal to a cost increase of 10-to-20 basis points annually, said Alan J. Auerbach, Robert D. Burch Professor of Economics and Law at the University of California, Berkeley. Fund managers would share this burden with investors, but the just how the two groups would split the tax increase is unclear, he said. “In short, the proposed tax changes, if they an effectively be enforced, would be progressive but also would reduce returns to investors, including pension funds, somewhat,” he said. Additionally, the taxation method also wouldn’t solve the problems of the distinction between capital income and compensation, Mr. Auerbach added. Russell Read, chief investment officer of the California Public Employees’ Retirement System, echoed Mr. Auerbach’s conclusion. “A delicate balance exists for a Limited Partner like CalPERS to be successful,” Mr. Read said. CalPERS’ private equity allocation is managed by the Alternative Investment Management program, and as of July 31 $17.4 billion (or 7.1%) of the fund’s total assets were invested. Since inception, the program has had a total return of 14%. As to whether a higher tax would affect the fiduciary duty of those who helm the funds that invest into these vehicles, Donald B. Trone, president of the Foundation for Fiduciary Studies, said that it probably won’t discourage investment fiduciaries who want to use these strategies. Theoretically, a tax hike, which would slash returns, would make hedge funds and private equity investments less attractive as a portfolio component, but fiduciaries are too excited about these strategies to stop using them — even if they are expensive, he said. “Unfortunately, in many cases where investment fiduciaries have invested in hedge funds and private equity, speculative hubris has supplanted procedural prudence,” Mr. Trone said. The House Committee on Ways and Means also held a hearing on carried interest today.