The great capital gains swindle

The US taxation loophole which allows private equity managers, such as Blackstone's outspoken Stephen Schwarzman, a lower tax level is 'indefensible'. So why is it still there?

Salon.com

There are many words that could be used to describe Barack Obama, but one adjective decidedly doesn’t fit: Aggressive. So it was more than passing strange when a prominent member of Wall Street – Stephen Schwarzman, chairman of the private equity giant Blackstone Group – compared actions by President Obama to one of the most notoriously aggressive acts by one of history’s most aggressive villains. Speaking to the board of a nonprofit group, Schwarzman fiercely denounced initiatives by the Obama administration: "It’s war. It’s like when Hitler invaded Poland in 1939.”

In the arena of political commentary, few things are considered more clearly below-the-belt than comparing an opponent to Hitler. So there was a small stir in August 2010 when it was reported that Schwarzman – whom Time magazine had included on its 100 most influential people list only three years earlier – had likened Obama to the Nazi strongman. Schwarzman acknowledged making the remark and then apologized for it, while reaffirming the sentiment behind it. But what was striking about the Hitler comment – besides its sheer viciousness and absurdity – was what had provoked it. Schwarzman wasn’t complaining about undue military force, torture, or ethnic cleansing. He was likening the president to the most reviled man in history on the grounds that Obama was trying to close a tax loophole that allowed hedge fund and private equity managers (like Schwarzman) to pay tax at a rate that Warren Buffett famously noted was lower than that paid by their secretaries.

In an era marked by gluttony and hubris, Steve Schwarzman has still managed to stand out.

His 60th birthday party in Manhattan in 2007 was so lavish – with live performances by Rod Stewart and Martin Short – it became Wall Street legend. Then there’s Schwarzman’s 35-room Park Avenue residence, his sprawling estate in Saint-Tropez, a spectacular spread in Jamaica, and his massive Palm Beach estate, where the executive chef says it typically costs about $3,000 a weekend to feed just Schwarzman and his wife.

Schwarzman is a major figure in private equity, part of the surging field of 'alternative asset' financial institutions that, along with hedge and real estate funds, appeared on the horizon two decades ago and now control trillions of dollars in assets. While hedge funds are well-known for contributing to the subprime mortgage crash, private equity funds are notorious for taking over established firms with borrowed money and essentially pillaging them. The bought-out companies are typically saddled with increased debt from the takeover and forced to make massive dividend and fee payouts to the private equity managers and their investors, while employees are shedded and union contracts gutted. The companies are usually chopped up into smaller pieces and sold soon afterwards at inflated prices, creating another windfall for the private equity managers. By 2007, the Blackstone Group had taken control of more than 112 companies worth nearly $200 billion. In 2011, Schwarzman ranked 169th on Forbes’ worldwide billionaire list, worth an estimated $5.9 billion.

Schwarzman may be rougher at the edges than most of the hedge fund and private equity crowd. But his outburst against Obama reminds us of the "war” he and others – by themselves or by proxies – have been engaged in to minimise their contribution to the public treasury. It’s an all-too-familiar tale of how effective the rich are at getting their way, even when the battle is being played out in a very public arena where a small group of billionaires advancing their own self-interest would seem a very tough sell.

'The most indefensible loophole'

[A paper on taxation by Victor Fleischer] found its way into the hands of congressional Democrats at a time when they were looking for fresh sources of revenue to pay for the expansion of the State Children’s Health Insurance Program and the Earned Income Tax Credit. The juxtaposition of high-flying hedge fund managers and children without health care seemed like a public relations nightmare for the Wall Street crowd.

Fleischer identified the fact that managers of private equity, venture capital and hedge funds were claiming a significant part of their incomes as capital gains (taxed at 15 percent), rather than treating them as regular income (taxed at 35 percent). That substantial difference in rates was magnified by the enormity of the incomes in question. A private equity manager receiving, say, $600 million as a capital gain would pay $90 million in tax. If the same income were treated as income from salary, it would be taxed at 35 percent (and also be subject to a 2.9 percent payroll tax), bringing the private equity manager’s tax bill to $227.4 million – almost $140 million more.

The ostensible purpose of the lower capital gains rate is to compensate investors for the risk they take in investing their capital. But private equity and fund managers aren’t investing their own capital. They’re investing other people’s capital. They’re simply money managers. By claiming capital gains treatment, they are passing off regular income as capital gains, simply to save themselves taxes.

Schwarzman himself helped put an unsavoury face on the fund manager set with his plan to turn Blackstone into a publicly traded company in the spring of 2007. The plan would not only allow Schwarzman and other top Blackstone executives to continue to qualify for the low capital-gains rate as fund managers, but would also allow their new multi-billion-dollar publicly traded company to largely avoid paying corporate taxes. If Schwarzman won the approval of SEC regulators, he and Blackstone co-founder Peter Peterson would receive billions of dollars worth of stock, plus hundreds of millions in cash. And this would surely set a precedent, enticing other private equity funds, as well as investment banks – including giants like Goldman Sachs and Morgan Stanley – to reorganise themselves along similar lines, making the paying of corporate taxes almost optional for Wall Street institutions.

Schwarzman’s move had pushed the issue of sweetheart taxation for private equity kings from law school reviews to the front pages of newspapers. A bill to stop Schwarzman – dubbed the Blackstone bill – quickly appeared in Congress.

Momentum seemed to be building against the Blackstone deal and more broadly for a bill, sponsored by Democratic congressman Sander Levin that would shut down the fund manager loophole completely. But Wall Street quickly organised a counterattack. Some of the largest private equity firms formed the Private Equity Council, and, within six months, the Council had retained four top lobby firms to handle the case.

Labour and public interest groups lobbied from the other side, presenting a letter to Congress signed by more than a hundred organisations across the country urging that the loophole be closed. But private equity had resources that were probably 1,000 times greater, according to Steve Wamhoff, legislative director of the Washington-based group Citizens for Tax Justice.

No argument seemed too extreme or silly to advance in defense of maintaining the loophole. Lobbyists insisted, for instance, that the tax break was crucial in the fight against cancer, pointing to the fact that the loophole also applied to those running venture capital funds, which sometimes invest in high-risk start-up firms – including those developing products to fight cancer. Private equity was trying to make the case that showering tax breaks on all fund managers, some of whom might be investing their funds in firms involved in fighting cancer, was an effective way to subsidise the fight against cancer – rather than simply increasing direct subsidies to cancer researchers or start-up firms.

In the end, the weakness of the case for maintaining the loophole didn’t matter. In three years of Congressional battles over the issue – with the Democrats mostly voting to shut down the loophole, and Republicans voting to keep it alive – the House passed a bill to shut it down three times. But Democrats finally abandoned attempts to overcome Republican obstacles in the Senate in June 2010. So, even with the Democrats holding the White House, the House and the Senate (including 60 seats for a while), "they were still incapable of closing the most indefensible loophole in existence,” notes Wamhoff.

Excerpted from "Billionaires’ Ball: Gluttony and Hubris in an Age of Epic Inequality” by Linda McQuaig and Neil Brooks. Copyright 2012. Excerpted with permission by Beacon Press.

This article first appeared on Salon.com. Republished with permission.

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