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Tax break on profits again in jeopardy

But critics say ending benefit for financiers would hurt economy

By Michael Kranish
Globe Staff / November 27, 2009

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WASHINGTON - An effort in Congress to eliminate a generous tax break for hedge fund managers, private-equity specialists, and venture capitalists, which could be taken up next week in the House Ways and Means Committee, is being met with resistance by opponents who say the move would weaken the economy.

The benefit has long been a target of tax equity advocates, who say it unfairly enriches high-earning financiers. Partners in those sectors of the investment industry enjoy a 15 percent tax rate on much of their profits, which are treated as capital gains, instead of the 35 percent rate they would pay if their earnings were taxed under normal income rules.

The House voted last year to kill the tax break, but the Senate balked. This year, President Obama advocated its elimination, a move that it is estimated would cut the deficit by $23 billion over the next 10 years. A fresh measure is expected to be considered in the House next week, but advocates say the outcome remains unclear.

The endurance of the special tax break is testament not only to the power of financial industry lobbyists but also to the support of key lawmakers. For example, Representative Richard Neal of Massachusetts, a member of the House Ways and Means Committee, voted against the tax break in 2008 and acknowledges the provision is perceived by many to be unfair. But now he wants to delay action, saying he is worried that eliminating the tax break this year could be “a job killer at a very precarious time.’’

Neal said he wants the matter addressed next year in broader legislation for a tax overhaul. Referring to the perception of unfairness when private-equity firms benefit from the current tax policy while laying off employees in job restructuring, he said, “You can’t defend it.’’

Massachusetts is home to scores of these types of investment firms, and it has the second-highest volume of venture capital investment, behind only California.

The issue has also come up in the campaign for the US Senate seat in Massachusetts. Stephen Pagliuca, a Democratic candidate, made part of his fortune as a managing partner at Bain Capital Partners, a private-equity firm. The company has hired lobbyists and joined an industry effort to retain the tax break.

In a recent mailing to Massachusetts voters, Pagliuca wrote, “Washington lobbyists are working overtime to make sure that real reforms never become law.’’

Pagliuca has said he supports raising the tax on capital gains from 15 percent to 20 percent, but he has not supported the proposal that much of the profit at private equity be taxed at the top rate for ordinary income, 35 percent.

Asked yesterday about Pagliuca’s stand, his spokesman, Will Keyser, said, “Steve believes that additional changes should be studied and would be open to supporting them if it can be structured in a manner that doesn’t hurt investment.’’ But Keyser said Pagliuca believes an increase beyond the 20 percent rate must be “weighed against the potential negative impact on capital formation for clean energy, oil and gas, real estate, and venture capital.’’

With Democrats scrambling to find ways to pay for a variety of costly programs, a proposal to kill the break is expected to come up for consideration as soon as Tuesday in Ways and Means. After the House in 2007 and 2008 voted to kill the tax break, chances for another vote for change are considered strong in the House but remain unclear in the Senate.

General outrage over the role of financial companies in the economic meltdown, high executive compensation, and favorable tax provisions for the wealthy interests have made the tax break an easy target. Warren Buffett, one of the world’s wealthiest individuals, has scorned such special provisions, saying in a widely quoted comment that many wealthy people in the United States “pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies.’’

The main proponent of eliminating the special tax treatment in the House, Democratic US Representative Sander Levin of Michigan, said in an interview his motivation is not just deficit-cutting, but equal taxation.

“This one is so prominent in terms of the issue of fairness,’’ Levin said.

Levin’s proposal would require that certain kinds of partnership earnings be taxed at the top rate of 35 percent for ordinary income. He described the tax equity issue this way: If a partner makes a profit by investing other people’s money, then those earnings should be taxed at the higher rate for ordinary income. But if a partner invests his or her own money, then that would be taxed at the lower rate for capital gains.

Backers of retaining the tax break on the books say long-term profits should be taxed at the capital gains rate, regardless of where the money originated.

“We are very concerned,’’ said Doug Lowenstein, president of the Private Equity Council. He said his group is trying to convey a basic argument to lawmakers: “Raising taxes on investment as we are trying to stimulate a recovery is bad tax policy and bad economic policy.’’

It is not yet clear how many businesses would be affected by the elimination of the tax break, because many details have not been worked out. Under some scenarios, the break would be eliminated for hedge funds, private-equity firms, commercial real estate partners, and venture capital companies. But there is also talk of what is known in Washington as “carve-outs,’’ preserving the break for certain narrow sectors. This has led to infighting among the broad coalition that in the past has worked together to save the tax break. For example, venture capitalists, who generally do not rely on borrowed money for their investments, do not like being lumped in with hedge fund managers, many of whom are heavily leveraged.

Terry McGuire, general partner of Polaris Venture Partners of Waltham, Mass., said he is concerned that Congress will undermine a system that has greatly benefited Massachusetts for years.

“It is hugely important,’’ McGuire said. “We have a tried-and-true system of innovation that involves entrepreneurs and venture capital. It is one that has worked incredibly well for the Commonwealth. It is an alignment of interests.’’

Michael Kranish can be reached at kranish@globe.com.