Analysis of the Impact of Increasing Carried Interest Tax Rates on the U.S. Economy

Dr. John Rutledge, Chairman, Rutledge Capital LLC

September 2007

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Introduction

In today's political climate leading up to the 2008 elections, a number of presidential candidates and members of Congress have singled out private equity sponsors, venture capital funds, hedge funds and other businesses organized using limited partnership agreements for punitive attention. They are proposing more than a doubling of income tax rates on so-called 'carried interest' from capital gains rates to ordinary income levels.

The Chamber would like to better understand how carried interest affects the US economy as a whole and how different sectors and industries may be impacted by the proposed tax increase. The Chamber approached Rutledge Capital to conduct a study of these issues. Rutledge Capital has conducted policy impact studies for the Chamber in the past, and has twenty years of experience in the private equity area, including structuring partnership agreements and raising and investing two private equity funds.

This paper reports on Phase 1 of the study, in which we take a macro-level survey of the impacts of proposed changes in the treatment of carried interest. In doing so we will define carried interest, look at its history, examine which industries rely on carried interest to structure investments, look at the size of the asset base investing through partnerships and how fast it is growing. We will outline the major proposed changes in tax treatment, analyze the likely impact of a tax increase on the economy, and look at who bears the burden of a tax increase, the General Partner, the Limited Partner, or the operating company being financed. We will examine the channels through which the proposed tax increase would impact the capital markets including prices, rates of return, and level of investment. Finally, we will look at the broad impact of proposed tax changes on the overall economy, jobs, incomes, investment activity, and tax revenues.

Later, in Phase II of the study, we will use more detailed data from private industry sources to do econometric work designed to estimate the impact of carried interest tax increases in greater detail, including impacts on selected sectors and industries.

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