[House Hearing, 110 Congress]
[From the U.S. Government Printing Office]


                       AMERICA'S WORKING FAMILIES


                               before the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION


                           SEPTEMBER 6, 2007


                           Serial No. 110-58


         Printed for the use of the Committee on Ways and Means

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                      COMMITTEE ON WAYS AND MEANS

                 CHARLES B. RANGEL, New York, Chairman

FORTNEY PETE STARK, California       JIM McCRERY, Louisiana
SANDER M. LEVIN, Michigan            WALLY HERGER, California
JIM McDERMOTT, Washington            DAVE CAMP, Michigan
JOHN LEWIS, Georgia                  JIM RAMSTAD, Minnesota
RICHARD E. NEAL, Massachusetts       SAM JOHNSON, Texas
MICHAEL R. McNULTY, New York         PHIL ENGLISH, Pennsylvania
JOHN S. TANNER, Tennessee            JERRY WELLER, Illinois
XAVIER BECERRA, California           KENNY C. HULSHOF, Missouri
LLOYD DOGGETT, Texas                 RON LEWIS, Kentucky
EARL POMEROY, North Dakota           KEVIN BRADY, Texas
MIKE THOMPSON, California            PAUL RYAN, Wisconsin
JOHN B. LARSON, Connecticut          ERIC CANTOR, Virginia
RAHM EMANUEL, Illinois               JOHN LINDER, Georgia
EARL BLUMENAUER, Oregon              DEVIN NUNES, California
RON KIND, Wisconsin                  PAT TIBERI, Ohio
BILL PASCRELL Jr., New Jersey        JON PORTER, Nevada

             Janice Mays, Chief Counsel and Staff Director

                  Brett Loper, Minority Staff Director

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.

                            C O N T E N T S


Advisory of August 30, announcing the hearing....................     2


Leonard E. Burman, Ph.D., Director, Urban-Brookings Tax Policy 
  Center.........................................................     7
Jason Furman, Director, The Hamilton Project, Brookings 
  Institution....................................................    21
Douglas Holtz-Eakin, Senior Fellow, The Peterson Institute, and 
  Former Director, Congressional Budget Office...................    35


Stephen E. Shay, Partner, Ropes & Gray LLP, Boston, Massachusetts    77
Leon M. Metzger, Former Vice Chairman and Chief Administration 
  Officer of Paloma Partners Management Company..................    91
Janne G. Gallagher, Vice President & General Counsel, Council on 
  Foundations....................................................    96
Suzanne Ross McDowell, Partner, Steptoe & Johnson LLP............    99
Daniel J. Shapiro, Partner, Schulte, Roth & Zabel LLP, London, 
  England........................................................   105


Peter R. Orszag, Director, Congressional Budget Office...........   151
C. Eugene Steuerle, Ph.D., Co-Director, Urban-Brookings Tax 
  Policy Center, and Former Deputy Assistant Secretary of the 
  Treasury for Tax Analysis, Reagan Administration...............   176
Darryll K. Jones, Professor of Law, Stetson University College of 
  Law, Gulfport, Florida.........................................   181
Victor Fleischer, Associate Professor of Law, University of 
  Illinois College of Law, Champaign, Illinois...................   188
Mark P. Gergen, Professor of Law, The University of Texas School 
  of Law, Austin, Texas..........................................   199
Jack S. Levin, Partner, Kirkland & Ellis LLP, Chicago, Illinois..   173


Leo Hindery, Jr., Managing Director, InterMedia Partners, New 
  York, New York.................................................   225
William D. Stanfill, Founding Partner, TrailHead Ventures, 
  Denver, Colorado...............................................   229
Orin S. Kramer, Chairman, New Jersey State Investment Council, 
  New York, New York.............................................   233
Jonathan Silver, Managing Director, Core Capital Partners........   235
Adam Ifshin, President, DLC Management Corp., Tarrytown, New York   250
Bruce Rosenblum, Managing Director, The Carlyle Group, and 
  Chairman of the Board, Private Equity Council..................   257

                       SUBMISSIONS FOR THE RECORD

National Association of Home Builders, statement.................    00
American Prepaid Legal Services Institute, statement.............   286
Chamber of Commerce, statement...................................   288
National Association of Publicly Traded Partnerships, statement..   294
National Center for Policy Analysis, statement...................   300
National Taxpayers Union, Alexandria, VA, statement..............   303
NGVAmerica, statement............................................   306


                       AMERICA'S WORKING FAMILIES


                      THURSDAY, SEPTEMBER 6, 2007

                     U.S. House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 10:10 a.m., in 
room 1100, Longworth House Office Building, Hon. Charles B. 
Rangel (Chairman of the Committee), presiding.
    [The advisory announcing the hearing follows:]



CONTACT: (202) 225-1721
August 30, 2007

                  Chairman Rangel Announces Hearing on

                   Fair and Equitable Tax Policy for

                       America's Working Families

    House Ways and Means Committee Chairman Charles B. Rangel (D-NY) 
today announced the Committee on Ways and Means will hold a hearing on 
fairness and equity in the Tax Code. The hearing will focus on a number 
of tax fairness issues, including the tax treatment of investment fund 
managers and the impact of the alternative minimum tax on working 
families. It will also examine the reasons why investment funds are 
being organized offshore. The hearing will take place on Thursday, 
September 6, 2007, in 1100 Longworth House Office Building, beginning 
at 10:00 a.m.
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee and for 
inclusion in the printed record of the hearing. A list of invited 
witnesses will follow.


    In 2001, President Bush introduced an economic stimulus package 
that he said ``erases inequities in the Tax Code or eases inequities in 
the Tax Code.'' At the time, there were divisions as to whether the tax 
cuts would provide the stimulus effect and relieve inequities in the 
Tax Code as suggested by the President. In addition to analyzing the 
effects of the President's tax packages, there are other aspects of our 
tax laws that are worthy of examination, including provisions related 
to investment funds such as private equity funds and hedge funds. 
Concerns have been raised about the manner in which investment fund 
managers are able to structure their compensation. Others have observed 
that current tax rules force investment funds to form outside the 
United States. It is appropriate to perform a comprehensive examination 
of fairness in the Federal income tax system to ensure that our tax 
policy is working effectively and fairly for all of America's working 
    In announcing the hearing, Chairman Rangel said, ``One of the 
fundamental duties of the Committee on Ways and Means is to conduct 
oversight of the Tax Code and ensure that our tax laws promote fairness 
and equity for America's working families. This hearing will examine a 
number of tax provisions to determine whether they are functioning 
fairly and equitably.''


    This hearing will focus on a comprehensive examination of Federal 
income tax fairness, with particular attention to investment fund 
manager compensation and the effects of the alternative minimum tax on 
tax rates.


    Please Note: Any person(s) and/or organization(s) wishing to submit 
for the hearing record must follow the appropriate link on the hearing 
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From the Committee homepage, http://waysandmeans.house.gov, select 
``110th Congress'' from the menu entitled, ``Committee Hearings'' 
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hearing for which you would like to submit, and click on the link 
entitled, ``Click here to provide a submission for the record.'' Once 
you have followed the online instructions, completing all informational 
forms and clicking ``submit'' on the final page, an email will be sent 
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submission for the record. You MUST REPLY to the email and ATTACH your 
submission as a Word or WordPerfect document, in compliance with the 
formatting requirements listed below, by close of business Thursday, 
September 20, 2007. Finally, please note that due to the change in 
House mail policy, the U.S. Capitol Police will refuse sealed-package 
deliveries to all House Office Buildings. For questions, or if you 
encounter technical problems, please call (202) 225-1721.


    The Committee relies on electronic submissions for printing the 
official hearing record. As always, submissions will be included in the 
record according to the discretion of the Committee. The Committee will 
not alter the content of your submission, but we reserve the right to 
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    3. All submissions must include a list of all clients, persons, 
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company, address, telephone and fax numbers of each witness.
    Note: All Committee advisories and news releases are available on 
the World Wide Web at http://waysandmeans.house.gov.
    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.


    Chairman RANGEL. The Committee on Ways and Means will come 
to order. I wish you all a good morning, and what a wonderful 
opportunity for us to wish my very good friend, Sandy Levin, a 
very, very happy birthday.
    As most of you know, when the new Congress came into 
effect, Jim McCrery and I had a lot of meetings to determine 
within the jurisdiction of the Committee on Ways and Means just 
what issues would lend themselves to bipartisan support. But we 
were very conscious of the fact that within our own party there 
was such strong policy differences that it would limit the 
ability for us to work together.
    There was one thing that was abundantly clear in our 
discussions, and that is we had a responsibility, as the 
constitutional revenue-raising Committee, to take care of the 
problems that have been presented by the alternative minimum 
tax. How we did that, of course, we have had and still do have 
a difference of opinion. However, I would want to make it 
public that we hope that the Republican minority would feel 
comfortable in having input in changes and reforms in the 
existing Code, notwithstanding the fact that ultimately you may 
not be able to support the package. So, while there are some 
revolutionary or different dramatic concepts as to which way 
the Code should be going, we do hope--and we will have caucuses 
on this where we can be candid and explain our positions--that 
you may want to do the best you can with a code that you don't 
like to perfect it, to make it at least more simple and more 
fairer to the taxpayers if ultimately you cannot support that 
    So, we have been driven by the alternative minimum tax. 
There's been a lot of interest in the papers, however, about 
the differences in which hedge funds and private equity funds 
operators are taxed. This has not been the goal of this 
Committee to target any of the tax provisions except the AMT. 
But it's fair to say that since the AMT is such an expensive 
revenue loser because the revenue we raised was never intended, 
that naturally we have to look at the entire Tax Code to reach 
the goal that we hope we can achieve, and that is to simplify 
the system so at the end of the day whether you vote for it or 
not, the taxpayer does not have to raise so many resources in 
order to find out what they owe the Federal Government; to make 
certain there's a sense of fairness so that the taxpayers would 
realize that just having higher income doesn't mean that you 
get more favorable rates, and that everyone that has to pay has 
some sense that it's a fair system.
    Of course, our overall objective should always be how we 
can improve the economy of the United States of America and 
therefore be in the position to raise the revenue to make her 
as strong as we would want her to be. So, before I yield to the 
Ranking Member, I want to thank Ritchie Neal for his 
Subcommittee being out front and having hearings that provided 
for the groundwork for the hearings that we're having today, 
and again encourage Members of the Committee that if after the 
conclusion of these hearings they believe that there was 
something that had been missed, the fact that you may not be 
able to support the final product should not inhibit you from 
improving whatever product comes out of our Committee, and 
hopefully the House.
    So, Ritchie, let me thank you for the work that you have 
done. Before I yield to the Ranking Member, I'd like to yield 
to you.
    Mr. NEAL. Thank you, Mr. Chairman, and thanks to Mr. 
McCrery as well and to Mr. English as well. Clearly, the 
hearings have been done in a bipartisan manner.
    Mr. Chairman, this morning I delivered to you and to Mr. 
McCrery a report on the two hearings held at the Subcommittee 
level on the important issue of alternative minimum tax. Since 
the AMT is going to be a major issue discussed during this 
first panel today, I want to give a brief overview to the full 
Committee on what we have learned.
    The Ranking Member on our Subcommittee, Mr. English, and I, 
both have a long history in trying to combat the growing 
problem of AMT on middle-income families. I believe sincerely 
that we both want to see some long-term solution enacted so 
that we can frankly move on to other subjects.
    We had two very good hearings at the Subcommittee level, 
and the staffs worked together to find excellent witnesses 
across the board. Our first hearing took a big picture look at 
the issue, including testimony from a Treasury witness and the 
taxpayer advocate. No one was in disagreement that AMT is a 
real problem for this Congress and beyond.
    Our second hearing focused on individuals and tax 
practitioners who have had real life experience with AMT. We 
heard from Maggie Rah, a constituent of mine from Chicopee, 
Massachusetts, whose family income of $75,000 will kick her, 
her husband and three kids into the AMT for 2007. Maggie told 
us that the extra 1,300 in AMT taxes means no trip to Disney 
World this year. We heard from Michael Day, a veteran 
firefighter from Baltimore County representing the rank-and-
file firefighters, many of whom have or will be hit by AMT this 
year. He referred to the AMT as a middle-class punch, and he's 
    I have brought some slides to illustrate the problem that 
Maggie and Michael identified. In slide one, this will show--
and it's from CRS, incidentally--it shows that the income level 
at which taxpayers might expect to AMT for 2007. You can see 
that a family of four taking the standard deduction and earning 
$66,000 may well pay higher taxes in 2007 because of AMT.
    Now let's step back and take a look at the national level. 
Slide two. The next slide is from the Joint Committee on 
Taxation. Joint Tax briefed our Members a few months ago and 
prepared this data at the time. It shows that almost half of 
the 23 million AMT returns for 2007 will be from taxpayers 
earning between $100,000 and $200,000 annually. It also shows 
that almost half of the taxpayers in the 75,000 to 100,000 
income group will be affected by AMT.
    The next slide, slide three, is another way to look at the 
macro data. It's from the Congressional Budget Office, and it's 
from 2005. But the spike when the patch expires is the same. 
Note the huge jump in liability for taxpayers in the $50,000 to 
$100,000 range, from almost nothing to 40 percent of that 
income group. Also in the $100,000 to $200,000 range, you will 
see a spike from about 15 percent to--listen to this--80 
percent of taxpayers in that group.
    These are people like Maggie Rah and Michael Day paying 
more in taxes than they thought and losing the tax cuts that we 
promised them.
    Slide four, the next slide also from Joint Tax, shows 
exactly how much of the recent tax cuts are lost to alternative 
minimum tax. You'll see that almost 60 percent of the tax cuts 
are taken back by $80,000 in income. But that those families at 
$200,000 are only losing 35 percent of their cuts. The AMT has 
a very skewed distribution.
    Slide five, the next slide, is from CRS on this same topic 
and highlights the takeback level in effect of AMT on a family 
of four at various income levels. The results are the same as 
Joint Taxes, but you can see going across the columns how it 
seems that everyone was going to get a tax cut compared with 
the 2001 tax level, but many, particularly those between 
$80,000 and $150,000, got much less of a tax cut than was 
    As you saw in the earlier Joint Tax slide, those making 
over $500,000 a year represent a tiny fraction of AMT returns 
and therefore lose little, if any, of the promised tax cuts.
    Last, let me conclude by using a slide from the Treasury 
Department. You'll note that we were very careful not to use 
any information or data from think tanks or partisan activity. 
Instead, we depended upon the professionals who advise us very 
day in a very important manner.
    This slide, slide six, shows how the AMT will soon overtake 
regular income tax in that it will cost more to repeal AMT in 
2013 than the regular income tax. For those of us that are 
gardeners, you can appreciate how difficult it is to get rid of 
an invasive plant like kudzu or bamboo. The more you trim it, 
the it seems to thrive. The AMT is the kudzu of our Tax Code. I 
think we should stop trimming it and look for a permanent 
solution in a bipartisan way.
    Many have quibbled over whose fault it is, but I will note 
for the record--and I had the staff go back and get the 
document--when Wilbur Mills called up the conference report on 
tax reform on November 22nd of 1969. The vote was 381 in favor, 
2 opposed, and 50 did not vote.
    This is a bipartisan problem. It demands a bipartisan 
solution. I thank Chairman Rangel for taking up the issue once 
    Chairman RANGEL. Thank you. Thank you. Again, I'd like to 
publicly thank Jim McCrery for his effort to, at least on our 
Committee, to have some degree of civility, even though it's 
abundantly clear that our political persuasions do not allow us 
to come together in agreement as much as we would like.
    Having said that, we look forward to having as much input 
that you can provide as we move forward to reform the Tax Code, 
and we do hope if there's areas of concern that you have, that 
you feel comfortable not only at the hearing, but Jim and I 
intend to have caucuses where we can exchange with each other 
changes we'd like to have made. So, at this point, I yield to 
the Ranking Member, Jim McCrery.
    Mr. MCCRERY. Thank you, Mr. Chairman. I do want to thank 
you for holding this hearing today. It's going to be a hearing 
that undoubtedly will cover a wide variety of tax topics, and 
we all look forward to that. It's going to be a long day, I 
think. So recognizing that, I'm not going to give a formal long 
opening statement. I might submit something for the record with 
your permission, Mr. Chairman. But I do want to compliment you 
and your staff. Generally speaking, you all have been open to 
us, open to our suggestions, even though you know we can't 
support a final product sometimes, you have been willing to at 
least take our suggestions and look at them. That has not 
always been the case. You have surprised us a couple of times, 
and I'm sure that was just an oversight on your part and it 
won't happen again.
    Mr. MCCRERY. So, thank you very much for the spirit that 
you continue to exhibit in running this Committee both at the 
Member level and the staff level. So, with that, Mr. Chairman, 
I look forward to today's hearing and exploring a wide variety 
of topics with the Committee.
    Chairman RANGEL. We have an extraordinary list of 
outstanding people that have adjusted their schedule in order 
to bring their ideas with us. Most of you have national 
reputations, and the Committee really appreciates the fact that 
you're testifying publicly. As our staffs have asked that 
hopefully we would ask you to exchange some ideas with us on 
certain specifics if at the end of the day something had been 
missed. But I want to thank you on behalf of the full Committee 
for your dedication to your country and to this cause.
    We have Dr. Leon Burman from the Urban-Brookings Tax Policy 
Center; Jason Furman, Director of The Hamilton Project, 
Brookings Institute; Douglas Holtz-Eakin, Senior Fellow, The 
Peterson Institution, and of course we know him as the former 
Director of the Congressional Budget Office.
    We'll start with Dr. Burman. Most of you know that we do 
have the 5-minute rule and that your entire statements without 
objection, as well as the statement from--the opening statement 
from the Minority Leader, will be placed into the record 
without objection. Once again, we thank you and start off with 
Dr. Burman.


    Mr. BURMAN. Thank you, Mr. Chairman, Ranking Member 
McCrery, Members of the Committee. Thank you for inviting me to 
discuss the issues of tax fairness, the 2001-2006 tax cuts, and 
the individual alternative minimum tax.
    Economic inequality is rising dramatically. Middle-class 
families are working harder than ever and productivity is 
soaring, but almost all of the gains are going to a tiny sliver 
of the population at the very top of the income scale.
    What explains the rising inequality? Increased 
globalization, information technology, the decline in labor 
unions and the development of a winner-take-all society where 
top performers receive almost all of the economic rewards are 
all candidate explanations. None of these factors is likely to 
reverse, so the trend in inequality appears inexorable.
    This is a problem. First, it is demoralizing for families 
to work so hard and fall further and further behind. Second, 
even if you believe that most economic growth arises from the 
efforts of a few highly talented individuals who deserve their 
outsized pay, rising inequality spurs populist calls for 
measures that could be very damaging to the economy, such as 
trade restrictions.
    By comparison, a progressive income tax is a relative 
efficient way to reduce the disparity of aftertax incomes. But 
at the same time that income inequality has been approaching 
levels not seen since the Great Depression, the Federal tax 
system has become much less progressive.
    Congress has enacted more than $2 trillion in tax cuts 
since 2001, disproportionately concentrated on the rich. In 
2006, the bottom 20 percent of income earners got an average 
$20 tax cut--three-tenths of a percent of their income. Most in 
that income group got nothing. The top 20 percent got an 
average tax cut of almost $5,800 or 5.4 percent of income. At 
the very top where the big winners in the economic lottery 
reside, the average tax cut was more than 6 percent of income.
    The tax cuts had another unfortunate side effect: they 
threaten to throw millions of American families onto the AMT. 
Under current law, over 23 million taxpayers will owe AMT this 
year. That's more than twice the number who would have been 
subject to the tax if the Bush tax cuts had not been enacted. 
The tax now hits families with very modest incomes and no 
special deductions, as Mr. Neal pointed out. For example, a 
couple with four kids earning $75,000 would see their tax more 
than double in 2007 because of the AMT.
    The AMT also--at least in theory--takes back a substantial 
portion of the Bush tax cuts. Unless Congress prevents it, the 
AMT will slice 20 percent off of those cuts in 2007. Because 
they're on the AMT, that hypothetical family of six would get 
no benefit from the lower tax rates or higher standard 
deduction enacted in 2001.
    Of course, Congress doesn't want to face the wrath of 23 
million angry AMT taxpayers. If past practice is a guide, you 
will again raise the AMT exemption for a year or two to spare 
most of the middle class from the tax. I share Mr. Neal's view 
that that would be an unfortunate response.
    But this means that the 2001-2006 tax cuts were really a 
lot bigger than budgeted. The total bill includes the cost of 
the periodic, increasingly expensive patches. In 2007, the 
patch would reduce revenues by over $50 billion. Put 
differently, the AMT masked a big part of the tax cuts, and 
probably allowed Congress to enact cuts much larger than it 
would have, had all of the cost been considered.
    The ironic fact is that even though the AMT appears to be a 
money machine, it has actually undermined fiscal discipline by 
hiding the full cost of large tax cuts.
    The AMT has other notorious defects. It's hideously 
complex. It actually raises marginal tax rates on most of its 
victims, undermining economic efficiency. And It is unfair, 
hammering married couples, especially those with children, and 
disallowing legitimate deductions. It is the perfect storm of 
bad tax policy.
    So, what should we do? The best approach would be to 
finance repeal of the AMT by broadening the tax base--for 
example, eliminating the deductibility of state and local 
taxes--rather than raising rates. Even better, AMT repeal could 
be part of fundamental tax reform, but there are obvious 
political challenges to either approach.
    Fortunately intermediate options exist that would help a 
lot. I have suggested financing AMT repeal with a surtax that 
would apply only to high income taxpayers. It would be very 
simple for taxpayers to comprehend and comply with. The 
Committee on Ways and Means majority staff has reportedly 
considered retargeting the AMT at those with very high incomes 
and offsetting the revenue loss through an additional income 
    Any repeal or reform option should be budget neutral, as 
the PAYGO rules require. Repealing the AMT without offsetting 
tax increases or spending cuts would drain Federal tax revenues 
just as the baby boomers start retiring, and demands on the 
Federal Government begin to swell. Outright repeal of the AMT 
without any other offsetting changes would reduce tax revenues 
by more than $800 billion through fiscal year 2017 assuming 
that the 2001-2006 tax cuts expire as scheduled. If the tax 
cuts are extended, the revenue loss nearly doubles to almost 
$1.6 trillion. Thank you.
    [The prepared statement of Mr. Burman follows:]
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    Chairman RANGEL. That 800 million loss in revenue based on 
eliminating the AMT, this I'd assume that the President's tax 
cuts that are supposed to expire in 2010 has expired?
    Mr. BURMAN. Yes it does. The cost doubles if the tax cuts 
are extended.
    Chairman RANGEL. That would be over $1.5 trillion?
    Mr. BURMAN. It would be almost 1.6 trillion, according to 
our estimates.
    Chairman RANGEL. So, somewhere along the line, we need some 
economists to share with us, assuming the bill is revenue 
neutral, as to what is the best way to distribute the tax 
liability, either in the higher income people whose cut is 
expected to expire on 2010, or to take the same amount of 
moneys and have the middle class be able to enjoy the benefits 
of that cut. Is that basically where you end up?
    Mr. BURMAN. Yes. One of the ironic things about the AMT, as 
Mr. Neal said, is that it actually doesn't affect very many 
people in the very, very highest income levels. You're actually 
more likely to be subject to the AMT if you earn between 
$75,000 and $100,000 than if you earned over a million dollars. 
It's an irrational tax system, especially given that it was 
originally designed to make millionaires pay some tax.
    Chairman RANGEL. Of course, if you took in consideration 
changes in the child tax credit and the earned income tax 
credit, you could have an even more equitable distribution of 
the tax liability. Is that correct?
    Mr. BURMAN. Sure.
    Chairman RANGEL. Good. Director Furman from The Hamilton 
Project, Bookings Institute. Thank you for being with us again.

                     BROOKINGS INSTITUTION

    Mr. FURMAN. Thank you for having me again, Mr. Chairman, 
Mr. McCrery, Members of the Committee, to talk today about how 
to make our tax system more fair and equitable.
    As you consider tax changes, I recommend keeping in mind 
three factors. First, the direct impact of tax changes on take-
home pay. Second, the economic effects of tax changes on 
before-tax incomes. Third, how the associated budgetary changes 
will affect future taxes and benefits for working families.
    Using an integrated approach, which I call dynamic 
distributional analysis, all three factors can be incorporated 
into a single variable--the change in the aftertax household 
income. My testimony today applies dynamic distributional 
analysis to assess the long-run economic impact of the 2001 to 
2006 tax cuts on working families. The bottom line: My analysis 
shows that even if you assume the tax cuts help the economy, 
even if you assume they boosted incomes, even if you assume 
that they partly paid for themselves through that, when you 
take into account the financing of the tax cuts in the long 
run, 74 percent of families would be left worse off with lower 
aftertax incomes. If none of those rosy scenarios took place, 
it would be even worse.
    Let me now walk you through the three steps in this 
analysis. First, the direct impact of the 2001 through 2006 tax 
cuts. Making the tax cuts permanent would result in a 0.7-
percent increase in aftertax incomes for the bottom quintile, 
and a 6.7-percent increase in incomes for the top 1 percent. 
That translates into an increase in aftertax income inequality.
    Second, I turn to the impact of the tax cuts on the 
economy. Well designed tax cuts that are paid for without 
increasing the deficit can have a modest positive impact on 
growth. For example, Treasury studied the effects of making the 
tax cuts permanent under the unrealistic assumption that they 
were paid for with reduced spending. Their analysis concluded 
that the tax cuts could raise national output by an amount 
equivalent to raising the growth rate by 0.04 percent annually 
spread over 20 years. Picture that. Instead of the quarterly 
growth rate being 3.0 percent, it would be 3.04 percent, a 
change that would be barely perceptible in data on the economy.
    The recent tax cuts, however, were enacted in conjunction 
with increases in spending and larger deficits. In this case, 
economic models generally show that the result of the higher 
debt is lower national savings, more foreign borrowing, less 
capital formation, and ultimately lower national income. 
Treasury itself found that given the current trends in fiscal 
policy, the sooner we eliminate the tax cuts, the higher 
national income would be.
    Third, let's consider how the budgetary implications of the 
tax cuts affect families. Every official scoring agency and 
credible economist has consistently stated that tax cuts do not 
pay for themselves through stronger growth. At best, stronger 
growth may offset a small fraction of the cost of tax cuts. At 
worst, tax cuts lead to higher debt, lower savings, hurting the 
economy and magnifying their budgetary cost.
    The recent revenue surprises do not alter this conclusion, 
especially since we have seen so many revenue surprises that go 
in the opposite direction, including positive revenue surprises 
following the 1990 and 1993 tax increases, and negative revenue 
surprises following the 1981 and 2001 tax cuts.
    Tax cuts inevitably require reductions in government 
spending or increases in future taxes. In either case, their 
indirect budgetary effect serves to reduce disposable incomes 
by reducing government benefits or raising taxes. Although some 
of the costs could fall on future generations, much of them 
will fall on the very same household that receives the tax cuts 
today. For example, a person might get a $500 tax cut today but 
lose $700 in present value terms in future Medicare benefits.
    Finally, although many analysts have considered these three 
channels in isolation, they should be combined together into a 
single, consistent assessment. Table 3 of my written testimony 
provides such an integrated assessment of making the tax cuts 
permanent. As you will see under the most optimistic 
assumptions, assuming that the tax cuts help pay for 
themselves, three-quarters of households would still end up 
with lower aftertax incomes if they were made permanent. This 
is because for most families, the tax cuts and modest boots to 
incomes are not nearly enough to compensate for the reduction 
in future government transfers like Social Security, Medicare 
and Medicaid.
    As the old saying goes, there's no such thing as a free 
lunch. Cutting taxes for the most affluent almost inevitably 
results in long-run reductions in the disposable income of 
working families. This lesson is confirmed by dynamic 
distributional analysis.
    Thank you again for the opportunity to address this 
Committee. I look forward to your questions.
    [The prepared statement of Mr. Furman follows:]
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    Chairman RANGEL. Thank you so much.
    Douglas Holtz-Eakin, Senior Fellow, The Peterson Institute, 
and someone that has provided invaluable service to the 
Congressional Budget Office and the Congress, welcome back.


    Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman, Mr. McCrery and 
Members of the Committee. It's a privilege to be here today. 
I've submitted a relatively long statement for the record. Let 
me take a few moments to make really three basic points about 
assessing the status of the U.S. Tax Code.
    Point number one is that it is the job of the Tax Code to 
raise funds to finance spending. It exists only for that 
purpose. In that regard, the Tax Code is currently doing pretty 
well. For fiscal 2007, the CBO projects that the Federal 
Government will raise 18.8 percent of GDP in revenues, above 
the typical amount in the past 40 years. The Federal Government 
will spend about 20 percent of GDP in Federal spending, a touch 
below the average for the past 40 years, and the result will be 
a deficit of 1.2 percent of GDP, a bit lower than the typical 
performance of the Federal Government.
    So, in terms of paying the bills----
    Chairman RANGEL. Excuse me. Are you including defense 
spending in that?
    Mr. HOLTZ-EAKIN. It's the CBO projection for the unified 
deficit, all revenues, all spending. So, that's for fiscal year 
2007. Now we know it hasn't been doing quite that well in 
recent years. Deficits have been larger, but we've seen quite 
rapid revenue growth in recent years. We've seen double-digit 
growth in some portions of tax receipts. Notable portions are 
corporate income taxes and capital gains taxes. I don't think 
it's sensible to project that we'll get double-digit growth 
forever, but there doesn't appear to be any pervasive problem 
in raising revenue out of this Tax Code.
    Going forward, the major focus will be on the spending 
side, where as is well known to this Committee, we will see 
Social Security, Medicare and Medicaid rise under current 
trends to a size that's comparable to the current entire 
Federal Government--20 percent of GDP--if we get good news in 
the health programs. If we don't, it will be larger yet.
    How will this play out? One possibility is we'll borrow 
money until credit markets say no and leave our kids with a 
very large bill. Another possibility is we'll try to raise 
taxes by 50 or 75 percent above their current levels and 
cripple this economy regardless of whether you're a ``supply 
sider'' or not. In either case, we will leave to the next 
generation a burden that is inappropriate, and that is the most 
pressing fairness issue facing this government, it's the most 
pressing fairness issue facing this Committee, which has 
jurisdiction over all those pieces that are the key components 
of the fiscal challenge.
    So, right now we're doing okay, but going forward, we must 
control the spending, and that's the central fairness issue 
that we face.
    The second part of the review would be to look at the 
ability of the Tax Code to raise revenue without additional 
extra costs, and there I can't say that we're doing so well. 
Everyone who looks at the regular Tax Code and then adds on the 
alternative minimum tax comes to the conclusion that the U.S. 
income tax is a Byzantine, complex morass that most individuals 
simply cannot navigate. The President's tax panel put a price 
tag on the cost of this and said that it imposes an extra $140 
billion per year--a thousand dollars for every man, woman and 
child--in just complying with the Tax Code. We clearly can do 
better and not impose an extra burden on the families of the 
United States in raising our revenue.
    A second cost, typically hidden, is the cost that the Tax 
Code imposes in the form of economic distortions; changing the 
way markets and families would like to do their business just 
for tax purposes, and a lot of financial engineering that we 
hear so much about. These are big costs to an economy that 
needs to grow to face the burdens of the baby boom, and that 
needs to be internationally competitive. If you look at the 
double tax on saving, if you look at the extra taxation on some 
forms of business, you look at the differential taxation of 
fringe benefits, you look at all sorts of high marginal tax 
rates, particularly for low-income individuals, this is a Tax 
Code that has compliance burdens and efficiency burdens that 
should be reduced, and it's not doing very well on that front.
    The last part is fairness. As the written testimony says, 
there are lots of complications in assessing fairness. So, the 
caveats are, one, we don't have an agreed-upon consensus on 
what fairness means. Two, we must distinguish between who sends 
in the check and who bears the economic burden of a tax, the 
genuine incidence. Three, there's lots of competing measures.
    I'll simply touch the high points, which is you can imagine 
a neutral system being one where we tax you equal to what you 
get back from the government, and you can look at the current 
tax system where low-income individuals, 40 percent of which 
pay no income tax, receive back benefits, so there's a 
redistribution toward them. High-income individuals who pay the 
vast majority of income taxes, do not receive back benefits 
comparable to that, and so we have a system that is by any 
measure in the large a progressive tax system that 
redistributes toward those at the lower end of the income 
    The second part of fairness would be do we treat equal 
taxpayers equally? The answer is no. We treat people with the 
same lifetime incomes who save and tax them more heavily than 
those who do not. We treat renters less generously than we do 
people who buy their homes. We treat people who pay equity in 
their homes less generously than those who borrow. We treat 
people who receive their services through state and local 
governments more generously than those who do not. The list 
goes on and on.
    So, we have a system that is meeting our revenue needs, but 
will not in the future unless we come to terms with our 
spending problem. That's the primary problem on fairness. We 
also have a system for any given level of revenue has severe 
impacts on our ability to grow and compete and doesn't meet the 
standard of fairness. We could use a much better Tax Code.
    Thank you. I look forward to the chance to answer your 
    [The prepared statement of Mr. Holtz-Eakin follows:]
Prepared Statement of Douglas Holtz-Eakin, Senior Fellow, The Peterson 
      Institute, and Former Director, Congressional Budget Office
    Chairman Rangel, Ranking Member McCrery, and Members of the 
Committee, thank you for the opportunity to participate in this 
important hearing. The topic of tax fairness raises myriad issues. In 
my comments today, I will focus on only a subset of the possibilities.
1. Objectives of Tax Policy
    Paying the bills. The central purpose of the Tax Code is to raise 
revenue to finance Federal outlays. According to the Congressional 
Budget Office (CBO), for fiscal 2007 total revenues will be nearly 19 
percent of Gross Domestic Product (GDP)--above the average for the past 
40 years--yet fall below total Federal spending equal to about 20 
percent of GDP.\1\ The resulting unified budget deficit of 1.2 percent 
of GDP lies well within the range of historical budget outcomes.
    \1\ Congressional Budget Office, The Budget and Economic Outlook: 
An Update, August 2007, p. xi.
    Unfortunately, in the years to come mandatory spending programs 
will grow quite rapidly.\2\ The rising fiscal pressures emanating from 
spending on Social Security and health programs, if left unchecked, 
will threaten the three pillars of U.S. post-war economic success. 
First, the successful U.S. economic strategy has been to rely largely 
on the private sector; the mirror image of this approach being a 
government sector that is relatively small (granted, ``small'' is in 
the eye of the beholder) and contained. Growth in spending of the 
magnitude promised by current laws guarantees a much larger government.
    \2\ See Congressional Budget Office, The Long-Term Budget Outlook, 
December 2005.
    Second, the small U.S. Government has been financed by taxes that 
are relatively low by international standards and interfere relatively 
little with economic performance. Spending increases of the type 
currently projected would entail taxes higher by 50 percent or more to 
unprecedented levels. Such a policy would impair economic growth and 
reduce living standards for future generations.
    Finally, a hallmark of the U.S. economy has been its ability to 
flexibly respond to new demands and disruptive shocks. In an 
environment where old-age programs--namely Social Security, Medicare 
and Medicaid--potentially consume nearly every budget dollar, to 
address other policy goals future politicians may resort to mandates, 
regulations, and the type of economic handcuffs that guarantee lost 
    In sum, the ability of the Tax Code to meet its primary objective 
is most threatened by the absence of reforms to mandatory spending 
programs. This raises the specter of a generational injustice: 
bequeathing to our children and grandchildren a rising burden of 
taxation, a less robust economy, or both. The most pressing issue of 
fairness cannot be addressed by raising taxes, but rather requires 
reducing the growth of spending.
    Keeping the burden of taxes low. The importance of keeping Federal 
spending contained to national priorities and thus permitting taxes to 
be as low as possible is straightforward: taxes directly reduce the 
ability of families to pay their bills and save for the future. 
However, even the best tax system impairs market incentives, imposes 
obstacles for households and firms alike, and undermines economic 
performance. A goal of tax policy should be to keep such interference 
and waste as small as possible.\3\
    \3\ This loss is sometimes referred to as the ``efficiency cost,'' 
``deadweight loss,'' or ``excess burden'' of the tax system and 
captures the reality that there is a loss to households above and 
beyond the amount of tax revenue collected.
    In this regard, unfortunately, our Tax Code is in need of a major 
overhaul. A vivid example of the type of distortion our Code presents 
is provided by health insurance. At present, employer-provided 
insurance is not treated as part of income so companies offer health 
insurance coverage as a tax-free benefit instead of higher wages or 
salaries. Employees and employers alike respond to the tax-based 
incentives and change compensation packages. The result is less revenue 
(and the need for higher tax rates elsewhere). The flip side of the 
coin is demand for more and more generous insurance which drives up 
insurance costs. In some cases, individuals go without insurance as a 
result. If individuals purchase insurance themselves, they do not 
receive the same tax treatment as when their employer purchases for 
them, generating biases in health insurance markets. In short, a 
poorly-designed Tax Code exacerbates our pressing health insurance 
    The provision of health insurance is just one of a multitude of 
economic decisions within our $13 trillion economy. Tax-based 
distortions permeate our daily economic lives. Decisions on saving, 
retirement, education, investment, debt and equity finance are driven 
by tax-based planning to the detriment of our ability to meet pressing 
national needs. The Tax Code is a basic impediment to the United 
States' ability to grow robustly and compete in global markets.
    The loss in economic performance is exacerbated by the sheer cost 
of complying with an overly complex Tax Code. According to the 
President's Advisory Panel on Federal Tax Reform, ``If the money spent 
every year on tax preparation and compliance was collected--about $140 
billion each year or over $1,000 per family--it could fund a 
substantial part of the Federal Government, including the Department of 
Homeland Security, the Department of State, NASA, the Department of 
Housing and Urban Development, the Environmental Protection Agency, the 
Department of Transportation, the United States Congress, our Federal 
courts, and all of the Federal Government's foreign aid.''\4\
    \4\ See the final report at http://www.taxreformpanel.gov/final-
    Fairness. A final objective is to raise taxes in a fair fashion. 
Unfortunately, there are two major obstacles to an easy evaluation of 
the success in meeting this standard. The first is figuring out who 
really pays a tax.\5\ For example, in 2006 the Federal Government 
raised $354 billion from the corporation income tax. However, 
corporations did not ``pay'' the tax in any meaningful sense--they 
merely sent in the check. In the process of meeting their tax 
obligation, however, firms could have raised prices, cut back on wages, 
reduced fringe benefits, slowed replacement of equipment or scaled back 
expansion plans, cut dividends, or many combinations of their options 
to alter their revenues and cost structures. The result is that the 
corporation tax is ``paid'' by customers, workers, or investors. 
Indeed, recent evidence suggests that the relatively high rate of the 
U.S. corporation income is ultimately paid by workers in the form of 
lower wages.\6\
    \5\ This is referred to as determining the economic incidence of a 
    \6\ See Kevin Hassett and Aparna Mathur, ``Taxes and Wages,'' AEI 
Working Paper #128, 2006.
    A second difficulty is the absence of an ethical consensus on 
distributional fairness. In the absence of such benchmark, two 
guidelines prove useful. The first is to note that individuals view 
market transactions as a ``fair deal'' when they get back value equal 
to what they paid. By analogy, a benchmark for judging the tax system 
is whether a taxpayer's liability is equal to benefits received from 
the Federal budget--a neutral system. If benefits received exceed 
taxes, the household is a net beneficiary of the tax system and vice 
    This perspective differs from two other metrics that are commonly 
employed--effective tax rates and tax shares. Effective tax rates are 
the ratio of taxes paid to income--roughly the share of income taken by 
taxes. A drawback to evaluating fairness using effective tax rates is 
that the rates may change because of movements in the denominator--
families' incomes--that have nothing to do with tax policy. Incomes are 
influenced by taxes, but also are determined by skills, education, 
effort, risk-taking and innovation, regulations, and other factors. Tax 
shares--the fraction of the overall taxes that each individual pays--
have the drawback that they ignore the spending side of the equation. 
Given that taxes are necessary only because of spending, this omission 
is striking.
    Viewed from this perspective, the U.S. Tax Code is highly 
progressive--lower income individuals receive much more than they pay 
in taxes. According to the CBO, the bottom 40 percent of the income 
distribution paid no Federal income tax in 2004.\7\ Of course there are 
other taxes. In particular, payroll taxes are the largest tax for a 
majority of households. But examining the payroll tax is ultimately a 
reminder of the need for social security reform. The progressivity of 
this programs will depend upon the scale of the benefits individuals 
receive in the future.
    \7\ See Congressional Budget Office, Historical Effective Tax 
Rates: 1979 to 2004, December 2006.
    A second perspective on fairness stems from the fact that the Tax 
Code assigns taxpayers with the same income, number of children, and 
other factors different tax burdens. As noted above, taxes will differ 
depending on whether a family purchases health insurance or receives it 
as part of an employer compensation package. Two families with the same 
income will pay different taxes because they reside in different 
states, and some families receive state-provided services for which 
they can deduct income and property taxes. A person who saves more of 
their earnings in taxable accounts will pay more in taxes than a non-
saver who has the exact same earnings year by year. Indeed, some 
inequality may stem from the sheer complexity of the Tax Code and the 
inability of individuals to take advantage of tax benefits for which 
they are eligible. These differences between otherwise similar 
taxpayers are at odds with basic fairness and undermine faith in the 
fairness of the Tax Code.
    Summary. The most pressing tax fairness issue facing the United 
States is the potential for dramatic tax increases, slower income 
growth, and reduced standards of living for future generations if the 
spending growth profile of the Federal Government is not reduced. All 
other fairness issues pale by comparison.
     At present, the Federal tax system is roughly achieving its goal 
of providing financing for Federal spending. However, there is little 
else to defend in the current Tax Code. It is overly complex and 
burdensome, interferes too much with commerce and economic 
competitiveness, and is riddled with uneven treatment. Far-reaching 
reforms are merited; more modest efforts will not succeed in raising 
Federal revenues in a pro-growth and fair fashion.
2. Recent Issues in Tax Policy
    In recent years, there have been numerous changes in Federal tax 
laws which has, in turn, spawned vigorous discussion regarding tax 
    Recent Trends in Tax Receipts. Table 1 shows total Federal revenues 
and key components over the period 1996-2006. As the table makes clear, 
Federal receipts are currently growing quite rapidly. Total receipts 
have grown at 14.5 percent and 11.8 percent in fiscal 2005 and 2006, 
respectively; a pace that exceeds the celebrated revenue surge of the 
1990s that drove the Federal budget to balance. Individual income tax 
receipts are also rising at rates above those from the earlier period, 
driven in part by growth rates of capital gains receipts equal to 21 
percent, 38 percent, and 23 percent in the years 2004-2006. Even more 
striking has been the very rapid increase in corporation income tax 
receipts, which hit a recent peak growth rate of 47 percent in 2005. 
Such rapid growth cannot, of course, be sustained indefinitely when the 
underlying economy is growing at 5-6 percent per year. However, the 
evidence to date suggests that the current tax system is generating 
adequate revenue growth.
    Tax policy and economic growth. Overall GDP growth fell 
dramatically in 2001 (0.8 percent) and 2002 (1.6 percent) as the 
economy suffered a recession and weathered the impact of terrorist 
attacks, corporate scandals, and higher energy costs. Since that time, 
annual GDP growth has averaged 3 percent and solid growth in payroll 
employment has resumed. Most analysts credit the 2001 Economic Growth 
and Tax Relief Reconciliation Act (EGTRAA) with mitigating the extent 
of the falloff in economic growth, largely because its passage very 
nearly coincided with the economic downturn.
    It is best, however, to view this timing as fortuitous and not as a 
signal that future Congresses should attempt to engage in fiscal 
``fine-tuning'' that attempts to counter the inevitable business cycles 
of the future. Instead, it would be preferable for tax policy to focus 
on promoting robust, long-term economic growth. What would such a Tax 
Code look like?
    Consumption-based taxation.\8\ A consumption tax is just what it 
sounds like: a tax applied to consumption spending. However, under that 
deceptively simple umbrella resides a vast array of potential variants. 
Consumption taxes can be flat or contain multiple rates; can be applied 
to households, firms, or both; and can be viewed as ``direct'' or 
``indirect'' taxes.
    \8\ This section draws on Douglas Holtz-Eakin, ``The Case for a 
Consumption Tax,'' Tax Notes, October 23, 2006.
    For purposes of my remarks today, let me focus on a few identities 
that give the flavor of the issues. For a household--or the country as 
a whole--all income (Y) is either consumed (C) or saved (S): Y=C+S. 
This suggests two broad strategies for taxing consumption. One is to 
tax consumption (C) as in a national sales tax. The alternative is to 
tax it ``indirectly'' by levying the tax on ``consumed income''--income 
after deducting saving or investment: (Y-S). This is the strategy taken 
by a value-added tax (VAT), the Hall-Rabushka flat tax, or the ``X-
tax'', a more progressive variant of the Hall-Rabushka tax developed by 
the late David Bradford.
    Interest in a U.S. consumption tax is not new. Advocates have 
touted the potential benefits from moving to a consumption tax for many 
years. However, I wish to separate my support from some of the more 
overreaching arguments. In particular, my support for a consumption-
based tax reform is not about:
    1. Simplicity. Some consumption taxes--notably the original Hall-
Rabushka flat tax--have been publicized on the basis of their 
``simplicity.'' Who can forget (admittedly tax economists have a 
limited reservoir of thrills) the first time they saw the Hall-Rabushka 
postcard tax return? Similar simplicity arguments have been made about 
a national retail sales tax, where advocates tend to argue that there 
is little to do except piggyback on existing state efforts.
    But this really misses the point for three reasons. First, no tax 
system will be that simple. For any household, the goal is to legally 
minimize its tax liability. The innate craftiness of the American 
populace will dictate that any tax system will acquire a growth of 
rulemaking that delimits the boundaries of acceptable behavior. That 
is, a certain amount of complex rule-making will be necessary. A common 
complaint of income-tax defenders is that consumption tax folks compare 
an ideal consumption tax with the actual income tax. This is truly 
unfair and no way to decide between the two. Second, as noted above, 
for many there is nothing simpler than the current income tax--they 
don't pay it. As is becoming more widely appreciated, the current 
income tax is not your father's income tax. Complexity of the income 
tax is the curse of those who pay it. Third, postcards are obsolete. 
Today your taxes are ``done''--that is computed--by tax-preparation 
software and filed on-line.
    2. Making taxes more or less visible. A common argument supporting 
a national sales tax is that it would make more visible the cost of 
government. Perhaps, but the ultimate measure of the size of government 
is its spending. Once the dollars have been committed, the taxpayer 
will pay one way or the other. Either taxes will be levied to match the 
spending, or there will be borrowing to cover the Federal deficit. It 
may be important to raise the visibility of Congressional decisions, 
but putting taxes on your register receipt does not display spending. 
Indeed, if a national sales tax did produce pressure to keep taxes low, 
it may do nothing to address the tsunami of future Medicare spending 
and lead to larger deficits.
    3. Raising the national saving rate. A consumption tax would remove 
the tax-bias in favor of current consumption, and many believe that 
this would raise the private saving rate. If so, then good. The main 
idea is to eliminate tax-based financial decisions and have households 
choose based more on the economic fundamentals. However, I suspect that 
the scope for dramatic changes is somewhat limited. Instead, the most 
rapid improvement in the national saving rate will come from 
controlling Federal spending and thus reducing government borrowing.
    Instead, a consumption tax meets the following needs of the tax 
    1. The philosophical foundation of the Tax Code. Public policies 
should mean something. As I have stressed, the Tax Code exists for a 
single purpose: it exists to finance the costs of public programs. The 
powerful behavioral effects of taxation are real, and a tribute to the 
power of market incentives as the mechanism by which taxes influence 
behavior is to change prices. Since the purpose of the Tax Code is to 
raise revenue, it has as its core mission reducing the resources of 
some households. The central question is why choose those who consume 
over those with income. Consumption is the spending that extracts 
resources from the economy. In contrast, saving is economic activity 
necessary to contribute to a growing economy. Recall the identity: 
Y=C+S. An income tax treats identically those high-income individuals 
who live frugally and plow their resources back into the economy and 
those that spend every night drinking champagne in a limousine while 
hopping from club to club. Taxing consumption reduces the burden on the 
former, while focusing it on the latter.
    2. Economic efficiency. A consumption tax would reduce the extent 
to which economic activity is dictated strictly by reducing taxes (an 
unproductive use of time and money). First, it broadens the tax base to 
include all consumption. The essential recipe in any tax reform is to 
broaden the tax base and lower tax rates. Specifically, the base would 
include the consumption of employer-provided health insurance 
(currently entirely untaxed) thereby correcting a major inefficiency 
that feeds health spending pressures. In addition, it would eliminate 
the current deduction for state and local taxes, thereby including 
consumption provided by sub-Federal Governments. Thus, it would improve 
the allocation of consumption spending across sectors.
    A consumption tax would not distort household choices in the timing 
of consumption--after all you would either pay the tax now or pay it 
later. In contrast, under an income tax households pay at both times if 
they choose to save and consume later. A consumption tax would equalize 
the tax treatment of investments in physical capital, human capital, 
and intangible capital. At present, the firm purchases of the latter 
two types of investment are ``expensed'' (immediately deducted), while 
physical capital expenditures are depreciated. Moreover, by eliminating 
the deduction for mortgage interest, the allocation of physical capital 
would be improved as business investments would compete on a level 
playing field with the construction of housing.\9\
    \9\ For estimates of the long-run impact on economic growth, see 
``Simulating Fundamental Tax Reform in the United States'' by David 
Altig, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and 
Jan Walliser, American Economic Review, 574-595.
    A desirable feature that is difficult to quantify is the impact on 
entrepreneurs. Entrepreneurial forces are widely acknowledged to be 
important to the success of the United States, but tax policy is rarely 
formulated with an eye to their incentives. For example, 
entrepreneurial ventures develop a scale and financial structure 
dictated by market conditions. In contrast, the Tax Code interferes 
with these incentives--extracting a double tax on equity in ``C 
corporations'', subsidizing leverage, and thus distorting the choices 
of business form and financing. The flat business-level tax does not 
depend on financial structure--it is focused on ``real'' business 
transactions--and yields the same liability regardless of legal 
    3. Acknowledgment of reality. Our current income tax is an exercise 
in fantasy. An important part of its administration is the taxation of 
the return to capital. To be successful, this requires that capital 
income--interest, dividends, capital gains, rents, royalties--be 
comprehensively measured and adjusted for depreciation and inflation. 
There is no reason to believe that the U.S. is even moderately 
successful in this effort, or that the continuing maturation of global 
financial markets will make it anything but less successful in the 
future. A consumption tax focuses the tax base on real economic 
activity--not financial transactions. This is an important difference 
in a world in which global financial markets have made if virtually 
impossible to tax capital income, and an excessive regulatory and 
enforcement regime has grown up around attempts to do so. Instead, the 
consumption tax focuses on ``taxing at the source'' before business 
income enters into financial markets and ultimately is paid to 
    Specifically, the X-tax (along with the VAT or flat tax) would 
impose a single-rate business-level tax on a base that consisted of 
total receipts minus the sum of purchases from other firms and employee 
compensation. Implicit in those receipts is the contribution of 
capital, which is taxed prior to distributions in the form of dividends 
or interest.
    4. Fairness. Because a consumption tax is neutral regarding the 
timing of consumption, it does not penalize those patient households 
that save their income for a greater lifestyle later in life. That is, 
two households with the same lifetime income will pay the same lifetime 
taxes. More generally, consumption taxes may be designed to achieve 
conventional distributional goals. To begin, under the X-tax, 
households are taxed on the basis of comprehensive employee 
compensation. However, such a system would include a generous exemption 
for a basic standard of consumption and a progressive rate structure.
    A concern often raised is that taxing compensation permits high-
income individuals to ``avoid'' tax on their capital income. However, 
an appropriately-designed consumption tax includes the vast majority of 
such earnings in its base. In the X-tax, saving and investment is 
immediately tax-deductible or expensed, but all principle and interest 
is taxed in the form of revenues at the entity level. Mechanically, 
this differs from an income tax only by the fact that under an income 
tax the saving and investment would be depreciated and not expensed. 
That is, the two approaches differ only by the timing of tax receipts 
to the U.S. Treasury--less up front for the consumption tax because of 
expensing, but more in later years because there is no ongoing stream 
of depreciation. Accordingly, the two tax bases differ only by the 
return to Treasury securities--the least risky and lowest rate of 
return. All additional returns--accruing from risk, monopoly power, 
luck, and other sources--are included in the tax base of both tax 
systems. Since these types of capital returns are responsible for the 
largest differences in incomes and consumption tax would capture these 
in the base, the distributional consequences of such a consumption tax 
would be in accord with U.S. tradition.
    JGTRAA and pro-growth taxation. Viewed from this perspective, the 
2003 Jobs and Growth Tax Relief Reconciliation Act is an important 
step. Reduced taxation of corporate equity returns reduces the bias 
toward debt finance, lowers the misallocation of capital in the economy 
and, combined with partial expensing of some investments represents a 
step toward a more efficient Tax Code. An impediment to fully realizing 
the potential of this improved tax policy, however, is the fundamental 
uncertainty over the future of the Tax Code. Eliminating this 
uncertainty, keeping taxes low and efficient, would benefit overall 
economic performance.
    The Alternative Minimum Tax. The Alternative Minimum Tax (AMT) has 
attracted attention in recent years because of the growing number of 
taxpayers who are projected to become liable for the AMT, the fact that 
the most affluent of taxpayers are longer exclusively the payers of the 
AMT, and the fact that most additional taxpayers will become liable for 
the AMT because the effects of inflation. Thus, in the narrow the major 
tax policy issue is the failure of Congress to index the AMT.
    Viewed from a broader perspective, however, the AMT raises larger 
issues. To begin, although some argue that the AMT is a better tax 
because it has a broader base (achieved by disallowing exemptions and 
deductions) and only two relatively low statutory rates, this is 
misleading. From an equity standpoint, there is a long history of 
acknowledging the impact of family size on tax liability and the AMT 
does not. From an economic efficiency standpoint, the key issue is that 
effective marginal tax rates are not always than the regular tax's 
marginal rates; sometimes, they are actually higher. A large portion of 
the AMT's lower rates reflects the tax-free threshold's zero rate. Once 
the AMT kicks in, the marginal rate jumps to 26 percent, well above the 
regular system's 10 to 15 percent. The highest marginal rate under each 
system is the same--35 percent.
    The more general problem is that the very presence of the AMT is an 
indictment of the basic Tax Code. It should be the case that a single 
Tax Code can be designed to raise needed revenues, while meeting 
sensible criteria for simplicity, fairness, and economic growth and 
competitiveness. Attempts to ``fix'' the AMT by modifying tax brackets, 
rates, or deductions will not address this fundamental problem. A more 
desirable approach would be to eliminate the AMT entirely, but do so in 
the context of a broader revamping of the Tax Code.
    Tax policy and the distribution of economic well-being. While 
recent U.S. GDP growth has been robust and payroll employment growth 
sustained, concern has arisen that growth is not translating into 
acceptable increases in standards of living for too many American 
households. This has generated a further concern that pro-growth tax 
policy per se is responsible. The facts, however, suggest otherwise. 
The dominant source of change in the income distribution is a long-term 
trend in the wage structure in the U.S., and not recent changes in tax 
policy. To the extent that policymakers wish to address this issue, the 
most fruitful approaches involve improving K-12 educational outcomes, 
thereby equipping future workers with better skills and the ability to 
be successful in college.
    A large literature in labor economics documents a substantial 
widening of the U.S. wage structure during the 1980s.\10\ Wage 
differentials by education, by occupation, and by age and experience 
group all rose substantially. The growth of wage inequality was 
reinforced by changes in non-wage compensation leading to a large 
increase in total compensation inequality. These wage structure changes 
translated into a rise in household income inequality. The trend to 
wage inequality in the 1990s was considerably slower than in the 1980s, 
with the key feature being that the highest earners (the 90th 
percentile of the wage and earnings distribution) continuing to grow 
faster than the median, but no noticeable decline for low earners. The 
more recent labor market data suggests a continuation of this 
    \10\ See, for example, Attanasio, Orazio and Steven J. Davis. 1996. 
``Relative Wage Movements and the Distribution of Consumption.'' 
Journal of Political Economy 104 (December): 1227-62;,Autor, David H., 
Lawrence F. Katz, and Melissa S. Kearney. 2005. ``Trends in U.S. Wage 
Inequality: Re-assessing the Revisionists.'' NBER Working Paper 11627, 
September; Autor, David H., Frank Levy, and Richard J. Murnane. 2003. 
``The Skill Content of Recent Technological Change: An Empirical 
Investigation.'' Quarterly Journal of Economics 118 (November): 1279-
1333; Cutler, David M. and Lawrence F. Katz. 1991. ``Macroeconomic 
Performance and the Disadvantaged.'' Brookings Papers on Economic 
Activity, 1991:2, 1-74; Cutler, David M. and Lawrence F. Katz. 1992. 
``Rising Inequality? Changes in the Distribution of Income and 
Consumption in the 1980s.'' American Economic Review 82 (May): 546-51; 
Goos, Maarten and Alan Manning. 2003. ``Lousy and Lovely Jobs: The 
Rising Polarization of Work in Britain.'' Unpublished paper, Center for 
Economic Performance, London School of Economics, September; Hamermesh, 
Daniel S. 1999. ``Changing Inequality in Markets for Workplace 
Amenities.''Quarterly Journal of Economics, 114(4), November, 1085-
1123; Karoly, Lynn and Gary Burtless. 1995. ``Demographic Change, 
Rising Earnings Inequality, and the Distribution of Well-Being, 1959-
1989.'' Demography 32: 379-405; and Piketty, Thomas and Emmanuel Saez. 
2003. ``Income Inequality in the United States, 1913-1998.'' Quarterly 
Journal of Economics 118 (February), 1-39.
    \11\ Another set of concerns relates to inadequacies in the 
measurement of earnings, income, and standards of living more 
generally. For example, (1) real wages have grown more slowly than real 
compensation because benefits are a rising portion of total 
compensation; (2) standard price indexes overstate inflation, causing 
an understatement of real compensation gains; and (3) traditional 
poverty measures failure to adequately reflect redistributive taxes and 
    Low-income features of the Tax Code. In 2007, the Treasury projects 
that the share of individual income taxes paid by low-income taxpayers 
will fall, while the share of taxes paid by high-income taxpayers will 
rise. At the same time, the share of taxes paid by the bottom 50 
percent of taxpayers will fall from 3.8 percent to 3.4 percent. Since 
there has not been a dramatic change in the distribution of spending, 
this indicates that the impact is becoming more progressive. At the 
very highest levels of income, this is especially true, as the share of 
taxes paid by the top 5 percent of taxpayers is projected to rise from 
55.3 percent to 56.5 percent.
    As these figures indicate, a great many Americans pay no income tax 
at all. In 2007, a married couple with two children will have no tax 
liability until their income reaches $42,850. For those low-incomes 
families near the poverty level, refundable tax credits like the child 
tax credit and the earned income tax credit (EITC) provide payments 
from the Treasury to those families. A single parent with one child and 
$14,257 of income (i.e., the estimated 2007 poverty level for a two-
person family) will receive $3,410 back from the Federal Government in 
    Taxation of carried interests. Recent discussions and legislative 
initiatives have raised the possibility of taxing so-called ``carried 
interests'' as ordinary income instead of capital gains. By itself, 
such a change would not improve the performance of the Tax Code. As 
noted earlier, a fundamental unfairness of the current Tax Code is that 
similar taxpayers are taxed differently. Under such a proposal, 
investments in real estate (for example) would face different effective 
tax rates depending upon whether they are undertaken by an individual, 
through a real estate investment trust, or via a limited partnership. 
This inequity would carry with it an efficiency cost as the higher tax 
would discriminate against a particular organizational form--the 
partnership--that was previously preferred by investors. Moreover, as 
noted above the benchmark for efficient, pro-growth tax policy allows a 
deduction from the tax base for all saving and investment, while taxing 
at a common rate all cash flows. The proposed tax change imposes the 
latter taxation, without the corresponding deduction. In short, it is a 
move in the wrong direction for the Tax Code.
     In the absence of broad reform, there appears to be little merit 
to changing the tax treatment. As noted in a recent analysis by Michael 
Knoll, taxing the cash equivalent of the carried interest will raise 
modest amounts of revenue.\12\ In reaching this conclusion, he computes 
the cash value of an option contract that mimics carried interest for 
general partners, and calculates the additional taxes that would be 
collected by taxing this cash grant as ordinary income. In his 
analysis, this represents the additional payments that limited partners 
would be required to offer in order to retain sufficient inducement to 
attract general partnership talent. Another perspective on this 
analysis, however, is to note that he employs a conventional formula 
for valuation that assumes independent freedom to exercise the option 
and deep, liquid markets for the underlying asset. In the context of 
some investments, these likely overstate the reality and thus the value 
of the option. At present, the Tax Code treats the grant of the carried 
interest as of low and hard to quantify value, assumes reinvestment of 
the grant, and taxes the result as a capital gain. While imperfect from 
the perspective of investment and growth, it is preferable to the 
proposed alternatives.
    \12\ Michael Knoll, ``The Taxation of Private Equity Carried 
Interests: Estimating the Revenue Effects of Taxing Profit Interests as 
Ordinary Income,'' University of Pennsylvania, August 2007.
    Taxation of publicly traded partnerships. A related initiative is a 
proposal to subject certain publicly-traded partnerships to the 
corporation income tax. As noted earlier, good tax policy imposes a 
single layer of tax and achieves investment neutrality by integrating 
the corporation and individual income taxes. Increasing the double-
taxation of saving and investment is a step in the wrong direction. 
Doing so in a discriminatory, non-uniform fashion increases distortions 
and represents unsound tax policy.

                                         Table 1 Tax Receipts 1996-2006
              Year                 Individual Income  Corporation Income   Social Insurance      Total Revenue
---------------------------------        Taxes               Taxes               Taxes       -------------------
                                  Billions   Growth   Billions   Growth   Billions   Growth   Billions   Growth
1996                                 656.4     11.2%     171.8      9.4%     509.4      5.1%   1,453.2      7.5%
 1997                                737.5     12.3%     182.3      6.1%     539.4      5.9%   1,579.4      8.7%
 1998                                828.6     12.4%     188.7      3.5%     571.8      6.0%   1,722.0      9.0%
 1999                                879.5      6.1%     184.7     -2.1%     611.8      7.0%   1,827.6      6.1%
 2000                              1,004.5     14.2%     207.3     12.2%     652.9      6.7%   2,025.5     10.8%
 2001                                994.3     -1.0%     151.1    -27.1%     694.0      6.3%   1,991.4     -1.7%
 2002                                858.3    -13.7%     148.0     -2.0%     700.8      1.0%   1,853.4     -6.9%
 2003                                793.7     -7.5%     131.8    -11.0%     713.0      1.7%   1,782.5     -3.8%
 2004                                809.0      1.9%     189.4     43.7%     733.4      2.9%   1,880.3      5.5%
 2005                                927.2     14.6%     278.3     47.0%     794.1      8.3%   2,153.9     14.5%
 2006                              1,043.9     12.6%     353.9     27.2%     837.8      5.5%   2,407.3     11.8%


    Chairman RANGEL. Thank you all for your splendid testimony. 
I hope that all of you would feel comfortable in submitting to 
the chair which areas of the existing Tax Code you would 
believe that we should focus on in order to make certain that 
at the end of the day with our so-called reform measure that 
more people will believe that we're doing the right thing.
    It's abundantly clear that one of the main reasons why Jim 
McCrery and I are in accord on taxes is that there's just no 
justification for who got caught up in the AMT. But in order to 
restore the lost revenues, we have to look at the entire Code. 
Also to remember that we have to encourage investment, which 
means that the Code, for good or for bad, has been used not 
just to raise revenue, but to direct people's behavior. Some of 
those things have worked, some of them have not worked, and 
we're hoping that there are a lot of provisions in the Code 
that people forgot why they were put in that we can take out 
and raise some revenue.
    Having said that, I'm going to yield to Mr. McCrery. But we 
will be following through and getting some of your ideas so 
that we can have more time to go through those things because 
one of the things that I am persuaded by is that we have a 
voluntary tax system because people believe that it's fair, or 
we want them to believe that it's fair, and we have to do that, 
and we've got a big job to do. Mr. McCrery.
    Mr. MCCRERY. Thank you, Mr. Chairman. Before we proceed 
with questioning the witnesses, Mr. Chairman, a former 
colleague of ours on the Committee on Ways and Means, Jennifer 
Dunn, we learned yesterday has passed away. Many of us on this 
Committee today served with Jennifer Dunn and know that she was 
a very valuable and respected Member of this Committee. We will 
miss her, not only here in this Committee, but as a friend and 
colleague. So, Mr. Chairman, in recognition of this Committee's 
respect for Jennifer Dunn and in memory of her, I would ask for 
just a moment of silence for the Committee before we proceed.
    Chairman RANGEL. The staff has sent condolences and flowers 
to the family of the deceased. She was quite a lady. She was a 
tough lady, a charming lady, and a great Member of this 
Committee, and she certainly will be missed, but not the great 
contribution she's made. We'll have a moment of silence in 
memory of her.
    [Moment of silence.]
    Chairman RANGEL. Thank you. Now we have a vote on the 
floor. What's the situation? I think it would be better if we 
take a short recess, go vote and come back and then yield to 
you. Thank you.
    Chairman RANGEL. I will ask Congressman Neal to assume the 
chair and then yield to Mr. McCrery.
    Mr. NEAL [presiding]. Thank you, Mr. Chairman. The chair 
now would yield to Mr. McCrery for his line of questioning.
    Mr. MCCRERY. Thank you, Mr. Chairman. Thank you, witnesses, 
for your excellent testimony. I just have a few questions. Dr. 
Furman, I guess I'll start with you, because your testimony was 
interesting but also somewhat confusing. In one instance, you 
said, or at least what I heard you say, was that even with all 
the tax cuts--I don't know if you said the bottom quintile, but 
you said lower income earners were worse off. If in fact that's 
what you said, I doubt that's what you meant in an absolute 
sense, but maybe you were speaking in a relative sense in terms 
of the gap between the lowest quintile and other wage earners. 
Would you clarify that?
    Mr. FURMAN. Yes, sir. I was actually speaking in an 
absolute sense. If you look at economic models that attempt to 
estimate the benefits of tax cuts for the economy, they always 
make financing assumptions about how the tax cuts are paid for.
    So, for example, Professor Greg Mankiw and Matthew 
Weinzierl have a model in which they try to study if you cut 
taxes, what would the benefit or harm to the economy be? To 
make that economic model work, they assume that the tax cuts 
are paid for because they cost money. They're paid for by, for 
example, cutting Medicare benefits, cutting Medicaid benefits, 
cutting Social Security or raising lump sum taxes. When you 
factor in the financing of the tax cut and the effect on 
households, 74 percent of households in my analysis, using the 
tax policies in the microsimulation model, are made worse off.
    That's using exactly the same models that, for example, the 
Treasury Department has used to argue that tax cuts will on 
average benefit the economy. Even if on average it does, when 
you take into account the financing in the Treasury model 
itself, most people are made worse off in absolute terms.
    Mr. MCCRERY. Okay. I better understand what you were saying 
now. While that may fit into your model, your model, like any 
other economist's model, is full of assumptions. In your model, 
you're assuming that Medicare or Social Security or some kind 
of benefit will be cut because of the tax cuts. But if we can 
just for the moment set aside those assumptions that haven't 
happened yet, and may not happen, if you just looked at the 
impact on the bottom line of the taxpayer, isn't it accurate to 
say that all taxpayers benefited in terms of money in their 
pocket from the Bush tax cuts, especially when combined with 
transfer payments like the earned income credit? That's 
essentially--it's scored even by CBO as a spending program in 
part. So, when you consider those spending programs like that 
in conjunction with the tax cuts, isn't it accurate to say that 
everybody got some tax relief or some relief in their 
    Mr. FURMAN. I think it's still not everybody, but it's 
substantially more than what I said, that relief differed quite 
a lot, was much, much larger for high-income people.
    Mr. MCCRERY. No.
    Mr. FURMAN. Than for low-income people. The key question is 
whether that is a sustainable increase in people's incomes or 
whether we're going to pay the bills and become much worse off 
for it as a result. That's what these economic models are 
trying to ascertain.
    Mr. MCCRERY. Yeah. I don't have any quarrel with the model. 
I understand how you get there. But I think you understand that 
those are assumptions. We can alter those assumptions with 
different policy changes. For example, we could solve the 
Social Security problem in a way that maybe your model doesn't 
contemplate, that would reduce benefits and also wouldn't 
necessarily over the long term take more revenue. So, there are 
all kinds of changes we can make in policy to alter the 
assumptions in your model.
    I just want to get this question out real quickly. Dr. 
Burman, you talked about taking the, or repealing or revising 
the AMT, and we ought to do it on a revenue-neutral basis. 
Implicit at least in your remarks, or at least I inferred from 
your remarks, that you would recommend letting the 2001-2003 
tax cuts expire on schedule which to me brings up the question 
that we don't talk about enough in this Committee, which is at 
what percent of GDP would you stop in getting revenues from the 
American people? Isn't that a question that we should consider 
from an economic standpoint? If you let all the tax cuts 
expire, if you do the AMT repeal on a revenue-neutral basis, 
you're going to get up to somewhere close to 21 percent of GDP 
coming into the Federal Government in revenue.
    Mr. BURMAN. As Dr. Holtz-Eakin pointed out in his 
testimony, the real issue is spending. If you look at the 
projections going forward, starting in 2010 when the baby 
boomers retire, the Federal Government's spending is set to 
explode. You need to figure out how to rein in the growth of 
entitlements. I think it's unlikely that you'd be able to rein 
them in so much that you wouldn't require additional revenues.
    So, my view is that undermining an important revenue source 
before you figure out how to control the growth in spending 
would be problematic. It would mean that you'd be pushing a lot 
of burdens on our children and on our grandchildren.
    Mr. MCCRERY. Well, I'm certainly a proponent
    Mr. BURMAN. Nobody likes taxes.
    Mr. MCCRERY. I'm certainly a proponent of solving the 
entitlement problem in this country from a spending standpoint. 
I don't think they're sustainable as they're currently 
structured. But I guess I'd just like for you, maybe all three 
of you, to just give us a ballpark figure of where you think if 
we started getting 25 percent of GDP in revenues, would that be 
damaging to the economy in a fundamental way, or would it be 30 
percent, or do you care?
    Mr. BURMAN. Well, in part it depends on how you raise the 
revenues. The current tax system is very distortionary. There 
are lots of loopholes and deductions. The basis is fairly 
narrow and the rates are higher than they would have to be if 
there weren't a broader tax base. The ideal thing would be if 
we could broaden the base and keep marginal tax rates 
relatively modest going forward like we did in 1986.
    As far as what the right level of revenue is, we need as 
much revenue as the government is spending over the long run. 
We should try to raise it in a way that's both fair and 
progressive but also does as little damage to economic growth 
as possible. If you look at the projections going forward, the 
spending on entitlement programs, according to CBO, is going to 
be as large as total current Federal spending, and you're still 
going to need defense. You're going to need courts. You're 
going to need to pay for Congress. So, the right level of 
revenue really depends on what you can do to spending.
    Mr. MCCRERY. If the other two witnesses would just comment 
briefly on my question.
    Mr. FURMAN. Sure. I agree first of all it depends on how 
you raise the revenue. But second of all, a key question is 
timing. What we've seen in the last 6 years is actually not 
really a tax cut so much as a shift in taxes. So, if you raise 
taxes by a small amount today, that forestalls the need for 
much larger tax increases in the future, which is why I'd 
rather see us act sooner than later, and then we can have a 
lower level of revenue as a share of GDP that is consistent 
with funding the government that we want.
    Mr. MCCRERY. Dr. Holtz-Eakin.
    Mr. HOLTZ-EAKIN. Well, I won't reprise my concerns over the 
spending side. If you spend it, ultimately you're going to pay 
for it. You're going to borrow the money now and raises taxes 
later or something of that nature. So, you've got to do the 
    The second two guidelines you can look at are either 
history. We've not typically gone above 18 percent of GDP, and 
there's a reason for that. We can't deploy the highly 
inefficient Tax Code we have without having people rebel at 
above that level. Or we can look at other countries where, at 
least on the business side, we are now looking like a tax 
unfriendly jurisdiction, and we can't allow that to happen.
    So, you know, we don't live in a vacuum. We've got to be 
cognizant of our international competitors, and we have to be 
cognizant of the fact that the private sector feels the burden 
of these taxes and responds.
    So, I would be hesitant to push much higher.
    Mr. MCCRERY. Thank you, Mr. Chairman.
    Mr. NEAL. Thank the gentleman. The gentleman from Michigan, 
Mr. Levin, will inquire.
    Mr. LEVIN OF MICHIGAN. Thank you very much. You know, when 
three economists testify I think the assumption is that your 
being economists, it's all going to be very complex and hard to 
understand I think for us here and for everybody else. But I 
must say from your testimony, certain key facts, key 
developments just spring forth.
    Dr. Burman, you say income inequality has been rising since 
the mid-eighties and now approaches levels not seen since the 
Great Depression. That's a dramatic statement unchallenged so 
far. Then Dr. Furman, you say this, because one of the 
arguments in favor of inequality is that it spurs growth. You 
essentially challenge that this inequality has been a major 
generator of economic growth. You quote, you cite the Treasury 
Department analysis saying--having the projection of very 
modest economic gain from the tax cuts made permanent 0.04. 
That's less than one--that's four one-hundredths, right, of 1 
    Mr. FURMAN. Right.
    Mr. LEVIN OF MICHIGAN. As you can imagine, Dr. Holtz-Eakin, 
we probably did look--we were going to look at your comments 
when you were with us. Going back to them, one of your comments 
regarding the President's tax policies, and I quote, ``taken 
together, the proposals would provide a relatively small 
impetus in an economy the size of the United States.'' So you 
have the tax cuts, including those regarding capital gains and 
dividends and the savings rate in this country has remained 
essentially stagnant.
    So if the motto is growth with equity, to put it rather 
plainly, and I'd like all three of you to comment, there's been 
almost historically high growth in inequality. It has not 
sparked basically economic growth. So we've gotten the worst of 
both worlds. So, comment on that. Dr. Holtz-Eakin, your 
testimony seems to talk about other things and a consumption 
tax and we can talk about that. But what is the thrust of the 
testimony of Dr. Burman and Dr. Furman is that it's been a bad 
deal for this country in terms of this nearly historic 
inequality that has not been a major spark of economic growth.
    So, why don't we go down the row and leave time for each of 
you, if you would.
    Mr. BURMAN. Thank you, Mr. Levin. It's certainly true that 
at the same time that economic inequality has risen 
dramatically, the economy has actually grown pretty well over 
the last two decades, but it's not clear that there's any link 
between the two.
    I would also say that as Dr. Holtz-Eakin has pointed out, 
that it's not tax policy that has caused the pre-tax inequality 
per se, although it can mitigate it somewhat. I think any 
economist would say that there is a link between tax policy and 
the economy, but there are ways you could actually make the tax 
system more progressive without entailing additional costs on 
the economy. You could probably make it more progressive and 
actually make the economy grow better.
    Mr. LEVIN OF MICHIGAN. Dr. Furman
    Mr. FURMAN. One of the numbers in my written testimony was 
that there was a $664 billion shift in income from the bottom 
80 percent to the top 1 percent----
    Mr. LEVIN OF MICHIGAN. Dramatic.
    Mr. FURMAN [continuing]. Over the last 25 years, 664 
billion. When you think of something like international trade, 
some people have estimated $500 billion to a trillion dollars 
of benefits from international trade. When you look at numbers 
like that, the benefits of trade, the magnitude of inequality, 
it says that the types of policy responses that we should have 
to deal with inequality, to deal with trade and globalization 
should really be at the scale of those problems and those 
issues. We've been going in the wrong direction for the last 6 
years. We really should be going in the right direction and 
quite substantially.
    Mr. LEVIN OF MICHIGAN. Dr. Holtz-Eakin, you have the last 
    Mr. HOLTZ-EAKIN. Yeah. I think Dr. Burman said it pretty 
clearly, which is that we have seen rising inequality in wage 
earnings in the eighties, dramatically at the top and bottom in 
the nineties, much more dramatic at the top than at the bottom, 
and those trends appear to continue today. They're not driven 
by tax policy. This is not a tax policy issue. The dividing 
line between those who get high earnings and those who do not 
are driven by education, and that if you want to go find out 
how to improve those outcomes, you would begin by having kids 
arriving at school ready to learn and you would improve the 
performance of the whole school system. That's it.
    Mr. LEVIN OF MICHIGAN. I agree. You're saying tax policy 
has been irrelevant to the growing income inequality?
    Mr. HOLTZ-EAKIN. I think it has had very little to do with 
the labor market earnings inequality that the professor's 
document that I referenced in my testimony. So, you're looking 
at the wrong culprit if you're looking at tax policy and labor 
market outcomes.
    Mr. LEVIN OF MICHIGAN. Dr. Furman.
    Mr. FURMAN. One thing I looked at again in my written 
testimony is if the Tax Code had stayed as progressive as it 
was in the year 2000, the progressive tax system would have 
offset 20 percent of the increase in inequality I talked about. 
Of that 664 billion, 20 percent of that would have been offset 
by the progressive Tax Code. But as a result of tax changes 
from 2001 to the present, the Tax Code ended up offsetting a 
much smaller portion of that increase in inequality, less than 
a third as much as it would have otherwise.
    So, I agree with Dr. Holtz-Eakin. I don't think taxes are 
the cause of inequality. But the tax system, even if you had 
just left it in place, would have solved about one-fifth of the 
problem. Instead, we tampered with it, and it solved less than 
10 percent of the problem.
    Mr. LEVIN OF MICHIGAN. Okay. Thank you.
    Mr. NEAL. I thank the gentleman. The gentleman from 
California, Mr. Herger, will inquire.
    Mr. HERGER. Thank you, Mr. Chairman. A question for Dr. 
Holtz-Eakin. We've heard many in the majority complain that 
President Bush and the tax relief of the last several years 
increased the number of taxpayers on the alternative minimum 
tax or AMT. I think we can all agree that negative effects of 
the AMT on the unsuspecting middle class Americans and about 
the need to eliminate this tax regime that was never intended 
to dip into the middle class. But my question to you is if a 
taxpayer did become subject to the AMT because President Bush's 
tax cuts lowered their regular tax liability, would they still 
receive an overall tax cut? In other words, whether or not they 
paid regular income tax or AMT, am I correct in saying that the 
Bush tax cuts would not increase the total income taxes of any 
    Mr. HOLTZ-EAKIN. That's correct. So, he gave them a tax 
cut. There's no question about it.
    The tables at the beginning show this. I mean, they say 
what fraction of the people's tax cuts got taken by the AMT? 
None of those fractions were over 100 percent. No one's taxes 
went up. They went down.
    Mr. HERGER. So, this allegation and implication that 
somehow the Bush tax reductions in which we've seen the results 
of a major increase in our economy, major increase in revenues, 
total revenues to the Federal Government, despite the fact that 
taxes went down, the fact that somehow these in the lower 
income tax bracket are paying more is just absolutely 
incorrect. Is that true?
    Mr. HOLTZ-EAKIN. It's incorrect. People are paying less in 
total taxes, and there's no question if you look at the problem 
with the AMT, the problem is not the cuts in the regular income 
tax. The problem is the AMT is not a very good tax. It's not 
indexed for inflation and it should have been a long time ago. 
It doesn't make any sense from the point of view of a tax base. 
It doesn't, you know, sort of recognize family size. It's got 
very high marginal rates. This is not a tax anyone should 
embrace. It's a bad tax. The real indictment is that we need it 
at all. The fact that we have an AMT says that our regular tax 
system makes no sense, so we're going to patch it on the side 
with this alternative. Fix the Tax Code. Stop staring at the 
    Mr. HERGER. Thank you. That's very helpful and incredibly 
important for trying to clarify this debate. You say in your 
testimony that recent evidence suggests the relatively high 
U.S. corporate income tax is ultimately paid by workers in the 
form of lower wages. Can you please speculate for us the 
effects on raising taxes on small businesses?
    Mr. HOLTZ-EAKIN. Well, there are two dimensions to that. I 
mean, the first is economists have struggled for a long time to 
try to pin who actually is harmed when we tax a particular type 
of business activity, in this case the C corporations, the 
Chapter C corporations.
    You know, corporations aren't going to pay that tax. 
They're either going to charge their customers higher prices, 
cut payments to shareholders and cut back on investment, reduce 
wages. It's going to go somewhere. Some of the recent evidence 
suggests that given the global mobility of capital, that what 
is really going to happen when that tax goes up is the capital 
won't tolerate a lower return, so the workers are going to pay 
it. So that tax is harmful on workers in the global context.
    The second piece of evidence is largely domestic, and in 
research I've done with multiple co-authors, the kinds of 
people who are in sole proprietorships, small businesses of 
different legal forms, appear to be unusually sensitive to 
taxes and tax increases cause them to invest less in the firms, 
cause them to grow their payrolls slower. They don't hire 
people. They don't give them raises. They tend to go out of 
business more quickly, if you have higher taxes.
    Mr. HERGER. Doctor, I thank you very much. Again, this just 
brings out the importance of the debate. The debate between the 
party that's in the majority that somehow feels we're not 
paying enough taxes, that taxes need to be increased, and the 
part I belong to, the minority party right now that feels that 
just the opposite is true. We need to be moving toward lowering 
our basic taxes, and the results are clear.
    Despite what conventional wisdom might predict, when we 
lower taxes at a time when taxes are high, revenues actually 
increase, and the opposite happens when we raise taxes. 
Revenues actually decrease, and we see the economy hurt. More 
importantly, we see our citizens hurt. So, I want to thank you 
very much for your testimony and for your being here testifying 
before our Committee today.
    Thank you, Mr. Chairman.
    Mr. NEAL. Thank the gentleman. The gentleman from 
Washington, Mr. McDermott, is recognized to inquire.
    Mr. MCDERMOTT. Thank you, Mr. Chairman. This is a country 
that fundamentally believes in hard work, and you could call it 
the Protestant work ethic or whatever you want to call it, but 
the value of work has really been the bedrock of our society. 
Today it looks like we're headed back, it seems to me, toward 
the Gilded Age when hard work didn't mean very much. We're the 
most productive workers in the world at this point, even 
beating the Norwegians, but we're returning to an age really 
when the nation's spoils seem to go to the few while the rest 
of the folks work.
    Now Mr. Burman's testimony is replete with data that bears 
out these facts. Income inequality is approaching levels not 
seen since the New Deal. Low- and middle-income families are 
working longer, harder, more efficiently, but their real wages 
are flat and they're falling in the face of rising energy, 
housing and health care costs.
    Since the year 2000, the cost of employment-based health 
premiums has gone up 87 percent. Now American families today 
are walking a tightrope over a snakepit really of economic 
insecurity. The social safety net has been ripped, but the 
corporate America seems to enjoy a real lifeline of tax 
holidays. There just seems to be a lack of fairness in the 
    I put up this slide on the screen for people to look at. No 
one disagrees with this. This is the Urban Institute, 
Brookings. This is--everybody realizes that all the money is 
going to the people on the far right end. The tax laws 
implemented over the last 6 years have exacerbated the 
challenges that globalization imposes on working families. 
Aftertax income inequality is dramatically more severe because 
of the tax cuts that have been put in place. It's obvious from 
looking at it, and Mr. Furman's testimony really bears that 
    Now as low- and middle-income families lose their health 
care, their pensions and their homes, the affluent are bathed 
in these tax cuts which were about to expire. Now the AMT nails 
middle-income again and volunteers fight an endless war in 
Iraq. The fortress of Wall Street really goes on almost 
untouched by this, and wants to protect a tax rate of half the 
rate that the ordinary people in this country are paying.
    It seems to me that our real issue here is that we need to 
design a tax policy and labor policy that responds to 
globalization. This is a new era. This is not the Industrial 
Age. This is the Globalized Age. I'd like, Mr. Furman, for you 
to talk a little bit about as these tax cuts expire--the 
Republicans set it up for them to expire in 2010, and I don't 
think we should, as they say, get in the way of a man when he's 
doing himself in. They did it. They set it up. We should let 
them expire. Then let's talk today about what we should do with 
things like unemployment insurance reform or universal health 
care or wage insurance or continuing education. I'd like to 
hear how you would spend the money which is going to come to us 
as a result of the expiring tax cuts. Or maybe just get rid of 
the AMT. I mean, that may be one thing. But there's some other 
things, it seems to me----
    Mr. FURMAN. Right.
    Mr. MCDERMOTT [continuing]. That we have to do to make 
equality in this society.
    Mr. FURMAN. Right. Thank you for asking me that question, 
and I run something called the Hamilton Project at the 
Brookings Institution, and we have put out policy proposals on 
every one of the issues you just mentioned, including wage 
insurance, health insurance and unemployment insurance. Of 
those areas, I think achieving universal health insurance is 
far and away the most important goal.
    You look at the tax cuts, they cost $200 billion a year. 
You could do a feasible plan for universal health insurance 
that costs maybe $100 billion a year, for half of the cost of 
what we did for the tax cuts, if you're willing to consider 
altering the tax exclusion for health insurance as the 
administration did, you might even be able to do a plan that 
gets health insurance for everyone at no additional cost.
    Mr. MCDERMOTT. Are you talking about a universal national 
health plan, or are you talking some kind of band-aid system on 
the present employer-based system? What are you talking about?
    Mr. FURMAN. The $100 billion number would be for something 
that builds on the existing system and fills in the cracks, 
providing options for people who don't have options within the 
system. If you switch to a national health insurance system, 
some form of single payer, the additional cost to the 
government would be more than $100 billion, although then you 
would have an additional savings to individuals of, you know, 
five or six hundred billion dollars a year of the premiums that 
they're paying for their health insurance right now.
    Mr. MCDERMOTT. So, the money----
    Mr. FURMAN. But I was talking about a more incremental 
system. It would still cover virtually every single one of the 
    Mr. MCDERMOTT. The bottom line is, there is the money to do 
universal health care coverage for all Americans inside this 
present system if we do it efficiently?
    Mr. FURMAN. The bottom line is that there are tradeoffs 
that have to be made, and if you do more in one area, you can 
do less in the other area. So, if you do tax cuts like that, 
you won't be able to afford to do universal health insurance.
    Mr. MCDERMOTT. Thank you, Mr. Chairman.
    Mr. NEAL. I thank the gentleman. The gentleman from 
Michigan, Mr. Camp, is recognized to inquire.
    Mr. CAMP. Well, thank you, Mr. Chairman. Dr. Holtz-Eakin, 
there's been a suggestion that income equality is rising, and 
using the data they use has a certain definition of income. But 
other experts define income in a different way and leave out 
significant amounts of cash and noncash income the households 
    Can you comment on what gets counted as income for purposes 
of some of these studies and discussions?
    Mr. HOLTZ-EAKIN. I'll comment briefly. It's a topic that's 
enormous, quite frankly. But----
    Mr. CAMP. It is enormous. I would agree with that.
    Mr. HOLTZ-EAKIN. The key thing for the Members to know is 
that there is absolutely a consensus that inequality in labor 
market earnings has increased over the past two-and-a-half 
decades, and there's a list of potential explanations. Much of 
them revolve around education, skills and abilities, period.
    Mr. CAMP. But, for example, does the definition of income 
include the value of the earned income tax credit?
    Mr. HOLTZ-EAKIN. So, the point I wanted to make is that's a 
very narrow slice of how people actually live. You want to get 
to, you know, how do people live at the end.
    Mr. CAMP. What do they actually have in real life? What 
resources do they have in real life?
    Mr. HOLTZ-EAKIN. Earnings. Then compensation including, you 
know, non-wage compensation, health insurance, things like 
that. Then you want to take that and add taxes net of 
transfers, or add transfers----
    Mr. CAMP. Taxes they pay and other----
    Mr. HOLTZ-EAKIN. The poverty statistics leave those out. 
Then you want to deflate them for the cost of living, and we 
have, you know, higher quality goods cheap. Then you get to a 
standard of living.
    Mr. CAMP. The Census Bureau figures don't do any of that, 
do they?
    Mr. HOLTZ-EAKIN. No.
    Mr. CAMP. So, the Census Bureau doesn't include food stamps 
or housing assistance?
    Mr. HOLTZ-EAKIN. No.
    Mr. CAMP. Medicaid spending. I think one of the 
difficulties this Committee has had is coming up with a uniform 
definition of poverty, because then these figures can be used 
to say whatever they want. I would just agree with you that 
this is an immensely complicated topic. I would ask unanimous 
consent to include in the record a report by the Heritage 
Foundation that expands on these and other definitions and 
deficiencies in the way income is calculated and would submit 
that for the record.
    But I also want to comment on some of these Census Bureau 
numbers that get put out there. For example, they often divide 
the population up into fifths. Those don't have equal numbers 
of people in them, do they? So, the top fifth has more people 
than the bottom fifth.
    Mr. HOLTZ-EAKIN. Depending on who does them, quite frankly. 
That's why it's hard to compare them.
    Mr. CAMP. I'm talking Census Bureau.
    Mr. HOLTZ-EAKIN. In the census poverty numbers?
    Mr. CAMP. Yes.
    Mr. HOLTZ-EAKIN. The census poverty numbers, the income 
distribution is over households, and you have to figure out 
household sizes and things like that.
    Mr. CAMP. Yeah. The quintiles are not equal in terms of 
numbers of people.
    Mr. HOLTZ-EAKIN. Right.
    Mr. CAMP. So you obviously are not making--obviously the 
comparisons, then, are not between comparable numbers of 
households in these various categories, and then results in a 
skewed percentage. So, I think that, without getting too far 
into the weeds on that, I think that it's important just to 
state that census figures ignore taxes paid and most of the 
social safety net that is available to the American people both 
in terms of Federal and state dollars. Is that an accurate 
    Mr. HOLTZ-EAKIN. Yes. The census figures are highly 
incomplete. I would highlight a second problem with them, which 
is that they're not counting the same people every year. The 
mobility of individuals across different standards of living is 
a key part of what goes on in the U.S. economy. The evidence 
doesn't suggest there's been a dramatic change in economy 
mobility. So, you know, the idea that somehow things are very 
different than they were 20 or 30 years ago is not supported by 
the data. We do have issues in giving people labor market 
skills, both in advance and after their job prospects change, 
that are real and genuine. But they're not addressed by those 
statistics at all.
    Mr. CAMP. Just in closing, I would agree. So, this leaves 
us with a definition of income that's incomplete and ignores 
really the efforts that are made in terms of the social safety 
net and the dynamics of our society where people are mobile and 
move from one income category to another over time, which would 
really--which really prevents us from getting a clear picture 
of what the situation in America is.
    So thank you for those comments, and I yield back the 
balance of my time.
    Mr. NEAL. The chair would recognize the gentleman from 
Georgia, Mr. Lewis, for inquiry.
    Mr. LEWIS OF GEORGIA. Thank you very much Mr. Chairman. Mr. 
Chairman, let me thank the witnesses for being here. Since we 
have these three distinguished economists here, I'd just like 
to ask a very general question, and maybe I can come back to 
something in particular. We have this unbelievable involvement 
abroad in a war in Iraq and Afghanistan. The only people that 
have been called upon to sacrifice are young men and our young 
women in uniform.
    I'd like to hear your opinion about is there some way to 
use the Tax Code to get other Americans to sacrifice, to pay 
something for our involvement in these two military conflicts? 
Is it fair? Is it right? Is this just?
    Mr. BURMAN. I'll certainly comment on the fact that as far 
as I know, it's unprecedented that we've launched a major war 
and at the same time enacted huge tax cuts. The mentality of 
the country is a lot different than it has been in the past. 
Bill Gates, Sr. and Chuck Collins in their history of the 
estate tax, explained it during World War I, as a 
``conscription of wealth,'' and by ones to the conscription of 
young men to serve in the military. Basically, it was a way of 
drawing on the people who were most wealthy to help support the 
effort as well so they could also share in the sacrifice.
    It's kind of ironic that at the same time that we have this 
war going, we've actually proposed to eliminate the estate tax, 
which is supposed to disappear in 2010.
    Mr. FURMAN. I guess I would agree with Dr. Burman. The last 
time I was before this Committee, CBO Director Peter Orszag 
read a letter that his staff had prepared him, and it was to 
the effect that there has not been a single other case, with 
the exception of one technical incident during the Mexican War 
in 1837 I believe, in which taxes were cut in a time of war. 
That's very unusual.
    It's especially unusual because it's not just a time of 
war. It's a time where we understand we're going to have for 
homeland security and for national security higher expenses 
going forward for a very long time. Even if we weren't in Iraq, 
even if we weren't in Afghanistan, just our homeland security 
needs are higher than what they were in the year 2000. In 
response to that, you normally don't try to cut taxes, borrow 
the money, and have to raises taxes substantially in the future 
as a result.
    Mr. HOLTZ-EAKIN. I think it's first important to note that 
there is no tax or budgetary sacrifice that's going to compare 
with the service of the young men and women in the armed 
forces. Let's be honest about that. That means that we should 
be honest about everything. That means we should, and I echo 
the comments of Mr. Furman, put on the books the real costs of 
fighting a war against a group of extremists who wake up each 
day trying to destroy this way of life, and it's going to be a 
long battle. Every dollar of expected spending in Iraq, 
Afghanistan and the rest of the fronts should be budgeted, and 
budgeted all the time. To pretend otherwise is bad government 
fiscal policy.
    At that point, the tradeoffs will have to be clear. As you 
know, I believe we have overspent the Federal budget many times 
going forward, so simply adding more spending is not something 
this Committee has the luxury of doing. There will have to be 
some cutbacks in spending and a tax policy that will not 
cripple the economy put in place.
    Mr. LEWIS OF GEORGIA. Thank you very much. Dr. Furman, you 
have suggested that the tax treatment of retirement saving 
provide a windfall for Americans who already have enough money 
and are already inclined to save, while offering few options 
for low- and moderate-income Americans to save for their 
    As you look at the years since the enactment of the 2001 
and 2003 tax cut and the performance of the economy, what 
changes do you recommend that we make to ensure that all 
taxpayers have enough money left over at the end of the day to 
put into savings?
    Mr. FURMAN. Mm-hmm. Let me recommend both a paper by the 
Hamilton Project written by Bill Gale, Peter Orszag and John 
Gruber, and also the work of the Retirement Security Project at 
Brookings. A minimal step would be taking things like the 
saver's credit, which were enacted, making them refundable and 
more transparent so that low- and moderate-income families 
could truly benefit from them in their savings.
    A set of more ambitious steps would make savings easier, 
more automatic, help people turn their savings into an annuity 
when they retire, so that they can have a stable income in 
their retirement and have more generous tax credits for low- 
and moderate-income families to help them save. So, there's a 
lot of steps both within the Tax Code and within pension reform 
you could take that I believe would be economically beneficial 
in terms of increasing national savings, and also beneficial in 
terms of increasing the retirement security of working 
    Mr. LEWIS OF GEORGIA. Thank you very much. Thank you, Mr. 
    Mr. NEAL. We thank the gentleman. The gentleman from 
Pennsylvania, Mr. English, will inquire.
    Mr. ENGLISH. Thank you, Mr. Chairman. Mr. Chairman, this 
testimony has been stimulating and certainly there have been a 
lot of surprises. For example, in Mr. Burman's testimony a 
couple of minutes ago to the effect that we've never financed a 
war while cutting taxes. My impression was that we had financed 
the Cold war during the eighties by cutting taxes, but that's I 
suppose maybe just my ideological perspective on things.
    Dr. Burman, I was also surprised by my good friend Mr. 
Neal's statement that the impact of the AMT was having a 
surprise impact on the Bush tax cuts. Wasn't the existence of 
the AMT pretty well known at the time, and weren't the 
estimates prepared by the Joint Tax Committee done with full 
anticipation that some taxpayers, depending on their 
circumstances, might be subject to the AMT?
    Isn't it true that taxpayers are receiving the full 
benefits of more than $1 trillion in tax cuts as estimated by 
the Joint Committee on Taxation? Maybe more importantly, isn't 
the suggestion that the Bush tax cuts have tossed people into 
the AMT a little misleading? Would you agree that while more 
people might be paying the AMT because of the interactions with 
the 2001 and 2003 tax cuts, there's not a single taxpayer who 
is paying more in taxes than they would if these bills had not 
been enacted?
    Mr. BURMAN. It's basically true. It turns out there are a 
few married people filing separate returns that actually might 
pay a little bit more, but almost nobody pays more taxes 
because of the interaction of the AMT and the 2001-2003 tax 
    Mr. ENGLISH. Outstanding. That's extremely helpful. Now the 
point you were----
    Mr. ENGLISH. I'm sorry, Mr. Chairman. Do I have the floor 
here? You also made an interesting point about your concern 
about undermining the revenue source. This was in response to 
Mr. McCrery that the tax cuts might be undermining a revenue 
source that is essential to deal with long-term entitlement 
challenges. I think that's an interesting argument. I think you 
also conceded that perhaps spending is a big part of the key 
    Now Dr. McDermott laid out his programmatic menu of things 
that could be invested. Would it not undermine the revenue 
source equally in dealing with long-term entitlement needs to 
encumber those moneys with new entitlements?
    Mr. BURMAN. I certainly think that would be a problem. 
Somehow you need to get the entitlements under control. I think 
there are probably ways that--actually, I'm sure there are 
ways--you could expand health insurance coverage without 
increasing overall spending. Dr. Holtz-Eakin, discussed the 
problems facing small businesses. I think one of the big 
problems facing small businesses right now is the way health 
care is financed. Actually, if some of the costs could be taken 
off the backs of small businesses, they would actually be able 
to compete more effectively with foreigners.
    Mr. ENGLISH. That's an excellent point. Dr. Burman, on a 
separate point, and I was delighted to see that the deduction 
for state and local taxes has been brought up. As the Joint Tax 
Committee has shown, the inability to deduct state and local 
taxes for AMT purposes is one of the primary preference items 
that causes individual taxpayers to become subject to the AMT.
    Some might argue that this is unfair, since those who have 
already paid the state taxes might be less able to pay Federal 
taxes. But isn't it also correct that the deduction for state 
and local taxes acts as an implicit subsidy by low-tax states 
of those living in high-tax states? Isn't it also true that 
residents of many of these low-tax states are on balance 
relatively less prosperous than those in high-tax states? If 
so, isn't there an equity concern when those who are better off 
are asking those who are worse off to help offset the cost of 
more extensive state and local government services that after 
all is their option?
    Mr. BURMAN. I agree with that. State and local tax 
deductions are actually very regressive. The largest benefits 
go to very high-income people, people who are above the AMT 
threshold, and it benefits the states with the largest tax 
bases. If you're actually going to try to provide assistance to 
the states, it would make a lot more sense to target it to the 
states that need help, places like Arkansas, Louisiana, where 
they get very, very little.
    Mr. ENGLISH. Dr. Furman in his testimony made the point 
that income inequality in America has increased nearly 
continuously since 1979. Dr. Holtz-Eakin, can you identify any 
time in history when a period of economic growth did not lead 
to an increase in income inequality?
    Mr. HOLTZ-EAKIN. I'm smart enough to know that I'm sure 
that you could slice some time period to find one where that 
isn't true, but by and large, markets reward--market rewards 
are different. To get growth, you have to have market rewards, 
and so you get differences in outcomes for the people who 
follow the market and those who don't. Inequality is part and 
parcel of a market economic system.
    Mr. ENGLISH. I have many more questions, but I'm out of 
time. Thank you, Mr. Chairman, for your indulgence.
    Mr. NEAL. We thank the gentleman. Mr. Burman, we've had 
some questions about how much of the Bush tax cuts some 
taxpayers lose to the AMT, with some losing as much as two-
    I want to ask you about a chart in your testimony, Table 1 
on page 4. It shows that some taxpayers at the highest incomes 
receive an average tax cut of $230,000. Do these taxpayers lose 
any of their tax cuts to AMT?
    Mr. BURMAN. Sure. They lose a little bit, but if you look 
at Table 3 of my testimony, the people with the highest incomes 
actually lose the smallest share among people with incomes over 
$50,000. The percent of the tax cut taken back for people 
earning over $1 million, basically that income group in the 
first table, is less than 5 percent. Families with incomes 
between $100,000 and $200,000 lose more than a third.
    Mr. NEAL. Mr. Furman, is that your position as well?
    Mr. FURMAN. I am less of an expert on the AMT than Dr. 
Burman is. In fact, everyone in the country is less of an 
expert on the AMT than Dr. Burman is, but I believe that's 
    Mr. NEAL. Thank you. Mr. Eakin.
    Mr. HOLTZ-EAKIN. Mr. Furman was talking while you were 
giving your question so I didn't actually get to hear you. I 
    Mr. NEAL. That's part of our strategy.
    Mr. HOLTZ-EAKIN. I see. I will stipulate, however, that Len 
Burman knows more about the AMT than I do.
    Mr. NEAL. Sometime ago as a Member of the Budget Committee 
as a designee from the Committee on Ways and Means, I had a 
chance to question you in your role, your former role. Is it 
still your position that the Bush tax cuts did not pay for 
    Mr. HOLTZ-EAKIN. I don't think tax cuts pay for themselves, 
and I don't think sensible economic evidence supports that 
position. Good tax policy matters, but it's not somehow a genie 
out of which you can pull money to spend. That's not the way it 
    Mr. NEAL. Thank you. I was driving along in the car, as I 
referenced earlier, a few months back, and I heard you repeat 
that in an interview you were doing with Carey Gross on Public 
Radio, and I thought the fact that you were willing to restate 
that position first in testimony before the Budget Committee, 
with the Public Radio show and today, it's very gratifying to 
all of us.
    Since I haven't used all of my time, I'd like to go to Mr. 
Tanner for inquiry.
    Mr. TANNER. Thank you very much, Mr. Chairman, and thank 
all of you for being here. I don't know of any reasonably sane 
person who thinks this country is on a long-term, sustainable 
financial path. A lot of reasons for that, but I don't know 
anyone who would argue that we can keep doing the same thing 
we've been doing for the last 6 years and be an economically 
viable entity known as the United States of America.
    As you know, I have been talking about this accumulation of 
debt, and we have been arguing vociferously for PAYGO rules 
that mean something, and we've been trying to talk about the 
debt accumulation that has taken place in the last 60, 70 
months as part of a larger problem.
    Balancing the budget is a good idea, but in and of itself, 
I don't think it's all that important. But the consequences of 
what we have done over the last 6 years with this new debt have 
resulted in an erosion of the tax base of about $85 billion a 
year. In other words, had we not embarked on this economic game 
plan that induced all this new borrowing, we would have on the 
same tax base about $85 billion to fix some of these problems 
like AMT, health care, education and so forth.
    What's even more disturbing to me is the fact that 75 
percent of this new debt, 1.6 trillion in the last 60 months, 
has been financed by foreign interests. Now I've talked to Dr. 
Holtz-Eakin about this before. I personally believe that 
countries like China are engaged in a long-term strategy to 
gain financial leverage on this country for a larger 
geopolitical reason, and I think I have some pretty good 
evidence to point that out. When we try to talk to them now 
about the currency or we try to talk to them about something 
else, they're not there yet, but eventually if we keep going 
down this same road, they'll be able to say United States, you 
better stay out of this or we'll roll Wall Street. We have the 
ability to do it.
    But all of that aside, what we're here today to talk about 
is trying to fix AMT specifically but the larger economic 
problem. Almost every economist I've talked to agrees that 
there is no way to cut spending out of domestic discretionary 
spending to fill this gap. It's impossible. There's just not 
enough money. You could virtually abolish the Federal 
Government here in Washington as we know it, and you still 
can't make ends meet if we continue down this path.
    Given that, if you accept that as a fact, and if you accept 
the fact that there's not currently the political will in this 
country to do something about entitlement reform, we have a 
short-term problem that has got to be fixed, because every year 
we borrow another 100, 200, 300 billion dollars, whatever it 
is, we erode the tax base the next year to the extent that we 
start paying interest on whatever we borrowed this year.
    Could I get your collective opinions as to what we can do? 
I personally, when it comes to AMT, the short-term fix every 
year is just money down the drain and it's not a rational tax 
policy to fix a particular problem. I could go on, but I'll 
stop there and ask--I see the yellow light come on--for your 
comments on my ramblings. Thank you.
    Mr. BURMAN. On the issue of AMT, the best thing would be to 
clean up the tax system overall, and as part of that you could 
come up with enough revenues to pay for financing the AMT. You 
could repeal the state and local tax deduction. That would 
raise more than enough money to do it. Those are difficult 
things to do, obviously.
    I put together an option sort of illustrate another 
alternative that would pay for repealing the AMT and retarget 
it on people who were its original intended targets, and that's 
a surtax on adjusted gross income over $200,000 for couples and 
$100,000 for singles, at a 4-percent rate. Now this isn't ideal 
tax policy, but it would be a lot simpler than the current AMT. 
People would understand it. It would actually raises taxes on 
millionaires, who were the original targets, and cut the on 
most other people, and it would be revenue neutral. It wouldn't 
add to the deficit over time.
    Mr. FURMAN. I would suggest--oh, should I answer the 
    Mr. TANNER. Please. Answer it, yes.
    Mr. FURMAN. Okay. Just very briefly, I would suggest two 
steps. One is to do no harm, and that would be the PAYGO rules. 
If you do that, I think you could avoid any immediate fiscal 
problems that we might otherwise face. So, for example, the way 
this Committee has handled S-CHIP by paying for the proposal 
and showing that you can expand children's health insurance 
without expanding the budget deficit.
    In the long run, PAYGO, though, isn't going to solve our 
problem. It's not going to get us out of the hole. It just 
means we won't dig any deeper. I think both the spending side 
and the revenue side are going to need to play a role into 
bring us into long-run fiscal balance, with a lot of the 
emphasis on health care, Medicare and a systemwide health 
    Mr. HOLTZ-EAKIN. I think you've got the diagnosis exactly 
right. This isn't a discretionary spending problem. It's the 
mandatory programs. The good news is, those are in your 
jurisdiction in this Committee. The bad news is those are in 
your jurisdiction in this Committee.
    My concern with the advice you're getting is that if the 
short-term fix is to raise taxes, however, that will always be 
the short-term fix. You will never come to grips with the 
entitlement programs. You cannot in any economically sensible 
way tax your way out of this problem. So if you repeat the 
short-term fix, you will have set course toward a cliff. I 
would encourage you to not do that. It is not something that 
can succeed in the long run.
    Mr. NEAL. Thank you. The gentleman from Missouri, Mr. 
Hulshof, is invited to inquire.
    Mr. HULSHOF. Thank you, Mr. Chairman. I was an economics 
major in college, did not do well in geography, and I'm not 
sure, maybe someone here knows, what point on planet Earth is 
exactly the opposite of Washington, D.C.? But I'm convinced 
after listening to some of my colleagues that we are that far 
apart on economics. That there are some of us here in 
Washington and there are some others on the other side of 
planet Earth as far as what to do about this economy.
    I appreciate my friend, and he is my friend, from 
Massachusetts, referencing the history, Chairman Mills, 
creation of the AMT. I lament the fact that in 1999 the 
President of the United States had the opportunity to 
completely and finally eliminate the alternative minimum tax 
and yet vetoed that bill. I wish we had had a bipartisan 
solution back then.
    Let me pick some of the points that you all have made in 
the time that I have. Dr. Holtz-Eakin, it's great to have you 
back. You indicated that tax policy has little impact on income 
inequality. I think you had been asked that, and you would 
acknowledge that again for the record, would you not?
    Mr. HOLTZ-EAKIN. Yes. It's not the source of income 
    Mr. HULSHOF. Can tax policy have an impact on the growth or 
the contraction of our National economy?
    Mr. HOLTZ-EAKIN. Absolutely.
    Mr. HULSHOF. Could you give an example or two?
    Mr. HOLTZ-EAKIN. Well, there's lots of economic research 
that suggests taxes that target consumption and not income will 
augment long-run savings investment and economic growth. The 
numbers never appear very dramatic, a couple of tenths of a 
percentage point growth rate per year. But remember, a couple 
of tenths of a percent per year is the difference between the 
United States and England. By doing that over a long period, we 
rose from being not much in the way of an economic power to the 
largest economy on the globe, and England went from the largest 
power on the planet to something that is far less impressive. 
That growth matters.
    Mr. HULSHOF. Would, for instance, the reduction of the cost 
of capital or savings and investment; i.e., dividends, capital 
gains, would that in your view at least have a positive 
economic benefit to certain sectors of the national economy?
    Mr. HOLTZ-EAKIN. I would encourage the Members to read the 
written testimony, which goes on at length about how you can 
construct a tax system that has no tax on that return to 
capital, nevertheless meets the standards of fairness, 
simplicity and clarity that I think the American people demand.
    Mr. HULSHOF. This is of course a simplified point of view, 
but my good friend from the state of Washington said, you know 
standing on the side to, as we do ourselves in, because of the 
tax cuts of 2003, and I would remind my friend that the economy 
was shedding 92,000 jobs per month in the 29 months before the 
'03 tax cuts on capital gains and dividends. Since then, the 
increase in net new jobs average about 167,000 per month.
    Now it's a very simplistic view to say that there's a cause 
and effect. Again, going back to those college days, full 
employment was considered to be 5 percent or less, and yet CBO 
says--I mean, we've had 22 straight months of unemployment at 
below 5 percent. CBO says that that rate will be about 4.5 
percent in this year and 4.7 percent in 2008. Again, just 
different view of the world.
    Let me ask you, Dr. Furman, something that Dr. Holtz-Eakin 
said to Mr. Tanner in response to Mr. Tanner. We can't tax 
ourselves out of a problem. Do you agree with that?
    Mr. FURMAN. I absolutely agree with that. I also would 
agree that we could not solve the entire problem on the 
spending side. I think both need to be part of the solution.
    Mr. HULSHOF. Well, let me make sure you understand. Do you 
believe that we can tax ourselves out of this problem or that 
we cannot tax ourselves out of this problem?
    Mr. FURMAN. I think taxes can contribute to solving this 
    Mr. HULSHOF. So, in other words, you think that a nation 
can tax itself into prosperity. You reference such back in the 
1990-1993 tax increases as somehow spurring economic growth. Is 
that your testimony?
    Mr. FURMAN. I believe that both the 1990 and 1993 tax 
increases helped the economy by reducing the budget deficit, 
contributing to national savings and fostering capital 
    Mr. HULSHOF. So, for instance, the 1993 luxury tax, was 
that a positive economic boon for, say, people that built boats 
or built luxury cars? Was that luxury tax then positive in the 
sense that certain sectors of the economy expanded as a result 
of that higher tax?
    Mr. FURMAN. I haven't studied the individual provisions. 
Taken as a whole, increasing national savings can increase 
capital formation and increase economic growth. Reducing our 
budget deficit is one of the main tools that policymakers have 
to raise national savings.
    Mr. HULSHOF. Final question. Do you agree then or disagree 
with the United States Treasury as they report that the top 5 
percent of income earners pay a greater share of the nation's 
bills after the '01 and '03 tax reductions? Do you agree with 
the U.S. Treasury's report on that?
    Mr. FURMAN. That is correct. Their share of income also 
went up over that period and----
    Mr. HULSHOF. Their share or proportion of paying the bills 
here has also gone up even after the tax reductions. Do you 
agree with that?
    Mr. FURMAN. When your share of income goes up, your share 
of taxes paid is going to go up as well.
    Mr. HULSHOF. Thank you.
    Mr. NEAL. We thank the gentleman. Another footnote to the 
gentleman. There were two former presidents that voted for that 
conference report in 1969 as well, President Ford and President 
Bush, Sr. both voted for it.
    The gentleman from Texas, Mr. Doggett, is invited to 
    Mr. DOGGETT. Well, thank you so much for your testimony. 
We've endured 12 long years in this Congress where 
particularly, though not limited, but particularly in the area 
of taxation, logic, fact-based analysis was viewed with 
disdain, and mythology and ideology were very much on the 
ascendancy. It is good to hear all three of you reconfirm the 
obvious, even though it seems to be disputed by some on this 
panel, that tax cuts don't pay for themselves. That theory has 
been the underlying principle for the borrow-and-spend policies 
that we've endured for the last 12 years, and I view it as a 
form of modern alchemy.
    As for no free lunches, to which Dr. Furman referred, we do 
still have at least 500-plus days of an Administration that 
believes in only free lunches now. The policies that we're 
looking at certainly have to consider that.
    It was good to hear all three of you agree as well that we 
need to find more than a short-term fix for the alternative 
minimum tax. Now as to that tax and its origin, which has had 
some discussion, this hearing just happens to coincide with the 
recent passing of Leona Helmsley, who I guess will have as part 
of her legacy the richest dog in America, but she famously said 
that taxes were only for the little folks. I would ask you, Dr. 
Burman, as the person who's been designated as the expert on 
the AMT if you agree that the original purpose of the 
alternative minimum tax that even the richest Americans should 
share in contributing to the cost of our security and other 
necessary services of government if narrowly structured and 
implemented, still remains sound public policy?
    Mr. BURMAN. The idea that somebody should pay a little bit 
of tax versus no taxes, that doesn't come out of any kind of 
economic principle or policy. The real issue is whether people 
were benefiting from tax breaks that were really unwarranted. 
My view is that in fact the best response for Congress in 1969 
would have been to say, look, there are these tax loopholes 
that we've created, that they're taking advantage of. We should 
get rid of them for everybody.
    The problem with the AMT is it says, well, we're going to 
trim it back a little bit so you don't embarrass us by taking 
too much advantage of these defects in the tax system. The 
better approach is to get rid of the loopholes across the 
board, not have two separate tax systems.
    Mr. DOGGETT. With reference to how we correct the AMT on a 
longer term basis, as you're aware, we've had testimony from 
where you're sitting from the Bush administration that they 
don't like the AMT but they refuse to show us how we could 
correct it over a long period of time and pay for it. I don't 
believe any of our Republican colleagues on this Committee have 
suggested any way to pay for correction of the AMT, though they 
join all of us in saying that it needs to be corrected over a 
long period of time. What would be the effect if we just 
followed the administration free lunch now approach and correct 
the AMT permanently or on a long-term basis and don't pay for a 
penny of the correction?
    Mr. BURMAN. I think that would be a very unfortunate 
policy. For one thing, even though middle-class people are 
falling prey to the AMT, most of the tax is paid by people with 
relatively high incomes, $100,000 and over. So, eliminating the 
AMT by itself would be another large tax cut on people with 
pretty high incomes. It would make the tax system even less 
    The other thing is that it would reduce tax revenues by 
$800 billion over the next 10 years. As we've all discussed, 
the revenue demands on the government are going to be 
unprecedented over the next 10 years and beyond, and I think 
that would be problematic.
    Mr. DOGGETT. Dr. Furman, do you agree with that?
    Mr. FURMAN. Yes, I agree with that.
    Mr. DOGGETT. Dr. Holtz-Eakin, do you believe we can correct 
the alternative minimum tax over a long period of time without 
paying for it any way?
    Mr. HOLTZ-EAKIN. I echo what Dr. Burman said, which is this 
should be fixed in the context of the whole Tax Code. We've 
seen examples of, you know, not because I like all the 
particulars, but the President's Advisory Panel put out plans 
that got rid of the AMT, broadened the tax base, you know were 
revenue neutral, and that's the route to go.
    Mr. DOGGETT. Dr. Burman, then, unless we find a way to pay 
for the alternative minimum tax correction, and you referred in 
your testimony to some of those, and Chairman Neal has taken a 
lead on that, there's really no way that this inequity can be 
corrected for the millions of American families that are either 
being impacted today or will be impacted in the future. Is that 
    Mr. BURMAN. Well, you could just eliminate it and increase 
the deficit. But if you're not willing----
    Mr. DOGGETT. Well, let me say no responsible way to correct 
this inequity unless we find a way to pay for it?
    Mr. BURMAN. I think revenue neutral reform is definitely 
the best approach.
    Mr. DOGGETT. Thank you.
    Mr. NEAL. Thank you. With the consent of Mr. McCrery, 
because there are more Members on this side rather than this 
side at the moment, we're going to do two, and Mr. Becerra is 
recognized to inquire.
    Mr. BECERRA. Thank you, Mr. Chairman. I thank the panel for 
their testimony. Appreciate it very, very much as we try to 
formulate some sound policy to address some of the concerns 
that taxpayers have expressed to us over the years.
    Let me try to touch on one point for 1 second. My 
understanding is that we have a civilian workforce being--not 
counting the military--of something approaching 150 million 
Americans who are employed. Today we have an unemployment rate 
hovering somewhere around 4 percent, 5 percent. There are some 
7 million, close to 7 million or so Americans who are 
unemployed. I make this comment only because my friend and 
colleague, Mr. Hulshof, made the point that full employment has 
often been described as being 5 percent, only 5 percent of 
Americans unemployed. I think we have to dispense and dispose 
of that type of thinking that we can call full employment 7 
million Americas, more than 7 million Americans in this 
economy, without work. I think that's one of the difficulties 
that I think economists run into and policymakers. When we talk 
about full employment, meaning when we've got 95 percent of 
Americans employed, or in this case, over 7 million Americans, 
that means they're out of luck, and we would totally discard 
them in our consideration of our policies if we feel we're 
under an economy with full employment.
    I think that's one of the reasons we have these 
difficulties today with regard to tax policy. When we hear 
people talk about tax cuts being the savior for the economy and 
for the American worker, I think all three of our witnesses, 
our expert witnesses, have said that tax cuts by themselves do 
not pay for their costs. If that's the case, the Bush tax cuts 
don't and won't pay for themselves either. Now that we find 
that it's really as a result of the Bush tax cuts that this 
alternative minimum tax problem will begin to hit more and more 
Americans that never thought that they would be lumped in with 
Exxon Mobil and all these other very lucrative companies and 
very, very wealthy Americans, it's because we have policies 
that seem so out of touch here in Washington compared to what's 
going on in average America. I think we do have to come up with 
a more rational approach.
    To me, the AMT is a symptom of our very chaotic Tax Code 
that tries to address general problems, but when you actually 
come down to it, the special interests get a better grip on the 
policy than do average Americans, and what we end up with is 
not what we thought we would conclude with it, quite honestly.
    My question to the three of you, whoever would like to 
answer this, is the following. If we do AMT relief, to whom 
should we target it?
    Mr. BURMAN. My preference would be to eliminate the AMT 
altogether and make up the revenues by making the tax system 
more progressive. The problem with the AMT is that it's hitting 
people whom it was never intended to hit. Certainly somebody 
earning $75,000 and taking the standard deduction was never the 
intended target of the AMT. They didn't choose to have their 
children as a tax shelter device. Even if they did, they 
probably should still be applauded because they're helping with 
the long-term entitlement problem.
    Mr. BECERRA. So, Dr. Burman, I sense what you're saying is, 
to make the Tax Code more progressive and to try to eliminate 
the disparities that we see today that middle class and modest 
income working families seems to be paying a greater share of 
their income in taxes than do those who are becoming very 
wealthy, that you would make it more progressive and therefore 
tax--make sure the Tax Code reflects that the more--the higher 
your income, the more you're going to pay in taxes?
    Mr. BURMAN. Right. The original intent of the AMT was to 
make sure the people who in current dollars would be 
millionaires were paying at least some tax, and the 4 percent 
surtax that I laid out would be one simple approach to do that. 
It would take the AMT completely off the backs of couples 
earning less than--$200,000.
    Mr. BECERRA. You wouldn't AMT if you had a progressive Tax 
Code because you'd always make sure that people are paying 
their fair share of taxes?
    Mr. BURMAN. Right. It would be nice to broaden the base and 
get rid of the unwarranted loopholes. That might even allow you 
to lower marginal tax rates, which would make Dr. Holtz-Eakin 
and the rest of us happier.
    Mr. BECERRA. Dr. Holtz-Eakin, I sense that you may want to 
    Mr. HOLTZ-EAKIN. I think he said something with which I 
disagree. I mean, you don't always need an AMT to have a 
progressive tax. You shouldn't have an AMT. The AMT is an 
acknowledgement that the tax system is broken. The basic job of 
constructing a Tax Code that raises the revenue in a sensible 
fashion has not been accomplished. It's not that the AMT is 
there to make sure that high-income people pay more taxes. It's 
to make sure that they don't exploit the loopholes provided 
legally in the regular tax in order to not pay taxes.
    So, be clear. The goal is not to have an AMT, because that 
would say, gee, we want to continue to fail at having a 
sensible Tax Code. No. We do not want to have that as the goal. 
How to target the AMT, I have no good guidance to give you. We 
don't have a tax system that has any foundation in terms of 
trying to meet objectives of fairness. It taxes high-income 
people who are productive, employing people, eager to improve 
the surroundings, are donating money to charity, the same as 
high income people who are slugs. That makes no sense to me. So 
I don't see how you ethically fix a tax system that has no 
ethical foundations. I wish you luck.
    Mr. BECERRA. I appreciate your answers [continuing]. Thank 
you very much, Mr. Chairman. I yield back.
    Mr. NEAL. Thank you. The gentleman from Kentucky, Mr. 
Lewis, is recognized to inquire.
    Mr. LEWIS OF KENTUCKY. The American people feel very simply 
this way, I do not think they feel like they do not pay enough 
taxes. I think their concern these days is how much the 
government is spending. Dr. Burman, your testimony shows a 
chart indicating that about 16 percent of all income is earned 
by the top 1 percent. Treasury and CBO data show the share of 
individual income taxes paid by the top 1 percent is about 37 
percent. Does this suggest the Tax Code is progressive in 
imposing greater burdens on higher income earners. That goes 
without saying.
    Mr. BURMAN. The Federal Tax Code overall is progressive.
    Mr. LEWIS OF KENTUCKY. If 37 percent is not enough, then 
how much would you like to see the top 1 percent pay? I think 
that is what I am trying to get here today: what is fair?
    Mr. BURMAN. It is actually not up to me to make that 
decision, you as the elected Representatives have to reflect 
what the people's preferences of the public are. People in 
polls overall, over the last 50 years anyway, have supported 
the idea of a progressive tax system where high-income people 
pay a larger share of their income in tax than lower income 
people. My personal view is that high-income people are doing 
so well that they could probably afford to carry more of the 
burden. They have gotten the largest gains from the economic 
growth over the last 20 years but it is really your call.
    Mr. LEWIS OF KENTUCKY. What share of taxpayers, and this is 
not a question, 37 percent of all income taxes are paid across 
the board by 90 percent of the lower income. The other question 
is should the upper income folks take over more of that burden 
or take over all of that burden?
    Mr. BURMAN. Well, there is certainly an argument for having 
everybody pay at least a little bit of tax. That said, low-
income people are in a situation where they really need help 
from the government. One nice approach is the refundable earned 
income tax credit, which can offset the income tax liability of 
people who are working and cannot afford to feed and clothe 
their families.
    I should also point out that if you just look at the income 
tax data, you get a somewhat misleading picture because most 
American families pay more in payroll taxes than in income 
taxes. If you look at taxes overall, payroll, excised income 
and state taxes, people at every income level are paying 
positive tax liability, it is relatively low at the bottom and 
around 20 to 25 percent at the very top. Even at the top, at 
the very top of the income distribution, people get to keep 
something like three quarters of the income that they are 
    Mr. LEWIS OF KENTUCKY. Mr. Tanner of course I think brought 
up the ultimate question, government expense is growing faster 
than what eventually we can tax the American people to keep it 
going, The PAY-GO rule, if we are going to spend more, we are 
going to have to figure out how to come up with the money, cut 
spending somewhere else or increase taxes. What is the breaking 
point for the American people? Wealth is created in the private 
sector, not in government. There comes a point when we kill the 
goose who is laying the golden egg and, as has been said here 
today, we cannot tax our way out of it but we are going to 
reach a point where we cannot grow the economy to meet the 
cost. So, we are going to have to come up with some good tax 
policy, and we are going to have to come up with a way to 
provide the necessary programs for the American people without 
breaking them. So, anyway I yield back. Thank you.
    Mr. NEAL. We thank the gentleman. Mr. Pomeroy is recognized 
to inquire.
    Mr. POMEROY. Well, I like my colleague's phrasing, I think 
he has squarely put forward an economic view and ideological 
view of the whole supply side economic theory that is addressed 
in this month's New Republic. I would just like to quote from 
an article discussing this theory: ``Supply side economics is 
not merely an economic program, it is a totalistic ideology. 
The core principle is that economic performance hinges almost 
entirely on how much incentive investors and entrepreneurs have 
to attain more wealth and that this incentive in turn hinges 
almost entirely on their tax rates. Therefore, cutting taxes, 
especially those of the rich who carry out the decisive 
entrepreneurial role in the economy, is always a good idea.'' I 
would like to ask our economists, each of whom I have great 
respect for and think that you draw your conclusions based upon 
the numbers, whether there is history to support this view, 
that in the end our ability to grow the economy depends on 
whether people invest and whether people will invest depends 
upon how much their tax rate is and so that reducing the tax 
rate always brings more investment? Let's start with you, Dr. 
Holtz-Eakin. I have got several more questions, I guess two 
more questions, so if we can do it quickly.
    Mr. HOLTZ-EAKIN. First and foremost, I do not think any of 
the major Ph.D.-granting economics departments uses The New 
Republic to teach economics, and so I would encourage us to 
look for more informed sources.
    Mr. POMEROY. Actually, just to reclaim the point, I do not 
quote The New Republic as an economic source, I do think this 
particular article in doing an analysis on the economic basis 
of the supply side economic theory offers value for our 
discussion today. In that respect, is there economic data that 
supports the view that a further reduction in tax always 
produces more incentive to invest and therefore the more you 
cut taxes, especially on the rich, it guarantees economic 
    Mr. HOLTZ-EAKIN. Every economist is trained that economic 
growth is a supply side phenomenon in the following sense: To 
grow, you must expand your capacity to produce by giving up 
something today and investing in either greater physical, 
    Mr. POMEROY. No, no, in the filibuster, is that completely 
related, Dr. Holtz-Eakin----
    Mr. HOLTZ-EAKIN. No, no, that is actually, with all due 
    Mr. POMEROY [continuing]. Into the tax rate applied?
    Mr. HOLTZ-EAKIN. With all due respect, if you want to 
answer the question correctly, you have to frame it correctly 
and so the question is how do you accumulate technology, 
physical capital, human capital, skills which allow the economy 
to be more productive? The answer is through incentives. Now 
where do taxes fit in that? Taxes impair incentives and so you 
should only use taxes to impair incentives if there are 
beneficial public programs that they need to finance period. 
You should not ever raise taxes----
    Mr. POMEROY. You are not answering my question and you are 
burning up my time, so let me ask you is the decision to invest 
or not invest hyperlinked to the tax rate? Is that the 
principal driving issue driving entrepreneurial investment in 
our economy?
    Mr. HOLTZ-EAKIN. It is inextricably linked to taxes, they 
are part of the rate of return. No way to take it out.
    Mr. POMEROY. Of course it is a factor, is it the principal 
factor so that cutting taxes, especially those on the rich, 
will always produce economic growth?
    Mr. HOLTZ-EAKIN. Those are two different things.
    Mr. POMEROY. Okay, you apparently have no interest in 
answering the question, move to the next panelist.
    Mr. FURMAN. An important determinant of national investment 
is national savings and, as I have talked about before, in the 
nineties we had higher tax rates, we also had higher rates of 
investment, higher rates of savings, higher rates of job 
growth. So, clearly the Tax Code in the nineties was compatible 
with very strong economic growth and, as I said, I believe it 
contributed to that strong economic growth by fostering 
national savings. There is more than just taxes that matter for 
economic growth. I am a supply sider, I agree with Dr. Holtz-
Eakin that it is the supply side that can create growth in the 
long run but for that supply side, you need high national 
savings, you need for example investments in the NIH, which 
went up in the nineties and have been cut in real terms in 
recent years. There are a lot of elements to a strategy for 
supply side economic growth that have nothing to do with lower 
    Mr. POMEROY. Pursuing the national savings issue, and, Dr. 
Burman, we will give you a shot at the question, but pursuing 
the national savings issue, I have distributed a chart and it 
is displayed and it tracks the national savings rates. You will 
see that the government savings, the bottom line goes into 
surplus but sharply into deficits featuring in part the revenue 
loss of the tax cuts passed under this administration. But as 
you look, even though those deficits while still in deficit and 
no longer a surplus, seems to be abating a little, the national 
savings rate has plummeted and is actually in deficit. So, the 
question then raises, Dr. Furman, has the tax cut strategy we 
have embarked upon under this administration produced an 
increase in national savings or has it actually potentially 
contributed to a national savings problem?
    Mr. FURMAN. Right, I would say almost any economist would 
agree that our National savings rate is between one and 2 
percentage points lower than it otherwise would have been if we 
had not had the tax cuts that were passed beginning in the year 
2001, without the tax cuts we would be saving one to 2 
percentage points more depending----
    Mr. POMEROY. With the Chairman's leave, could Dr. Burman 
briefly respond to the first question, basically the Laffer 
Curve question?
    Mr. BURMAN. It depends, I think this is what Dr. Holtz-
Eakin was trying to say, on how you cut taxes. If you cut taxes 
by broadening the tax base, holding revenues constant, most 
economists would say that that would encourage savings, 
investment and economic growth. If you do what we did in 2001 
and 2003, borrow the money to finance the tax cuts, on the one 
hand individuals might have an incentive to save more, 
businesses to invest more, but the government is borrowing more 
and that is draining the capital that businesses need to 
finance for investment, increasing interest rates. The other 
thing is looking at the savings rate, it is hard to make 
personal savings move. Almost all the economic evidence 
suggests that personal saving is relatively unresponsive to tax 
rates. I am not saying there is no response but it is very 
small. So, basically tax cuts can be good for the economy, they 
could be bad for the economy. Tax increases is the same thing.
    Mr. POMEROY. But if you are going to have tax cuts that are 
good for the economy, they should be paid for so you do not 
drive the deficit deeper. They should be broad-based and the 
distribution tables we have seen of the tax cuts recently 
enacted during this administration show disproportionate effect 
to the wealthiest few, probably not spurring deeper investment. 
They already had the money to invest. I yield back.
    Mr. NEAL. We thank the gentleman. The gentle lady from 
Ohio, Ms. Tubbs Jones, is recognized to inquire.
    Ms. TUBBS JONES. Thank you, Mr. Chairman. I want to salute 
you or celebrate you for all the work that you and the Chairman 
have been doing in this area. I am pleased to have an 
opportunity to participate in this discussion, particularly 
about AMT. I am looking at some statistics that arise from the 
11th Congressional District of Ohio and the people who are 
impacted by this imposition. I am personally of the belief that 
we need to do more than put a bandage on the AMT, that we need 
to in fact implement it such that it is taken care of over a 
period of time so that taxpayers, much like businesspeople, 
have a knowledge about what is going to happen in the future 
for their planning.
    I in fact have two letters from my constituents, one dating 
back to--originally back to 2005 in March and it comes from a 
young man by the name of Tony Mastrioani, and he says, ``When 
we worked together in the prosecutor's office, we prosecuted 
matters deemed criminal by statute. For how it will potentially 
decimate our district and others, alternative minimum tax ought 
to be considered criminal. The AMT increased my Federal tax 
liability by over $13,000. This increase did not result so much 
from my income level but rather was directly related to the 
fact that Cleveland Heights has among the highest property tax 
rates in the state and the state of Ohio is among the states 
with the highest income tax rate.'' It goes on to talk about 
what he thinks we ought to do to fix the AMT.
    Another letter from another constituent of mine by the name 
of Doug Bondman says, ``I am writing to strongly encourage you 
to repeal, re-write the AMT statute. As you are probably aware, 
when the AMT was established, there was no provision for 
inflation adjustment.'' So I am concerned that this 
administration, in the course of trying to fix taxes, has 
failed at any point other than say we will fix it year by year. 
I am only going to give a short amount of time, answer that 
question for me first, Mr. Furman, your position or your 
comment with regard to what I have discussed about AMT? Burman, 
I am sorry, Mr. Burman, I apologize.
    Mr. BURMAN. I completely agree with you that the AMT ought 
to be eliminated. I do not think it has a place in the income 
tax and there are a number of options to do that in a fiscally 
responsible manner and it would be great for you to do it.
    Ms. TUBBS JONES. Mr. Furman.
    Mr. FURMAN. I agree with that as well. I would like to say 
as part of a broad tax reform, it would be wonderful to get rid 
the AMT. The AMT should not be necessary. If this Committee 
were able to undertake something that eliminated the AMT for 
the vast majority of people that paid it but still kept it in 
place for higher income people, I think that would also be a 
very substantial contribution to improving tax policy in this 
    Ms. TUBBS JONES. Mr. Holtz-Eakin, I am going to switch to 
another subject matter. Did I hear you say that there was no 
ethical standard in our taxing policy, is that what you said?
    Mr. HOLTZ-EAKIN. When I see the U.S. income tax, I do not 
see anything that looks like a coherent approach to taxation 
that is based on single standards for raising revenue, 
achieving economic efficiency and having some notion of 
    Ms. TUBBS JONES. So, you do not really intend to use the 
term ``ethical?'' You know I am chair of the Ethics Committee 
so I am concerned about what you are saying the conduct of 
Members of Congress as ethical, so you do not really mean that 
it is not ethical?
    Mr. HOLTZ-EAKIN. One can look at pieces of the Tax Code and 
wonder if they have an ethical foundation that we would not be 
proud of because there is no place in a good Tax Code for rifle 
shot provisions that----
    Ms. TUBBS JONES. Maybe you ought to define ``ethical'' for 
    Mr. HOLTZ-EAKIN. What are you trying to achieve with the 
Tax Code? What is the standard of fairness? Mine would be that 
we should tax people more if they take more out of our economy. 
We should tax them on that basis, not on the basis of what they 
contribute. Income is a measure of what you contribute to an 
economy. It is your labor, it is your capital, it is your 
skills and energy. Consumption is what you take out.
    Ms. TUBBS JONES. Mr. Eakin, thank you. I am running out of 
time. I have one more question. Tell me in two or three words, 
each of you, how you can say, if anybody says that the tax 
policy does not cause inequality in this country? Tax policy 
absolutely causes inequality in this country even if it is 
based on the income of the people, we are looking at the fact 
that the income in this country has separated, that there are 
more rich people and more poor people than ever. There is this 
disparity, how is it that tax policy could not have an impact?
    Mr. BURMAN. The point we were making I think that it is not 
likely it is a major factor in the distribution of pre-tax 
income. My position is that the income tax plays an important 
role in the distribution of aftertax income, that is it can 
mitigate the effects of rising economic inequality. Of course, 
over the last 6 years, the tax system has actually been going 
in the opposite direction and becoming less progressive at the 
same time that pre-tax incomes have been spreading out.
    Ms. TUBBS JONES. So, you are saying it has become less 
progressive and therefore it has a greater impact on the income 
of folks?
    Mr. BURMAN. On aftertax income, which is of course what 
matters to individuals.
    Ms. TUBBS JONES. One more answer and then I am done. Mr. 
    Mr. FURMAN. The changes in the tax policy have not caused 
the increase in inequality but had we not changed tax policy, 
then the Tax Code would have solved a meaningful portion of the 
    Ms. TUBBS JONES. But the fact that the way our tax policy 
operates, it operates in the interest of people giving to 
charity and charity impacts those at the lower income stream 
because are more generous only because the Tax Code allows them 
to be generous?
    Mr. FURMAN. Oh, aftertax income is higher this year than it 
would have been in the absence of the tax cuts enacted starting 
in 2001.
    Ms. TUBBS JONES. I am out of time. Thank you.
    Mr. NEAL. I thank the gentle lady. The gentleman from New 
York, Mr. Reynolds, is recognized to inquire.
    Mr. REYNOLDS. I thank the Chairman for holding this 
important hearing, which touches two critical tax policy issues 
that I have been involved with for some time: the tax treatment 
of carried interest and the tax relief from the AMT or, as I 
like to call it, the ``stealth tax.'' I want to take a moment 
to talk about a few key aspects of these two key issues, both 
because they have such an enormous impact in my home state of 
New York, as well as the country as a whole. Let me make three 
specific points about the Levin-Rangel proposal to raise taxes 
on investment partnerships by reclassifying their carried 
interest as ordinary income rather than capital gains.
    First, the Democrats are using Blackstone as a Trojan horse 
to smuggle into law higher taxes on capital gains. Anyone who 
thought the new Democratic majority might actually wait until 
2010, the year the lower taxes on capital gains and dividends 
are scheduled to expire, to raise taxes on investments should 
be concerned. This bill is likely just the first of many 
legislative assaults on the very tax incentives that have 
helped create 8.3 million jobs over the past 4 years, a period 
that has seen net job growth of 47 consecutive months. Indeed, 
Democrats' new PAYGO rules will inevitably force them into 
additional massive tax increases in order to fund their 
voracious appetite for spending. While certain Wall Street fund 
managers may be easy political targets, it is clear the new 
majority is using Blackstone as the Trojan horse to sneak 
through far broader tax increases. But the truth is that the 
2003 tax cuts have worked. Mr. Chairman, notwithstanding some 
of the revisionist history we will hear today that we have 
already heard and will hear, particularly with the recent 
turbulence we have seen in the credit markets, now is not the 
time to make an economic u-turn by raising taxes, especially 
when those tax hikes would discourage capital investments.
    Second, this proposal would have a profound impact across 
our National economy, from Wall Street to Main Street. 
Proponents of the carried interest rate tax hike claim they are 
only going after wealthy private equity hedge fund managers, 
the Wall Street ``fat cats'' that so offend Democrats' notion 
of tax fairness. However, the Levin-Rangel bill would actually 
affect not just private equity and hedge funds but partnerships 
across the spectrum, from small venture capital firms to local 
real estate partnerships in each of our communities.
    When Democrats use the phrase ``tax fairness,'' watch out, 
it always seems to translate into tax increases on the middle 
class. Indeed, not just investment partnerships themselves will 
be affected by the Levin-Rangel proposal. Lost in all the 
political rhetoric is the fact that university endowments, 
charitable foundations, and public and private pension plans 
are among the biggest investors in private equity and hedge 
funds. For example, New York's common retirement fund, the 
nation's third largest public pension fund with over one 
million members, retirees and beneficiaries, have made 
substantial investments in private equity and other alternative 
investment vehicles. It helps bring the consequences of this 
proposed tax hike into focus when we remember that grandma's 
retirement security may be at stake.
    Third, this proposal would hurt U.S. competitiveness in 
global financial markets and further undermine New York's 
position as the preeminent financial center of the world. As 
the sole Republican Member on this Committee from New York, I 
am particularly concerned that this legislation would make a 
bad situation worse for U.S. competitiveness in international 
capital markets, especially in the wake of Sarbanes-Oxley. 
Though well-intentioned, Sarbanes-Oxley is now widely viewed as 
having put a significant drag on our economy and having 
undercut our capital market competitiveness where once New York 
was unquestioned global headquarters for capital formation. For 
example, billion dollar IPOs now occur far more regularly in 
London and Hong Kong. Unfortunately, the damage Sarbanes-Oxley 
has caused through excessive corporate regulation would only be 
compounded by the Levin-Rangel carried interest proposal 
through higher taxes on investment partnerships. The last thing 
Congress needs to do is give investment partnerships new 
reasons to explore their global options by imposing new taxes 
on entrepreneurial risk taking here at home.
    Let me turn briefly to AMT. The new majority talks a good 
game about wanting to solve the AMT problem but history shows 
that Democratic majorities created the AMT regardless of the 
vote outcome in 1969, made it worse in 1993, opposed full 
repeal of this unfair stealth tax in 1999. Republicans on the 
other hand have consistently enacted legislation to limit AMT's 
growing reach into the middle class during our years of the 
majority. As author of the House Middle-Class AMT Relief bill 
for 2006, the Stealth Tax Relief Act, I was pleased that 
Congress was able to enact the most recent temporary patch 
without raising taxes and with an overwhelming bipartisan vote 
of 414 to 4. But now more than 8 months have come and gone 
since that temporary relief expired, and we are still yet to 
see an actual proposal from House Democrats on how to address 
the AMT.
    While I had originally hoped that we could have used these 
past few months to make bipartisan progress on long-term AMT 
solutions, the time has come to begin focusing our attention on 
a realistic temporary fix for middle class America stealth tax. 
Just as Senator Bachus has recommended and just as we did in 
2006, we should enact that critical relief without raising 
taxes somewhere else.
    I thank the Chairman and yield back the balance of my time.
    Mr. NEAL. We thank the gentleman. The gentleman from 
Connecticut, Mr. Larson, is recognized to inquire.
    Mr. LARSON. Thank you, Mr. Chairman. Mr. Chairman, let me 
acknowledge your work and that of Chairman Rangel to provide 90 
million Americans with direct tax relief finally. A lot of 
crocodile tears on the other side of the aisle about everything 
that would have, could have, should have. It has taken the 
leadership of Mr. Neal and Mr. Rangel to bring this to 
fruition, and I commend you both for that. I also commend our 
analysts today (a) for your endurance and your willingness to 
take a number of obvious important questions as it relates to 
this subject matter before us. The first question I have 
because it is always good discussion here on the Committee is I 
believe it was Milton Friedman who famously said, ``To spend is 
to tax.'' Are tax cuts simply another form of spending?
    Mr. FURMAN. No, what he meant is that if you lower taxes 
today at the same time that you raise spending, which is what 
we have seen for the last 7 years, you are not actually 
lowering the long-term tax burden, you are shifting taxes by 
borrowing money today, which necessitates for any given level 
of spending even higher taxes than you would otherwise have had 
in the future. So his point--and I know a number of 
conservative economists who have argued that the tax cuts 
enacted in recent years do not need an economic definition of 
tax cuts because they have been accompanied by higher debt and 
will lead to higher taxes in the future.
    Mr. LARSON. Well, if that logic follows through, would 
refusal to extend the Bush tax cuts simply be a choice not to 
spend more money to the wealthy?
    Mr. FURMAN. It would be a choice to borrow less and would 
mean that we would need less of a tax increase in the future 
when our entitlement problems are severe.
    Mr. LARSON. Do the other panelists want to comment?
    Mr. HOLTZ-EAKIN. I think it is really simple, the threshold 
issue is do you spend the money, so do you authorize and 
appropriate money out of the Federal budget? Once you do that, 
you are going to pay for it. If you choose not to raise taxes 
this year, you will borrow and raise taxes to pay off that 
debt. There is no way around that. His point was simply if you 
commit to those resources in the public sector, you will take 
them from the private sector one way or another.
    Mr. BURMAN. There used to be a commercial for a muffler 
company saying, ``You can pay me now or you can pay me later.'' 
Basically if you spend money, you have to pay for it. You can 
pay for it with current taxes or future taxes or future 
spending cuts.
    Mr. LARSON. I believe it was the Fram Oil commercial as a 
matter of fact and so the American public is paying now and 
will be paying later.
    With respect, Mr. Furman, in the Hamilton Project paper you 
co-authored, you wrote, ``As capital moves more quickly across 
borders, capital income becomes increasingly elusive of tax.'' 
It often seems to me that there are separate sets of rules for 
different people and that this contributes greatly to income 
inequality. We are very good at taxing wages, people fill out 
W-2's and the employer withholds the tax and so forth. In this 
age of globalization, it seems there are more and more ways of 
making money and often the IRS and Congress itself cannot keep 
up. So, my question is, I hope you will all join in, but are 
sophisticated financial systems making it easier for 
corporations to avoid paying taxes? If so, how do we make the 
rules, i.e., the Tax Code, more fair to ensure that everyone 
can benefit from globalization? Are we now in the 21st century 
working with a Tax Code that was designed for another century? 
If so, how do we remedy this?
    Mr. BURMAN. I think those are probably the hardest 
questions that will be facing us over the next couple of 
decades. It certainly is true that globalization and technology 
have made it harder to sustain a tax base. Some people would 
say, well, the problem is you are trying to tax income but, as 
Dr. Holtz-Eakin has pointed out, that exempting the return to 
savings or exempting savings from taxing under a consumption 
tax does not solve the problem, you shift it. Right now we have 
to measure income. People try to hide income from the Treasury. 
If we said we were only going to tax spending, then people 
would make wages look like spending. The best thing is to 
eliminate as many loopholes as possible, to broaden the base 
and keep the rates as low as you can while maintaining 
revenues. One thing we all know is that the rewards for tax 
avoidance and evasion go up the higher the tax rate is, so that 
puts a huge premium on having a relatively efficient tax 
    Mr. LARSON. Mr. Furman.
    Mr. FURMAN. I would say there are some places where there 
are disagreements between the parties and between the different 
persuasions, like the level at which you want to tax capital. 
One thing we should all agree on though is that you want to tax 
it in a consistent and coherent manner. So, for instance, it is 
indefensible that debt-financed investment right now, corporate 
investment is taxed at negative 6 percent. No one would defend 
that at the same time that equity financed corporate investment 
is taxed at 36 percent. So, the substantial scope for making 
the tax rate that you pay on different types of activities, 
corporations, partnerships, debt, equity, different forms of 
investment at the business level, at the individual level, 
making those more coherent. Once you are paying similar tax 
rates on different types of activities, you can make those tax 
rates lower, you can reduce the rewards to financial planning, 
and you can do a better job of dealing with some of those 
challenges in terms of technology, financialization and 
globalization that have been eroding our tax base.
    Mr. LARSON. I see that my time has expired. I do not know 
if the Chairman----
    Mr. NEAL. I thank the gentleman. The gentleman from Oregon, 
Mr. Blumenauer, is recognized to inquire. There are four votes 
on the House floor. We will move to Mr. Ryan next after Mr. 
    Mr. BLUMENAUER. Thank you very much, Mr. Chairman.
    Chairman RANGEL. I really do not know whether we have time 
to do this in the regular order, notwithstanding the fact that 
those who have not inquired want to inquire. It would mean 
bringing the panel back, and I guess that would be close to 45 
minutes. However, if there are people who are scheduled to 
speak that would be willing to yield and be the first ones to 
come back to testify, if that is so, it would prevent us from 
having to bring the panel back. So, let me informally ask, 
among those who are about to inquire, any of you willing to be 
the first to inquire of the second panel by yielding so that we 
can dismiss this panel?
    Mr. BLUMENAUER. If that is your preference, Mr. Chairman, I 
am happy to relinquish----
    Chairman RANGEL. Is there anyone who would have a problem 
with it but that would prefer that the panel come back? There 
is no way in the world for us to do this anyway. The only 
question is whether or not those who want to continue would 
have the panel come back. If you put up your hand and say you 
want them to continue, then they will have to come back even if 
it is only one. But if unanimously you are prepared to say that 
you will accept the priority in terms of those of you who have 
not questioned the panel, then it will make it easier for us to 
go vote and then do that. As a matter of fact, I would ask that 
you consider that, would you? Well, by unanimous consent, we 
want to thank this panel because they have agreed to come back.
    Mr. RYAN. Mr. Chairman? We still have about 5 minutes left, 
can we do about 5 minutes before they leave?
    Chairman RANGEL. Yes, it will be a Democrat that is up for 
5 minutes, will that help you at all?
    Mr. RYAN. I have got one question.
    Chairman RANGEL. No you do not because you are not next. 
Mr. Blumenauer has got 5 minutes.
    Mr. RYAN. No, after Earl. We have what 6 minutes left on 
the clock?
    Mr. NEAL. There is time for Mr. Blumenauer to inquire.
    Mr. RYAN. Look, it is fine, I am just saying we can run 
this thing out to the end, then let's dismiss the panel. That 
would be all I would suggest. Let's use up what time we have 
and then dismiss the panel.
    Chairman RANGEL. Okay, Mr. Blumenauer, I am asking to yield 
to the gentleman, yield to you for your questions.
    Mr. RYAN. Thank you.
    Chairman RANGEL. I would just like to hear the question 
    Mr. RYAN. I just had one quick question I wanted to ask.
    Chairman RANGEL. I want to listen to it.
    Mr. RYAN. Wonderful. I wanted to ask each of the three of 
our economists, this is probably a yes or no answer, do you 
believe that a lower capital gains tax rate on capital gains is 
appropriate? Then I have one follow-up. Let's just start with 
you, Mr. Burman, and go down the line.
    Mr. BURMAN. Sorry, a lower capital gains tax rate?
    Mr. RYAN. Is a lower capital gains tax rate a good thing, 
is it appropriate?
    Mr. BURMAN. No, I have a book on the subject.
    Mr. RYAN. I realize that. Mr. Furman and Mr. Holtz-Eakin.
    Mr. FURMAN. I would like to see us move toward a more 
consistent way of taxing capital and business income and that 
consistency is more important to me than the ultimate rate that 
you end up at.
    Mr. HOLTZ-EAKIN. Yes.
    Mr. RYAN. Okay, Mr. Burman, because you have written most 
extensively on this, you just did this very interesting op-ed 
in the Washington Post about a month ago where you basically 
conclude, and correct me if I get this wrong, that the whole 
debate about carried interest, really if they want to get this 
right from your perspective, which is not to tax carried 
interest at the capital gains rate, instead of just plugging 
this particular loophole so to speak, we should just get rid of 
the lower preferential rate on capital gains altogether and 
that if they do not do that, if they are short of that, then 
smart people will get around whatever block Congress puts in 
front of it, like the Rangel-Levin bill, and they will find 
another way of taxing carried interest at 15 percent instead of 
the higher 35-percent rate which you seem to advocate they 
ought to go to, is that correct?
    Mr. RYAN. I would eliminate capital gains tax rate except 
in the case of corporate stock where there is an argument for 
providing a credit for taxes paid at the company level. So, 
putting something in the Code to prevent carried interest from 
being taxed as capital gains, from your perspective the only 
real way to do that is simply to eliminate the preferential tax 
treatment on capital gains itself and then, as you mention, on 
double taxation on corporate tax credits, is that basically 
what you are saying we ought to go to?
    Mr. RYAN. If you cannot fix the capital gains tax regime 
overall, it would make sense actually to get rid of the tax 
break and to move in the direction of the right taxes, which is 
taxing these things that seem to be gains as income. So, I 
would not agree with that.
    Mr. RYAN. I just think it sheds light on where this 
ultimate debate kind of ends up going. I thank the Chairman for 
his indulgence.
    Mr. NEAL. I thank the gentleman. Mr. Davis has asked that 
he be allowed to use 1 minute to get to the panelists.
    Mr. DAVIS. Thank you, Mr. Chairman. I just want to pose one 
question and invite whichever one of you wants to take it, a 
swing at it. One of the ironies to me, when the administration 
sent up its budget earlier this year, there was a very 
interesting contradiction. As it has done the last several 
years, the administration resumed permanence of the 2001 and 
2003 tax cuts and made a number of representations about their 
essentialness to economic growth and job creation. At the same 
time, the administration beyond a 1 year fix, presumed that the 
AMT levels would continue to escalate over the next several 
years. I thought that was a striking contradiction. If we are 
concerned about tax rates impacting economic growth, it would 
seem to me that we would be equally concerned about the AMT 
levels. Do any of the three of you, perhaps you Dr. Holtz-
Eakin, want to comment on that contradiction and whether you 
were struck by it as well?
    Mr. HOLTZ-EAKIN. I did not read the budget carefully enough 
to be struck by it but the bottom line is the Tax Code affects 
growth through its incentives on----
    Mr. DAVIS. Well, just speak to that point, do you see that 
as a contradiction or any one of you want to speak to that?
    Mr. HOLTZ-EAKIN. All marginal tax rates matter whether they 
are AMT or otherwise. That is that.
    Mr. RYAN. Dr. Furman.
    Mr. FURMAN. I think it essentially is not a budget, does 
not even meet the definition of a budget if it does not include 
a set of very predictable things both on the tax side and 
spending side in the future.
    Mr. NEAL. I want to thank the panelists, as usual, most 
informative and delighted you were here. The Chair will declare 
the Committee in recess.
    Mr. NEAL. We will begin to receive testimony.
    Mr. Shay, we would like to welcome you to open testimony 
for the second panel.
    Mr. SHAY. Thank you, Mr. Chairman. My name is Stephen Shay. 
I am a partner at the law firm of Ropes & Gray. The views I am 
expressing today are my personal views and do not represent the 
views of either my clients or my law firm.
    With the Chairman's permission, I would like to submit my 
testimony for the record and summarize my testimony in 
hopefully brief oral remarks.
    Mr. NEAL. So, ordered.

                     BOSTON, MASSACHUSETTS

    Mr. SHAY. I will direct my testimony toward how fairness 
concerns may be taken into account in U.S. tax rules relating 
to the taxation of foreign business income, that is income 
earned from conducting economic activity outside of the United 
States. There is a joint Committee pamphlet that has a good 
summary of our international tax rules so I will not cover 
    I have previously testified that the current U.S. rules for 
taxing international income, foreign income, while complex do 
represent the best of all worlds for U.S. taxpayers engaged in 
international activity. Taxpayers that are earning high tax 
foreign business income can use excess foreign tax credits 
against other low tax foreign income. The effect of this cross-
crediting is to provide an incentive to a taxpayer with excess 
foreign tax credits to earn low taxed foreign income and then 
to credit the high foreign tax against the U.S. tax on this low 
foreign tax income. So, the current state of our credit rules 
does provide an incentive to invest to earn foreign income that 
is subject to lower taxes.
    In addition, allowing U.S. taxation of foreign, active 
foreign business income earned through a foreign corporation to 
be deferred until repatriated as a dividend subject to some 
anti-deferral rules encourages investment in lower tax foreign 
countries. Over a long enough period, the difference between 
the foreign effective rate and the U.S. effective rate can be 
quite valuable in an even appropriate--I'm sorry, even approach 
exemption. In practice, the current U.S. system of worldwide 
taxation with elective deferral of U.S. tax on foreign 
corporate business income while complex can be managed to 
achieve very low effective rates of tax on foreign income. 
Indeed, the overall effect can be more generous than an 
exemption system for taxing foreign income.
    There is no o priori reason for taking foreign income, 
which is subject to these benefits, and excluding it from a 
fairness analysis as we would the taxation of other income in 
the U.S. system. In other words, there are some special 
considerations with respect to international income but at the 
end of the day, it is part of the overall U.S. tax system and 
should be evaluated under the same criteria that we evaluate 
the taxation of other forms of income.
    If the U.S. taxation of foreign business income is lower 
than on domestic business income, U.S. persons who do not earn 
the foreign business income will be subject to heavier taxation 
solely because of where their business or activity is located. 
This violates the ability to pay norm and can be justified only 
if there is an identifiable benefit to individual U.S. citizens 
and residents.
    In my testimony, I have explained why I think a limited 
foreign tax credit that does eliminate double taxation is 
justifiable even though on its face it is inconsistent with an 
ability to pay criterion. I go into that in the testimony.
    But I do conclude that our current rules do permit 
excessive crediting of foreign taxes and to some extent that is 
illustrated by the fact that if you go to an exemption system, 
we actually would, it is estimated we would raise revenue and 
that is a result of the fact that under our current system we 
can cross credit foreign taxes to a point that you get more of 
a benefit than you would if you just exempted foreign income 
    In my testimony, just outlining at a very high level some 
thoughts for how one might address the current rules. I 
respectfully submit that reducing the scope for deferral and 
more closely aligning the foreign tax credit rules to the 
purpose of avoiding double taxation should be supported on the 
grounds of fairness as well as sufficiency.
    I want to make a note about inter-company transfer pricing. 
A taxpayer's ability to control inter-company pricing is a 
fundamental attribute of international taxation. The necessary 
flexibility of tax rules relating to transfer pricing, that is 
to allow taxpayers to carry on their businesses, is a critical 
factor in assessing a structure of those rules. In order to 
restrict transfer pricing abuse, the focus must be on reducing 
the effective tax rate differential between earning the foreign 
income and the U.S. income and that is the thrust of the 
direction of the changes I would support, as I have said, on 
both fairness and efficiency grounds.
    The current foreign tax--I'm sorry, reducing the scope for 
deferrals would be a key element and improving the foreign tax 
credit by repeal of the sales source rules and rationalization 
of source rules for taxing income from intangibles would 
contribute in this regard.
    The changes that I describe in my testimony would move 
toward equalizing the taxation of foreign and domestic business 
income and the results, I submit, would be a fairer tax system.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Shay follows:]
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    Mr. NEAL. We thank the gentleman. Mr. Leon Metzger, former 
vice Chairman and chief administration officer of Paloma 
Partners Management Company, we welcome your testimony.
    Mr. Metzger.


    Mr. METZGER. Mr. Chairman, Mr. Ranking Member, and 
distinguished Members of the Committee, I applaud your efforts 
to conduct a hearing on fairness and equity in the Internal 
Revenue Code. I am here to explain why some hedge funds are 
organized offshore. Investors in hedge funds can be classified 
as U.S. taxable, U.S. tax-exempt, and foreign. In a master 
feeder arrangement, the fund advisor manages only one pool of 
trading capital, the ``master'' fund, which is either an 
onshore or offshore limited partnership, or an offshore 
corporation that ``checks the box'' to be treated as a 
partnership for U.S. tax purposes. The master fund's capital is 
supplied by two or more feeder funds. Taxable investors invest 
in one ``feeder'' fund, a flow-through entity, while U.S. tax-
exempt and foreign investors invest in the other one, an 
offshore corporation.
    Usually, hedge funds compensate their advisers in two ways: 
a management fee, frequently 2 percent of capital under 
management, and incentive compensation, typically 20 percent of 
the profits. In my experience, most hedge fund income of U.S. 
taxable investors is taxed at ordinary rates because, one, 
funds tend to trade rapidly in and out of positions, which 
generate short-term capital gains or losses; two, all capital 
gains and losses deriving from short sales are treated as 
short-term; three, gains or losses from section 1256 regulated 
futures contracts, no matter how long the positions are open, 
are treated as 60 percent long-term and 40 percent short-term 
capital; and, fourth, many funds elect section 475 mark-to-
market ordinary-income treatment.
    Hedge fund advisers to offshore corporate feeder entities 
often defer their management fee and incentive compensation for 
periods as long as 10 years when they expect that the benefit 
of deferral will exceed the benefit of being taxed partially at 
preferential rates. Therefore, hedge fund advisers that can 
elect to defer their income instead of receiving a carried 
interest often do so.
    How does deferral work? The offshore corporation accrues 
the compensation for the advisor but does not pay it. Each 
year, the notional value grows or contracts at the same rate as 
the performance of the fund. Assuming an adviser uses the cash 
method of accounting, the adviser does not record any taxable 
income until the compensation is paid.
    Why do U.S. tax-exempt investors invest offshore? These 
investors would be subject to tax on their share of earnings 
from unrelated--if they invested in a flow-through entity. 
Typically, the income they receive when they redeem their 
shares is not considered unrelated debt--financed income 
because these blocker corporations prevent the debts from being 
attributed to tax-exempt investors. These offshore corporations 
are located in either no- or low-tax jurisdictions. In general, 
the only U.S. tax paid by these corporations is the U.S. 
withholding tax on dividends received. Often, derivative 
financial instruments are used to avoid the dividend 
withholding tax.
    There has been talk about possibly taxing U.S. tax-exempt 
investors on their indirect share of unrelated debt-financed 
income even if they invest through offshore corporations. If 
the purpose of such a law is to raise revenues to offset the 
elimination of the alternative minimum tax, it is worth noting 
that many of the beneficiaries of pension plans that invest in 
hedge funds are middle-class taxpayers. What they save in AMT, 
they might give back in reduced pension benefits, if such a law 
were enacted.
    Foreign investors invest through offshore blocker 
corporations to maintain confidentiality and to avoid the U.S. 
regulatory environment applicable to U.S. taxable investors. 
These corporations also allow foreign investors to avoid direct 
liability from the fund's ``effectively connected income,'' if 
    My written statement addresses other important issues. 
Thank you for inviting me to testify. I would be happy to 
answer any questions you may have.
    [The prepared statement of Mr. Metzger follows:]
 Prepared Statement of Leon M. Metzger, Former Vice Chairman and Chief 
      Administration Officer of Paloma Partners Management Company
    Mr. Chairman, Mr. Ranking Member, and Distinguished Members of the 
    I applaud your efforts to conduct a hearing on fairness and equity 
in the Internal Revenue Code (Code). I am here to explain why some 
investment funds are organized offshore.\1\
    \1\ By way of background, I teach hedge-fund management courses at 
Columbia, New York, and Yale Universities. An expert witness, 
arbitrator, and consultant on financial-services matters, I was 
associated with a hedge fund management company for 18 years, most 
recently as its vice chairman and chief administrative officer. My 
opinions do not necessarily reflect those of any institution with which 
I have been or currently am affiliated. I do not hold myself out to be 
a tax expert.
    Investors in hedge funds, which are private investment vehicles, 
can be classified as U.S. taxable; U.S.-tax-exempt; and foreign. Each 
has a different goal. For example, taxable investors prefer long-term 
capital gains (LTCGs) and qualified dividends to short-term capital 
gains and ordinary income, flow-through\2\ status of their investment 
vehicles, and the flexibility to invest in certain derivative financial 
instruments that would minimize their current tax liabilities. U.S. 
tax-exempt investors might want to avoid investing in flow-through 
entities that generate unrelated debt-financed income (UDFI).\3\ 
Foreign investors might want to avoid investing in an entity that 
generates income that is effectively connected with a U.S. trade or 
business. U.S. tax-exempt and foreign investors want the investment 
entity to minimize the amount of U.S. withholding taxes, and all three 
types want to avoid incurring costs that pay for a transaction that 
benefits the other type but not itself.\4\
    \2\ Flow-through entities in this context either can be general or 
limited partnerships; limited liability companies (LLCs), which are 
treated as partnerships for tax purposes; S corporations; and certain 
trusts. For purposes of this discussion, when I use the term, ``flow 
through,'' I am referring to either partnerships or LLCs.
    \3\ UDFI is considered unrelated business taxable income (UBTI) to 
otherwise tax-exempt investors.
    \4\ For example, a notional principal contract (e.g., swap) may 
achieve an inferior pre-tax economic result compared to a direct 
investment, but, post-tax, it may generate a superior result for 
taxable investors notwithstanding the financing cost involved. For an 
investor who does not pay taxes, the financing cost of the contract 
represents an economic cost without any offsetting gain.
    Most hedge funds use one of two structures to satisfy the 
investors. In a side-by-side arrangement,\5\ the fund adviser\6\ 
manages two or more pools of trading capital, one in the U.S. for 
taxable investors, and the others offshore for U.S.-tax-exempt and 
foreign investors, often by splitting tickets\7\ between or among the 
    \5\ A side-by-side structure could look like this:
    \6\ For this testimony, the term, ``adviser,'' includes advisers, 
LLC managers, and general partners.
    \7\ Splitting tickets is the process where the adviser enters one 
trade on behalf of two or more clients, and subsequently allocates the 
trade between or among those clients.
    In a master-feeder arrangement,\8\ the fund adviser manages only 
one pool of trading capital, the ``master'' fund, which is either an 
onshore or offshore limited partnership, or an offshore corporation 
that ``checks the box'' to be treated as a partnership for U.S. tax 
purposes. The master fund's capital is supplied by two or more 
``feeder'' funds. Taxable investors invest in one feeder fund, also a 
flow-through entity, while the U.S.-tax-exempt and foreign investors 
invest in the other one, an offshore corporation.
    \8\ A master-feeder structure could look like this:
    Usually, hedge funds compensate their advisers in two ways: a 
management fee, frequently 2 percent of capital under management; and 
incentive compensation, typically 20 percent of the realized profits, 
which is structured either as another fee, if paid by an offshore 
corporation, or as a special allocation of partnership profits, also 
known as a ``carried interest,'' if paid by a flow-through entity. If 
the feeder is a flow-through entity, often the management fee and 
incentive compensation are paid to separate entities for state or local 
tax reasons. Usually, the offshore corporation pays just the adviser.
    In the early days of master-feeder arrangements, the master funds 
were more often located onshore. More recently, the trend is for master 
funds to be located offshore.
    In my experience, if one looks at the total pool of taxable income 
generated by all hedge funds, most of that income is not taxed at 
preferential rates. Reasons for this range from the fact that such 
funds tend to trade rapidly in and out of positions, which generates 
short-term capital gains and losses, to the rule that all capital gains 
and losses deriving from short sales, no matter how long the short 
sales are held open, are treated as short-term. Furthermore, gains or 
losses from section 1256 regulated futures contracts, no matter how 
long the positions are open, are treated as 60 percent long-term and 40 
percent short-term capital. Last, many funds elect section 475 mark-to-
market ordinary-income treatment. Hence, the preferential-rate income 
from the carried interest may be less than what many might have you 
    Hedge fund advisers to offshore corporate-feeder entities often 
defer their management fee and incentive compensation for periods as 
long as ten years when they expect that the benefit of deferral will 
exceed the benefit of being taxed partially at preferential rates. For 
example, if a fund earns 10 percent pre-tax, of which 65 percent of its 
income is derived from preferential-rate income, the adviser will earn 
more, after tax, if he or she elects a ten-year deferral rather than 
accepting a carried interest. On the other hand, at a 20 percent pre-
tax growth rate, almost 90 percent of a fund's income would need to be 
derived from preferential-rate income to make the manager prefer a 
carried interest to a ten-year deferral.\9\
    \9\ This table illustrates scenarios under a ten-year deferral:
    How does the deferral work? The offshore corporation accrues the 
compensation to the adviser but does not pay it. Each year, the 
notional value grows or contracts, as the case may be, at the same rate 
as the performance of the fund. Assuming an adviser uses the cash 
method of accounting, the adviser does not include any income until it 
is paid. Advisers who opt for deferral take real economic risk because 
if the fund loses money, their eventual compensation will be reduced 
pro rata. Deferred compensation is subject to the claims of the general 
creditors of the offshore corporation.
    Hedge fund advisers to onshore flow-through entities might also 
structure their management fee as a carried interest.\10\ If the fund 
loses money and the management fee is paid in the form of a carried 
interest, however, the manager might need to borrow money to fund 
operations. Hence, these managers might take real economic risk to 
reduce their taxes. The incentive compensation in this case typically 
is an allocation of partnership profits.\11\
    \10\ Fund Managers' Taxes May Rise as Senate Targets Fees 
Stratagem, By Ryan J. Donmoyer, Bloomberg News, June 19, 2007, http://
www.bloomberg.com/apps/news?pid=20601070&refer= home&sid=aYdxW3YnhjK4
    \11\ In a U.S. corporation or partnership, there is a disincentive 
to deferral insofar as the employers will receive a current deduction 
if the compensation is paid currently. In a domestic situation, there 
is thus a tension between employees, who want to defer their 
compensation, and employers that wish to take a current deduction. When 
a hedge fund is formed with an offshore corporate feeder, there is no 
countervailing force working to ensure that the deduction is taken into 
account as soon as possible (unless it is a flow-through entity or a 
corporation that elects to check the box to be treated as a partnership 
for U.S. tax purposes). This lack of an incentive is one reason why 
hedge fund managers are able to defer their compensation for a 
significant portion of time.
    Why do U.S.-tax-exempt investors invest offshore? These investors 
would be subject to tax on their share of earnings from UDFI if they 
invested in a flow-through entity. Typically, the income they receive 
from a corporation when they redeem their shares is not considered UDFI 
because the corporate ``blockers'' prevent the debt from being 
attributed to the tax-exempt investors. And, the offshore corporations 
are located in either no- or low-tax jurisdictions. In general, the 
only tax paid by these corporations is the U.S. withholding tax on 
dividends received. Often, the adviser is able to use derivative 
financial instruments to avoid the dividend withholding tax.\12\
    \12\ IRS Probes Tax Goal of Derivatives, by Anita Raghavan, The 
Wall Street Journal, July 19, 2007, page C1.
    While it may seem like an artificial device to allow a U.S.-tax-
exempt investor to avoid UBTI simply by investing through a blocker 
corporation, it is questionable if UDFI from investments in hedge funds 
that trade securities\13\ was ever the type of UBTI Congress had in 
mind when it enacted in 1950 and expanded the definition of UBTI in 
1969 to cover abusive sale-leaseback transactions in which certain 
organizations rented their tax-exempt status for a fee.\14\ Recently, 
there has been talk about possibly taxing the U.S.-tax-exempt investors 
on their indirect share of UDFI even if they invest through offshore 
corporations. If the purpose of such a law is to raise revenues to 
offset the elimination of the Alternative Minimum Tax, it is worth 
noting that many of the beneficiaries of pension plans, which invest in 
hedge funds, are middle-class taxpayers. What they save in AMT they may 
give back in reduced pension benefits.\15\ While an overhaul of UDFI, 
section 514 of the Code, could lead to renewed abusive transactions, by 
allowing U.S.-tax-exempt investors to continue to rely on blocker 
corporations, Congress need not repeal section 514.
    \13\ Admittedly, the term, ``hedge fund,'' is a self-designated 
moniker and certain of those funds engage in commercial activities that 
would not necessarily be considered trading in securities.
    \14\ Statement Regarding Unrelated Debt Financed Income and 
``Blocker Corporations,'' June 27, 2007, Council on Foundations, http:/
    \15\ I thank my NYU students, who called my attention to this 
    Foreign investors invest through offshore blocker corporations to 
maintain confidentiality and to avoid the U.S. regulatory environment 
applicable to U.S. taxable investors. The blocker corporation also 
allows foreign investors to avoid direct liability from the fund's 
``effectively connected income,''\16\ if any.
    \16\ In general, active business income other than trading in 
stocks, securities, and commodities.
    If the master fund were an offshore corporation rather than a 
partnership, why might the adviser receive its compensation at the 
feeder-fund level rather than at the master-fund level? If deferral 
were so much better than receiving preferential-rate income, would it 
not make more sense if the master fund elected to defer the income? The 
answer is that because the master fund checks the box to be treated as 
a partnership, the investors in the U.S. feeder would not be entitled 
to a tax deduction for the adviser's deferred fees until they were 
paid, which would mean that their taxable income would exceed their 
economic income, which is usually an undesirable result.
    Why might a master fund be domiciled offshore? First, the 
regulatory burden might be simpler there. Second, the administrative 
burden of withholding taxes is removed from the fund, which eliminates 
its risk of being subject to penalties for under withholding. Third, in 
certain jurisdictions, the fund may be able to achieve a higher degree 
of leverage than what U.S. regulators might allow. Last, there may be a 
sourcing (and thus withholding) benefit with regard to certain notional 
principal contracts.
    Why might a master be domiciled onshore? First, the adviser might 
prefer to use Delaware law. Second, while the fund has the 
administrative burden of dealing with withholding taxes, it can hold, 
for a longer period, the cash that would otherwise be needed to be 
withheld, and earn income on such cash.
    What are some of the advantages of the master-feeder arrangement 
compared to side-by-side funds? First, the adviser does not need to 
split tickets to generate similar returns between the funds. Second, if 
an investor withdraws from or contributes to a fund, the positions sold 
to meet the redemption or the asset purchased with the new funds will 
be spread pro rata among all investors, which enables the investors to 
earn similar returns, without requiring the adviser to re-balance the 
portfolios. Third, a larger pool of capital may ease credit terms, as 
there is more collateral.
    What are some of the disadvantages of the master-feeder arrangement 
compared to side-by-side funds? First, the fund may lose the ability to 
invest in, say, a U.S. broker-dealer, which has customers, or a lending 
business because that might generate effectively connected income, 
which foreign investors want to avoid. Second, the adviser has the same 
fiduciary responsibility to all investors and cannot favor one class 
over another. Therefore, for example, the master may have to turn down 
the opportunity to invest in a derivative financial instrument that 
could convert ordinary income into LTCGs because the cost to finance 
such an investment would be borne by all investors, including those 
that do not stand to benefit from the tax savings. In such instances, a 
feeder fund might make an investment that another feeder cannot.
    In this section, I will address other issues.
    Carried interest is not a recently discovered nefarious tax 
loophole. Advisers to hedge funds and other industries have used it for 
many years.
    I do not believe that hedge-fund and private-equity advisers should 
be subject to one set of tax rules, while others, who provide similar 
services, are subject to different rules, whether more lenient or 
strict. Singling out specific industries for special adverse tax 
legislation by enacting, e.g., a ``hedge-fund adviser's windfall 
profits tax'' would be poor public policy. I agree with H.R. 2834, in 
this respect, that a carried interest is no different whether the 
investment vehicle holds real estate, oil and gas, venture capital, or 
stocks, bonds, and derivative financial instruments.
    Some have argued that if all carried interest were taxed at 
ordinary rates, it might lead to fund managers' increasing their 
compensation beyond the typical ``2 and 20'' arrangement, which would 
reduce the returns of investors like pension plans and endowments. 
There is no requirement for advisers to charge ``2 and 20.'' Indeed, it 
has been reported that one can find managers who charge ``3 and 50,'' 
``5 and 44,'' and ``4 and 23.'' And, some charge less than ``2 and 
20.'' The adviser's compensation typically is determined by the market. 
Advisers that have exceptional performance records or that have 
convinced investors that the prospects of exceptional performance are 
excellent, may try to charge more than ``2 and 20.'' In contrast, 
advisers that have less-stellar performance records will encounter 
resistance from investors if they try to charge higher fees. Fees will 
increase if advisers try to raise them and the investors acquiesce.
    If Congress decides to tax all income from carried interests as 
ordinary, some funds might try to replace a ``2 and 20'' structure with 
some variation of a higher management fee and partially non-recourse 
loan from the investors economically similar to a 20 percent carried 
interest. Effectively, the adviser would retain economics and tax 
consequences similar to the 20 percent carried interest on the positive 
side, but now would be exposed to any negative performance\17\ and 
would incur interest expense, which might be offset by the higher 
management fee. If the economics for investors were potentially 
impaired by this type of arrangement, such deal could be implemented 
only if investment demand for those funds were relatively inelastic.
    \17\ Should, for example, the fund implode, the adviser might have 
cancellation-of-indebtedness (COD) income from the loan and capital 
loss from the decline of its share of the fund, which would not 
necessarily offset because of the difference in character between those 
types of income. On the other hand, if, because of such an implosion, 
the adviser becomes insolvent, section 108 of the Code may exclude the 
COD income while simultaneously reducing the basis of the adviser's 
interest in the fund.
    Does the U.S. economy truly benefit from preferential-income 
rates\18\ and is ``realization,'' rather than change in market value, 
the appropriate aspect for determining when income should be taxable to 
certain persons? If we retain the status quo, taxpayers will continue 
to arrange their affairs so that they can achieve the best character, 
timing, and source.
    \18\ Market liquidity and price discovery might not change 
significantly if preferential rates were eliminated. Paul Krugman, an 
economic professor at Princeton University, says, ``[There's] very 
little evidence that taxing capital gains as ordinary income would 
actually hurt the economy.'' The New York Times, July 13, 2007, page 
A19. The majority of trades that are executed on the New York Stock 
Exchange are on behalf of public institutional investors, which do not 
benefit from preferential rates (see, e.g., http://www.calstrs.com/
Investments/NYSEBoard112003.pdf). Alan S. Blinder, an economics 
professor at Princeton University and former vice chairman of the 
Federal Reserve, says, ``[The] evidence--[that lower taxes on capital 
gains boost investment] is iffy at best, and there are better ways to 
spur investment, like, say, the investment tax credit.'' He adds, ``The 
tax preference for capital gains undermines capitalism--a system in 
which capitalists, not the state, are supposed to make the investment 
decisions.'' The New York Times, Sunday Business, July 29, 2007, page 
    Thank you for inviting me to share my views with you. I would be 
happy to answer any questions you may have.
    This analysis does not consider the effect of any state and local 
taxes, e.g. New York City's Unincorporated Business Tax, which would 
make a deferral less desirable, as would a shorter period.
    Mr. NEAL. Thank you, Mr. Metzger. Janne Gallagher, who is 
vice president and general counsel of the Council on 
Foundations, we welcome your testimony.
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    Ms. GALLAGHER. Thank you. I want to acknowledge Professor 
Schmalbeck's assistance in helping us puzzle through these 
complicated issues.
    The Council on Foundations is a membership organization of 
grant-making institutions. Our mission is promoting and 
enhancing responsible and effective philanthropy worldwide. My 
statement today could be summarized in two simple points: 
First, foundations seek diversified investment portfolios in 
order to maximize their ability to serve the common good. 
Second, we encourage any legislation that will remove the 
barriers to direct investment by foundations in U.S. hedge 
    Before offering some background on why many foundation 
investments and hedge funds are in corporate entities located 
outside the United States, let me stress that the Council on 
Foundations does not advocate the use of offshore blockers nor 
do we have a position on whether Congress should restrict such 
    Foundations investing through offshore blockers are 
sophisticated investors. They include hedge funds among their 
investments to diversify their portfolios, improve their yields 
and enhance the preservation of their capital in down markets. 
Based on surveys of our members, hedge funds were a small but 
significant portion of investment portfolios, averaging about 
8.4 percent for private foundations and about 7.5 percent for 
community foundations.
    Foundations invest in hedge funds to produce a stream of 
revenue that provides support to communities in the United 
States and around the world. I do not know of any foundation 
that wants to invest in offshore blocker corporations. The 
current law is such that foundations that elect to invest in 
hedge funds would not be prudent stewards of their assets if 
they did not use these corporations to block the application of 
a tax that we believe Congress never intended to apply to this 
form of investment.
    We believe Congress should consider changing current law to 
permit foundations to invest directly in U.S. hedge funds 
without incurring adverse tax consequences. If the section 514 
debt-financed property rules did not apply to hedge fund 
investments, tax-exempts would be able to invest directly in 
U.S. hedge funds and the use of offshore blockers would end.
    We believe these changes can be accomplished without 
creating new opportunities for abuse, and your next witness has 
some recommendations in that regard.
    Foundations that invest in offshore blocker corporations do 
so in order to avoid exposure to unrelated debt-financed income 
tax liabilities under section 514. Most hedge funds make use of 
borrowed funds in some of their investment strategies but 
because they are generally organized as limited partnerships, 
the flow through characteristics of the partnership entity 
results in any debt incurred by the hedge funds being imputed 
to their charitable organization investors.
    To address this problem, hedge funds have created foreign 
corporations in low tax jurisdictions and under a series of 
private letter rulings from the Internal Revenue Service, the 
dividends those corporations distribute to their charitable 
shareholders are free of any debt-financed taint.
    Congress enacted the debt-financed property rules primarily 
to prevent transactions that use the charitable organization to 
convert ordinary business income into gains that could be taxed 
at lower rates as capital or quasi-capital gains. 
Unfortunately, section 514 does not distinguish between 
legitimate and illegitimate uses of debt. Further, debt today 
plays a much more important role in investment portfolios than 
it did back in 1969.
    Finally, a number of post-1969 changes to the tax law 
generally make the transactions at which section 514 was aimed 
uneconomical or pointless, most significantly, the fact that 
corporations no longer enjoy a rate preference on their capital 
gain income.
    In closing, we urge Congress to review the continued needs 
of the debt-financed property rules in light of other changes 
to the Tax Code and the distorting effect those rules have on 
investments by tax-exempt organizations. A further reason to 
look at section 514 is to address the disparity in the current 
exemption that is afforded to pension funds and universities 
but not to other charitable organizations if they invest in 
debt-financed real property. There is no apparent policy reason 
for this distinction, as joint Committee explanation notes, and 
we believe that section 514 without an exemption for other 
kinds of charitable entities unfairly disadvantages efforts by 
foundations to manage and diversify their portfolios through 
the inclusion of investments in real property. We ask that you 
consider making that exception available to all charitable 
organizations. Thank you very much.
    [The prepared statement of Ms. Gallagher follows:]
               Prepared Statement of Janne G. Gallagher,
       Vice President and General Counsel, Council on Foundations
    Thank you. Accompanying me is Richard Schmalbeck, Professor of Law, 
Duke University. Professor Schmalbeck is the primary author of the 
Council's June 27 White Paper, ``Statement on Unrelated Business Income 
and Blocker Corporations.' We have submitted a copy of the paper as 
part of the record of this hearing.
    The Council on Foundations (COF) is a membership organization of 
more than 2,000 grantmaking foundations and giving programs worldwide. 
For more than 55 years, the Council has served the public good by 
promoting and enhancing responsible and effective philanthropy. My 
statement today could be summarized in two simple points:

      Foundations seek a diversified investment portfolio to 
enhance their returns and their ability to serve the common good.
      We encourage any legislation that will remove the 
barriers to direct investment by foundations in U.S. hedge funds.

    Let me provide some background on why many foundation investments 
in hedge funds are in corporate entities located outside the United 
States. But, I want to stress at the outset that the Council on 
Foundations does not advocate the use of offshore blockers, as these 
entities are commonly called, nor do we have a position on whether 
Congress should restrict such use.
    Foundations investing through offshore blockers are sophisticated 
investors that include hedge funds in their investment portfolios to 
diversify their portfolios, improve their yields and enhance the 
preservation of their capital in down markets. They invest in hedge 
funds as part of an overall investment strategy that is designed to 
produce a stream of revenue that provides support to communities in the 
United States and around the world. I don't know of any foundation that 
wants to invest in offshore blocker corporations, but current law is 
such that foundations that elect to invest in hedge funds would not be 
prudent stewards of their assets if they did not use these corporations 
to block the application of a tax that we believe Congress never 
intended to apply to this form of investment. The Council believes the 
solution is to change current law to permit foundations to invest 
directly in U.S. hedge funds without incurring adverse tax 
consequences. If the section 514 debt-financed property rules did not 
apply to hedge fund investments, tax-exempts would be able to invest 
directly in U.S. hedge funds and the use of offshore blockers would 
end. We believe these changes can be accomplished without creating new 
opportunities for abuse.
    Many tax-exempt organizations, including universities, foundations, 
and pension funds, include hedge funds in their investment portfolios. 
According to Council surveys, community foundations invested an average 
7.5 percent of assets in hedge funds in 2006, while private foundations 
allocated 8.4 percent to hedge funds in 2005. From an investment 
viewpoint, these strategies have been successful, producing returns 
that have generally exceeded overall market performance measures in 
both rising and falling markets. They are not, of course, without risk, 
as recent events have demonstrated, and the Council has taken steps to 
educate our members about factors to consider in making investments in 
hedge funds. For example, our just-published report, 2006 Investment 
Performance and Practices of Community Foundations, includes a five-
page article, ``The Dimensions of Investment Risk--Hedge Funds and Non-
Market Risk,'' by a highly-respected investment consultant.
    Tax-exempt organizations face a problem, however, in structuring 
their investments in hedge funds in ways that do not create exposure to 
unrelated debt-financed income tax liabilities under section 514 of the 
Internal Revenue Code. Hedge funds make use of borrowed funds in some 
of their investment strategies, especially those involving arbitrage. 
Because hedge funds are usually organized as limited partnerships, 
rather than as corporations, that borrowing is imputed to their 
partners, including any charitable organizations that may be limited 
partners. If a hedge fund were organized as a corporation, it could 
freely use debt in pursuit of its investment strategies, and still pay 
dividends to charitable stockholders that would not be characterized as 
unrelated debt-financed income. However, operating through a corporate 
structure would generate income tax liabilities at the entity level 
that are otherwise completely avoidable and that would be unacceptable 
to the fund's non-exempt investors.
    To address this problem, hedge funds have created foreign 
corporations in low-tax jurisdictions. These corporations, in turn, 
invest in limited partnership hedge funds--typically in funds organized 
and operated within the U.S. The foreign corporations under these 
arrangements pay little corporate income tax in the countries in which 
they are incorporated (because of the very low rate structures 
generally prevailing in those countries). However under a series of 
private letter rulings from the Internal Revenue Service, the dividends 
they distribute to their charitable shareholders are free of any debt-
financed income taint.
    Congress enacted the debt-financed property rules primarily to 
prevent transactions that used a charitable organization to convert 
ordinary business income into gains that could be taxed at lower rates 
as capital (or quasi-capital) gains. Unfortunately, section 514 does 
not distinguish the legitimate use of debt from sham transactions. 
Investment portfolios maintained by taxable individuals and entities 
often make judicious use of debt to enhance returns in ways that cannot 
be described as abusive of any tax rules and which does not present the 
abuse section 514 was designed to prevent. Further, a number of post-
1969 changes to the tax law that have nothing to do with charitable 
organizations would generally make the transactions at which section 
514 was aimed either uneconomic or pointless today. The most 
significant among these is the fact that corporations no longer enjoy 
rate preferences on capital gain income, which obviates any attempt to 
convert ordinary business income into capital gain in most cases. There 
may be a few special circumstances to which the unrelated debt-financed 
property rules should still apply, but hedge fund investments are not 
among them.
    The primary purposes of the unrelated business income tax, and of 
the debt-financed property rules, are to protect the integrity of the 
corporate income tax, and to preserve a level playing field in cases 
where nonprofit organizations and profit-seeking firms compete. 
However, in cases where a nonprofit organization merely makes an 
investment, but does not actively conduct a business, Congress has 
provided exemption for the passive investment income received by the 
organization from the unrelated business income tax. This exemption 
extends both to income that was subject to tax at the corporate level 
(dividends), but also to income (rents, royalties, capital gains) upon 
which no corporate tax was paid. The income of hedge funds is not 
ordinarily exposed to corporate-level taxation, due to the widely 
accepted structuring of such funds as limited partnerships. Individual 
investors in such funds are and should be liable for taxes on the 
income of the funds; but since charitable entities are normally not 
liable for taxes on income from their investments, they should not be 
taxed on investment income generated by hedge funds. The use of blocker 
corporations effectively achieves this result, but the use of blockers 
would not be necessary if the tax were not construed as applying to 
theses investments.
    The issue of the use of offshore blocker corporations in hedge fund 
investments illustrates the need for Congress to review the continued 
need for the debt-financed property rules in light of other changes to 
the Tax Code and the distorting effect of the rules on investments by 
tax-exempt organizations. An additional reason for undertaking such a 
review is to address the disparity in the current exemption for 
investments in debt-financed real property, which excludes only 
investments made by universities and by pension plans and not those by 
other tax-exempt organizations including foundations. There is no 
apparent policy reason for this distinction, which unfairly 
disadvantages efforts by foundations to manage and diversify their 
portfolios through the inclusion of investments in real property. We 
ask you also to consider making this exemption available to all 
charitable organizations if you undertake a reform of section 514.
    Mr. NEAL. Thank you, Ms. Gallagher.
    Suzanne Ross McDowell is a partner at Steptoe & Johnson. Ms. 
McDowell, we welcome your testimony.



    Ms. MCDOWELL. Thank you. Mr. Chairman, Ranking Member Mr. 
McCrery and Members of the Committee, thank you for inviting me 
to appear today. My practice focuses on the law of tax-exempt 
organizations. In the eighties, I served in the Office of Tax 
Policy at the Treasury Department where I was responsible for 
issues relating to tax-exempt organizations, including issues 
relating to debt-financed income property. Since leaving 
Treasury, I have written papers and given presentations on the 
debt-financed income rules. My testimony will focus on these 
rules. It represents my views, not those of my firm, any 
client, or any other organization.
    Let me begin with a brief overview of current law. For over 
50 years, congressional policy has been to exclude most types 
of investment income from the unrelated business income tax. 
However, if the investment income is derived from property that 
was acquired with debt, the income is taxed under the debt-
financed income rules. Thus, the debt-financed income rules are 
an exception to the general congressional policy of exempting 
investment income of tax-exempt organization from tax.
    The original purpose of the debt-financed income rules, 
however, was not so broad. Rather, when enacted in 1969, these 
rules were intended to foreclose abusive sale leaseback 
transactions. These transactions permitted businesses to sell 
property to tax-exempt organizations in transactions that 
converted ordinary income to capital gains and allowed the tax-
exempt purchasers to buy the property over time while investing 
little or none of their own capital. No one suggests that it 
was not a good idea to put an end to such transactions.
    The unrelated debt-financed income rules can be avoided on 
securities and financial products by investing through foreign 
corporations referred to as ``blocker entities,'' as Mr. 
Metzger described.
    At first blush, blocker entities may look like a loophole 
that should be shut down. However, blocker entities are 
frequently used to avoid the application of unrelated debt-
financed income rules to legitimate, non-abusive transactions 
that were not the intended target of the rules. Thus, before 
taking action on blocker entities, it makes sense to take a 
look at the policy and impact of the unrelated debt-financed 
income rules.
    These rules tax all debt-financed investments of tax-exempt 
organizations even though they were enacted for the narrower 
purpose of foreclosing abusive sale leaseback transactions. The 
current breadth of application of these rules would be 
justified only if all leveraged investments of tax-exempt 
investors should be discouraged. The purpose of leverage is to 
increase the investor's return on investments. The tradeoff for 
the increased return is taking on greater risk. The increased 
risk of an individual investment, however, can be reduced 
through diversification in the investor's portfolio. 
Furthermore, investments that do not use debt or leverage may 
be as risky or riskier than leveraged investments. Thus, taxing 
all debt-financed income is not an effective way to protect 
tax-exempt investors from risks if, indeed, that is the 
purpose. Moreover, the level of risk permissible for tax-exempt 
organizations is already addressed by various other laws at 
both the Federal and state level. These laws, which are 
explained in more detail in my written statement, permit the 
prudent use of debt financing.
    As more fully described in my written statement, an 
additional problem with the debt-financed income rules is that 
they have been applied in a rigid manner that makes formalistic 
distinctions between debt and leverage. The result is that the 
rules tax transactions which involve straightforward borrowing 
in the traditional sense while permitting investors who use 
leverage in more sophisticated transactions to escape tax.
    Finally, blocker entities are not the only way to avoid the 
debt-financed income rules. These rules can also be avoided by 
investing in mutual funds or REITs and through certain 
contractual arrangements.
    I urge the Committee to significantly restrict the 
application of the debt-financed income rules. Under current 
law, there is an exception for real estate transactions if the 
transactions meet certain requirements which are designed or 
intended to prevent abuse. The exception is currently available 
only to pension funds and universities. This exception and its 
requirements should be used as the model for a broader 
exception to the debt-financed income rules applicable to all 
types of debt-financed property and available to all tax-exempt 
organizations. My written testimony expands on this suggestion.
    If Congress amends the unrelated debt-financed income rules 
as suggested, tax-exempt investors would no longer be forced to 
invest offshore and use blocker entities to avoid unrelated 
debt-financed income rules on legitimate investments. Further, 
the current disparate treatment between direct borrowing and 
leverage and between different types of tax-exempt investors 
would be eliminated.
    Thank you again, and I would be pleased to answer any 
questions you may have.
    [The prepared statement of Ms. McDowell follows:]
Prepared Statement of Suzanne Ross McDowell, Partner, Steptoe & Johnson 
    Mr. Chairman and Members of the Committee:
    My name is Suzanne Ross McDowell. I am a partner in the law firm 
Steptoe & Johnson llp in Washington, D.C. My practice focuses on the 
law of tax-exempt organizations with particular emphasis on tax, 
corporate governance, and commercial transactions. From 1983 to 1987, I 
served in the Office of Tax Policy at the U.S. Department of Treasury 
and was responsible for issues relating to tax-exempt organizations, 
including issues related to the debt-financed income rules. Since 
leaving the Treasury Department, I have written academic papers and 
given presentations on the debt-financed income rules and numerous 
other topics relevant to tax-exempt organizations.\1\
    \1\ Taxing Leverage Investments of Charitable Organizations: What 
is the Rationale?, 39 Case W. Res. L. Rev. 705 (1988); Taxation of 
Unrelated Debt-Financed Income, 34 Exempt Org. Tax Rev. 197 (2001).
    My testimony today will focus specifically on the unrelated debt-
financed income rules. These rules impose a tax on investment income of 
an exempt organization that would otherwise be tax-exempt solely 
because the exempt organization uses debt to acquire the property that 
produces the income.\2\ To avoid the tax imposed by the debt-financed 
income rules, exempt organizations often use so-called blocker entities 
to acquire investments. Generally speaking, a blocker entity is a 
corporate entity formed in a low-tax jurisdiction that is interposed 
between an investment and the exempt organization. The corporation 
``blocks'' the attribution of any debt to the exempt organization, and 
thus enables the exempt organization to avoid the application of the 
debt-financed income rules. My testimony will cover the history and 
purpose of the rules, the types of transactions they discourage, and 
the policy concerns that should be considered by Congress in the course 
of its evaluation.
    \2\ IRC Sec. 512(b)(4); 514(a)(1).
Legislative History and Current Law
    Tax-Exempt Status of ``Passive Income.''  Since 1950, tax-exempt 
organizations have been subject to the unrelated business income tax 
(``UBIT'') on income from businesses that are not related to their 
exempt functions. When Congress enacted the UBIT, it excluded certain 
types of investment income--commonly referred to as ``passive 
income''--from the tax. Specifically, dividends, interest, royalties, 
annuities, most rents, and capital gains and losses were not subject to 
UBIT.\3\ In the years since the enactment of the UBIT, exceptions have 
been added for payments with respect to securities loans,\4\ loan 
commitment fees,\5\ and income from the lapse or termination of 
options.\6\ According to the legislative history, Congress excluded 
these types of income from UBIT because it did not think they posed 
serious competition for taxable businesses and because such income had 
long been recognized as a proper source of revenue for educational and 
charitable organizations.\7\
    \3\ IRC Sec. Sec.  512(b)(1), (2), (3), (5).
    \4\ IRC Sec. 512(b)(1), (a)(5).
    \5\ IRC Sec. 512(b)(1).
    \6\ IRC Sec. 512(b)(5).
    \7\ H.R. Rep. No. 2319, 81st Cong., 2d Sess. 38-40 (1950); S. Rep. 
No. 2375, 81st Cong., 2d Sess. 30-31, (1950).
    Unrelated Debt-Financed Income Rules.  The exclusion for ``passive 
income'' does not apply to the extent that such income is derived from 
debt-financed property.\8\ In other words, income earned by an exempt 
organization from debt-financed property is subject to tax. Property is 
treated as debt-financed if indebtedness is incurred before or after 
the acquisition or improvement of the property that would not have been 
incurred but for such acquisition or improvement.\9\ The portion of 
income that is subject to tax is the fraction equal to the average 
acquisition indebtedness for the year over the average adjusted basis 
of the property for the year.\10\
    \8\ Section 514 applies to all debt-financed property but contains 
several exceptions which have the collective effect of generally 
limiting its application to investment income.
    \9\ IRC Sec. 514(c)(1).
    \10\ IRC Sec. 514(a)(1).
    The debt-financed income rules were passed in 1969 to foreclose 
abusive sale-leaseback transactions. In such transactions, a charitable 
organization would acquire property (usually real estate) from a 
taxable business, often borrowing to finance the entire purchase price. 
As a condition of the sale, the exempt organization would lease the 
property back to the seller on a long-term basis. The exempt 
organization would repay the loan, plus interest, with the lease 
payments or ``rental payments'' received from the seller-lessee. The 
exempt organization would receive both (i) the difference between the 
``rental payments'' and the sale price and (ii) outright title to the 
property, all without investing or risking much, if any, of its own 
funds. The seller would obtain capital gain treatment for the sale 
price received and large deductions against taxable income for the 
``rental payments'' made, all while continuing to operate its business 
using the property in the same manner as before.\11\
    \11\ S. Rep. No. 552, 91st Cong., 1st Sess. 62-63, reprinted in 
1969 U.S.C.C.A.N. 2027, 2091-92; H.R. Rep. No. 413, 91st Cong., 1st 
Sess. 44-46, reprinted in 1969 U.S.C.C.A.N. 1645, 1690-91.
    Application of Unrelated Debt-Financed Income Rules to Securities 
and Financial Products. The debt-financed income rules have been 
challenging to apply to securities and other financial products. 
Neither the Internal Revenue Code (the ``Code'') nor the Treasury 
regulations thereunder define ``indebtedness'' for purposes of the 
debt-financed income rules. Consequently, in determining whether a 
particular transaction creates indebtedness and therefore is subject to 
tax, the Internal Revenue Service and the courts have looked to common 
law definitions of indebtedness and definitions in other parts of the 
Code. The result has been that the rules have been applied in a 
formalistic manner. Generally, when a tax-exempt investor borrows funds 
and has a clear obligation to repay the funds, the debt-financed income 
rules have been applied. Thus, securities purchased on margin have been 
held to be debt-financed property.\12\ A pension plan that used a 
certificate of deposit (``CD'') with a low interest rate as collateral 
to borrow funds to acquire a new CD with a higher interest rate, was 
subject to UBIT on the new CD because it was purchased with borrowed 
funds.\13\ In this case, the pension fund was not seeking to leverage 
its investment. Rather, it didn't want to redeem the low-interest CD 
before its maturity date because it would have incurred penalties, but 
it wanted to reap the benefits of an increase in interest rates. 
Similarly, the withdrawal of the accumulated cash value of life 
insurance policies for the purpose of investing the funds in property 
with a higher rate of return creates acquisition indebtedness and 
therefore is unrelated debt-financed income when such withdrawals are 
used to purchase securities.\14\
    \12\ See, e.g., Elliott Knitwear Profit Sharing Plan v. Comm'r, 614 
F.2d 347 (3d Cir. 1980), Alabama Central Credit Union v. United States, 
646 F. Supp. 1199 (N.D. Ala. 1986); Ocean Cove Corporation Retirement 
Plan v. United States, 657 F. Supp. 776 (S.D. Fla. 1987); Henry E. & 
Nancy Horton Bartels Trust for the Benefit of the University of New 
Haven v. United States, 209 F.3d 147, 156 (2d Cir. 2000).
    \13\ See Kern County Electrical Pension Fund v. Comm'r, 96 T.C. 845 
    \14\ Mose & Garrison Siskind Memorial Foundation Foundation v. 
United States, 790 F.2d 480 (6th Cir. 1986).
    In contrast to the above examples, many transactions that do not 
involve debt in the traditional sense but do involve leverage are not 
subject to the debt-financed property rules. In many cases, because the 
transactions were not clear cases of borrowing, the IRS relied on 
Congressional intent to exclude investment income from tax in reaching 
its conclusion that the debt-financed income rules do not apply. Thus, 
securities lending transactions,\15\ short sales of stock,\16\ 
commodities futures contracts,\17\ securities arbitrage 
transactions[18] and notional principal contracts\19\ are not treated 
as debt-financed property and are not subject to UBIT.
    \15\ Rev. Rul. 78-88, 1978-1 CB 163.
    \16\ Rev. Rul. 95-8, 1995-1 CB 107. See also PLR 9637053 (Sept. 13, 
1996); PLR 9703027 (Jan. 17, 1997).
    \17\ Gen. Couns. Mem. 39620 (April 3, 1987).
    \18\ Gen. Couns. Mem. 39615 (March 23, 1987).
    \19\ Treas. Reg. Sec. 1.512(b)-1(a)(1).
    Limited Exception for Real Estate.  Income earned from real estate 
is excluded from the unrelated debt-financed income rules under a 
limited exception, but only if certain conditions are satisfied. \20\ 
Additionally, the exception only applies to real property acquired by 
pension trusts, schools, colleges and universities. To qualify for the 
exception, the real estate transaction must not have certain 
characteristics of the sale-leaseback transactions that were the target 
of the rules when first enacted. Thus, for example, the transaction 
cannot involve (i) seller financing; (ii) indebtedness determined by 
reference to income from the property; or (iii) a lease back to the 
seller.\21\ Additionally, in the case of real estate investments made 
by partnerships, the exception is limited to transactions that do not 
permit tax-exempt partners to transfer tax benefits to taxable 
partners.\22\ Certain of these rules that limit the exception for real 
estate partnerships, most notably the so-called ``Fractions Rule,'' are 
exceedingly complex and difficult to apply in practice.\23\
    \20\ IRC Sec. 514(c)(9).
    \21\ IRC Sec. 514(c)(9)(B)(i)-(v).
    \22\ IRC Sec. 514(c)(9)(B)(i)-(v).
    \23\ IRC Sec. 514(c)(9)(E).
    ``Blocker Entities.''  The unrelated debt-financed income rules can 
be avoided on securities and financial products by investing through 
foreign corporations referred to as ``blocker entities.'' A blocker 
entity is a foreign corporation usually established in a low tax 
jurisdiction. The tax-exempt investor invests in the foreign 
corporation and the foreign corporation in turn invests in a hedge fund 
or other similar debt-financed investment. Income from the hedge fund 
or other investment is distributed to the foreign corporation, which 
pays little or no tax on the income as a result of the jurisdiction in 
which it is established. The foreign corporation in turn pays the 
income to the tax-exempt investor as a dividend. Because dividends are 
not subject to UBIT, the income from the hedge fund is not taxable to 
the tax-exempt investor and the debt-financed income rules are avoided. 
Most hedge funds are partnerships and, in the absence of the blocker 
entity, debt-financed income would be passed through to the tax-exempt 
investor as debt-financed income and would be subject to tax.\24\ The 
Service has issued private letter rulings upholding the treatment of 
income received from a foreign corporation used as a blocker entity as 
a dividend that is not subject to UBIT.\25\
    \24\ IRC Sec. 512(c).
    \25\ Priv. Ltr. Rul. 199952086 (Sept. 30, 1999).
    At first blush, blocker entities may appear to be a ``loophole'' 
that should be shut down. However, blocker entities are frequently used 
to avoid the application of the unrelated debt-financed income rules to 
transactions that were never intended to be within the scope of the 
rules. Thus, before taking action on blocker entities, Congress should 
re-evaluate the policy and impact of the unrelated debt-financed income 
    \26\ In the 1980s, blocker entities were used to avoid UBIT on 
offshore captive insurance companies. See Priv. Ltr. Rul. 8819034 (Feb. 
10, 1988). In response, Congress added Section 512(b)(17)(A) to the 
Code, providing that foreign source income from offshore captive 
insurance companies is taxable. Small Business Job Protection Act of 
1996, Pub. L. 104-188, section 1603(a). Those cases, however, involved 
the operation of an active unrelated business--an activity that the 
UBIT is clearly intended to tax.
    The unrelated debt-financed property rules tax all debt-financed 
investments of tax-exempt organizations, although they were enacted to 
foreclose abusive sale leaseback transactions. The current breadth of 
application is justified only if all leveraged investments of tax-
exempt investors should be discouraged. The purpose of leverage is to 
increase the investor's return on investment. The trade-off for the 
increased return is taking on greater risk.\27\ The increased risk of 
an individual investment, however, can be reduced through 
diversification in the investor's portfolio. Furthermore, investments 
that do not use leverage may be as risky or riskier than leveraged 
investments. Thus, taxing all debt-financed income is not an effective 
way to protect tax-exempt investors from risk.
    \27\ For example, if an investor buys $100,000 worth of stock and 
the value of the stock increases by 10 percent in one year, the 
investor has earned $10,000. If this same investor borrowed another 
$100,000 at 8-percent interest and invested $200,000 in the same stock, 
it would earn $20,000 on the stock and, after paying $8,000 in interest 
on its debt, would net $12,000, an increase in its rate of return from 
10 percent to 12 percent. Of course, if the $200,000 in stock did not 
earn at least $8,000 to cover the interest payment, the investor would 
have a loss. Thus, the leveraged investment is riskier because the 
return on the investment must be at least 4 percent for the investor to 
avoid a loss.
    Moreover, the level of risk assumed by tax-exempt organizations is 
already addressed by various other laws that create legal standards for 
permissible investments of tax-exempt organizations. At the Federal 
level, investments of private foundations are subject to the 
jeopardizing investment rules of Code section 4944 and pension funds 
are subject to the fiduciary standards of ERISA.\28\ At the state 
level, directors of nonprofit corporations must adhere to the common 
law duties of care and loyalty. Additionally, most states have adopted 
the Uniform Management of Institutional Funds Act (UMIFA), which 
provides uniform rules governing the investment of endowment funds held 
by charitable institutions.\29\ UMIFA was approved by the National 
Conference of Commissioners on Uniform States Laws (NCCUSL) in 1972, 
and established a standard of business care and prudence in the context 
of the operation of a charitable institution. Prior to UMIFA, each 
investment of a charitable institution was evaluated separately, an 
approach that led directors of charities to feel compelled to limit 
investments to fixed income investments dividend-paying stocks. UMIFA 
changed the law to permit an approach that is more in line with modern 
portfolio management theories, looking at the portfolio as a whole 
rather than investment by investment.\30\ In 2006, the NCCUSL further 
modernized the standards applicable to charitable institution fund 
management and approved a revision of UMIFA entitled the Uniform 
Prudent Management of Institutional Funds Act (UPMIFA).\31\ UPMIFA 
expanded the application of UMIFA to charitable trusts and incorporated 
the more modern standards of the Uniform Prudent Investor Act passed by 
NCCUSL in 1994. UPMIFA provides that, ``[m]anagement and investment 
decisions about an individual asset must be made not in isolation but 
rather in the context of the institutional fund's portfolio of 
investments as a whole and as a part of an overall investment strategy 
having risk and return objectives reasonably suited to the fund and to 
the institution.'' \32\
    \28\ Employee Retirement Income Security Act, Section 404 29 U.S.C. 
    \29\ According to the NCCUSL, UMIFA has been adopted in 47 states.
    \30\ When originally passed, UMIFA did not apply to charitable 
trusts. In 1992, the Restatement (Third) of Trusts adopted standards 
similar to UMIFA and reformulated the Prudent Man Rule to provide that 
borrowing is permissible if the tactic is ``employed selectively and 
cautiously.'' See Restatement (Third) of Trusts (The Prudent Investor 
Rule), Sec. 227 (1992). Two years later, the NCCSL approved the Uniform 
Prudent Investor Act and incorporated the principles of the Restatement 
and principles of modern portfolio management. As described above, 
these standards were further incorporated into UPMIFA in 2006.
    \31\ According to NCCUSL, UPMIFA has already been adopted by 13 
    \32\ UPMIFA Sec. 3(e)(2).
    In summary, debt financing increases the risk of an individual 
transaction, but that is not a reason to discourage all debt financing 
without regard to the level of risk and return of a charitable 
institution's investments as a whole, as the debt-financed income rules 
do. Moreover, the debt-financed income rules are unnecessary for this 
purpose because other laws govern investment standards with a more 
nuanced and aggregate approach that is consistent with modern 
investment theory.
    An additional problem with the debt-financed income rules is that 
they have been applied in a rigid manner that makes formalistic 
distinctions between debt and leverage. As described above, the result 
is that the rules tax transactions which involve direct borrowing while 
permitting investors who use leverage in more sophisticated 
transactions to escape tax.
    Rather than focusing on the use of blocker entities to avoid the 
unrelated debt-financed income rules, I urge Congress to evaluate the 
operation of the debt-financed income rules and to significantly 
restrict the application of these rules. Under current law, there is an 
exception for real estate transactions of pension funds and 
universities if the transactions meet certain requirements. This 
exception, and its requirements, should be used as the model for a 
broader exception applicable to all types of debt-financed property and 
available to all tax-exempt organizations.
    First, the exception should not be limited to pension funds and 
universities. While some argument may exist that pension trusts are 
uniquely focused solely on investments and are therefore distinct from 
other exempt organizations, a similar argument cannot be made to 
distinguish colleges and universities from other tax-exempt 
organizations. Therefore, exceptions to the debt-financed income rules 
should apply to all tax-exempt organizations.
    Further, the exception should not be limited to real estate. As 
discussed above, the current debt-financed income rules apply to many 
legitimate investment transactions that are not abusive and were not 
the intended target of the rules. The current real estate exception 
includes requirements that (i) the indebtedness be for a fixed amount; 
(ii) the seller not provide financing; and (iii) the lender not have 
the use of the property. These requirements should be retained as a 
condition to a new broader exception that applies to all debt-financed 
    Finally, the current real estate exception includes restrictions 
applicable to investments made through partnerships which are intended 
to prevent the transfer of tax benefits from tax-exempt partners to 
taxable partners. These restrictions are tailored to real estate 
transactions and do not lend themselves to application to investments 
in other property such as securities and other financial products. 
Although I am not aware of hedge funds and other investment 
partnerships being used to transfer tax benefits from tax-exempt 
partners to taxable partners, nevertheless, Congress should give the 
Treasury authority to promulgate regulations in the future if necessary 
to foreclose such transfers in non-real estate partnerships.
    If Congress amends the unrelated debt-financed rules as suggested, 
tax-exempt investors will no longer be forced to invest offshore and 
use blocker entities to avoid the unrelated debt-financed income rules 
on legitimate investments. Further, the current disparate treatment 
between direct borrowing and leverage, and between different types of 
tax-exempt investors, will be eliminated.
    I would be pleased to answer any questions you may have.
    Mr. NEAL. Thank you, Ms. McDowell.
    Our next panelist is Mr. Daniel Shapiro, a partner with Schulte, 
Roth & Zabel. Welcome, Mr. Shapiro.


                      LLP, LONDON, ENGLAND

    Mr. SHAPIRO. Thank you, Chairman Rangel, Ranking Member 
McCrery and Members of the Committee. I am Daniel Shapiro. I am 
a founding partner of the New York City law firm of Schulte, 
Roth & Zabel, and I am resident in that firm's London office.
    I have provided tax advice to private investment funds for 
over 30 years. I appear today on behalf of the Managed Funds 
Association, whose members include professionals in hedge 
funds, funds of funds, and managed future funds.
    In accordance with the Committee's request, MFA's prepared 
statement for the record and my summary remarks today focus 
principally on how hedge funds are structured, and in 
particular, as others have discussed, why U.S.-based hedge fund 
managers establish foreign funds outside of the United States 
and why U.S. tax-exempt organizations invest in those foreign 
    Hedge funds sponsored by U.S. managers play an important 
role in the U.S. capital markets and make positive 
contributions to the U.S. economy. The ability of U.S. managers 
to compete globally for talented personnel for investment 
opportunities and for investors is influenced by many factors, 
including the U.S. tax system. Hedge funds are structured in 
accordance with established principles of Federal tax law and 
the structures promote congressional tax and economic policies. 
This includes the funds that U.S.-based managers establish 
outside the United States in order to compete with non-U.S. 
managers for passive investors from all over the world.
    For more than 40 years, Congress has structured the Tax 
Code to encourage passive foreign investments in the U.S. by 
non-U.S. investors. Among other things, Congress has exempted 
most forms of interest payments made to foreign investors from 
U.S. withholding tax and it has likewise exempted their capital 
gains from U.S. taxes generally. Despite this advantageous 
treatment, for a variety of reasons, some of which have been 
mentioned, rather than investing as partners in U.S. hedge 
funds partnerships, most foreign investors strongly prefer to 
use foreign corporate hedge funds as a vehicle for their U.S. 
hedge fund investments. U.S. hedge fund managers would be 
competitively disadvantaged if they did not offer such foreign 
corporate structures to foreign investors.
    As also has been discussed previously by two of the 
panelists, pension funds, university endowments, certain other 
tax-exempt organizations, such as foundations, also invest in 
foreign hedge funds sponsored by U.S. managers. They make their 
hedge fund investments into foreign hedge funds, as has been 
said, to avoid the application to that investment income of the 
technical unrelated business income tax provision. These 
provisions, sometimes referred to as UBIT, subject income of 
tax-exempt entities, generated through debt financing, to a 35 
percent Federal tax. As has been mentioned, the UBIT rules 
would apply if a tax-exempt organization invested in a hedge 
fund in the U.S. structure as a limited partnership would use 
as leverage. But by investing in a foreign corporate hedge fund 
and not in a transparent U.S. partnership, the tax-exempt 
organization is not deemed to be using debt financing because 
the leverage used by the foreign corporate fund does not pass 
through the tax-exempt shareholder.
    As mentioned, the conclusion that investments in foreign 
corporate funds by U.S. tax-exempt organizations does not 
trigger the adverse UBIT tax result has been specifically 
confirmed by a number of recent IRS rulings, as well as 
implicitly by Congress in connection with 1996 tax legislation. 
Moreover, from a tax policy point of view, as has been 
mentioned before, there appears to be very little basis for 
imposing UBIT on passive investment income received by a tax 
organization where it has no liability for the leverage used by 
the foreign fund, has no control over the funds investments or 
the extensive leverage, and does not incur any indebtedness to 
acquire or carry the investments where they would be taxed if 
they did. As this Committee knows, many tax-exempt 
organizations, especially universities, starting with Harvard 
and Yale, have been able to achieve substantial growth in their 
endowments by investing significant percentages of their assets 
in foreign hedge funds. If universities and other exempt 
entities, such as pension funds, which are increasing their 
allocations to foreign hedge funds and fund to funds, were 
subject to UBIT on such investments, their rate of return would 
be substantially diminished.
    As noted, and I will not talk about this much because it 
was not our precise purpose, some managers defer the receipt of 
fees they receive from offshore funds. What I would just point 
out is that many foreign investors frequently expect these 
deferral elections to be made so that there is a resulting 
deferral which buttresses the alignment of interest between the 
U.S. manager and the foreign investor. The onerous tax rules, 
which you may be aware of, applicable to a U.S. taxpayer 
investing directly into one of his foreign funds, effectively 
prevent a manager from investing directly in the fund. So 
deferral of fees by U.S. managers, which allow those fees to 
continue to be invested during the deferral period only, along 
side the foreign investors do ultimately get taxed at the top 
income tax rate of 35 percent when they are received by the 
managers at the end of the deferral period, and they are 
subject to the comprehensive tax regulatory regime enacted by 
Congress in 2004 to govern deferred compensation arrangements.
    MFA is aware that this Committee is considering various 
other tax policy issues, some related to carried interest, the 
application of the publicly-traded partnership rules, to public 
offerings, MFA has significant reservations regarding some of 
these proposals and would welcome the opportunity to present 
its views on these issues to the Committee in greater detail as 
the legislative process moves forward.
    Thank you.
    [The prepared statement of Mr. Shapiro follows:]
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    Mr. NEAL. Thank you, Mr. Shapiro. By an unanimous consent 
agreement just prior to moving over to the House floor, the 
Chair will recognize Mr. Blumenauer and then Mr. Cantor.
    Mr. BLUMENAUER. Thank you, Mr. Chairman. We are in the 
midst, as you know, of a series of fascinating panels here 
helping us to understand some very complex interrelationships 
dealing with issues of hedge funds, how we are treating 
investment income, dealing with the alternative minimum tax and 
in particular what we are going to do with the alternative 
minimum tax as it has broader applications to people. But there 
is a thread of tax equity and revenue stability that goes 
through this. I was just curious if I could to start, Mr. 
Shapiro, with you, you are referencing, for instance, maybe it 
is not directly on point but it is in the back of people's 
minds about ways that compensation can be deferred, rolled over 
time, and you were talking about the alignment of interest that 
some feel is desirable, makes sense to me, hedge fund managers, 
the people that are participating in it, is there any reason 
why this alignment of interest for a sub-set of hedge fund 
managers is any different than an alignment of interest that 
people may have for other valued employees in other business 
enterprises? Are they somehow special or are there other 
broader applications that would obtain from the alignment of 
    Mr. SHAPIRO. Well, there are--if I understand your 
question, there are deferred compensation arrangements of 
various kinds that apply.
    Mr. BLUMENAUER. There are but they are limited in nature 
and not every employee has the employee to have this broad 
deferral, and I am just wondering if there is something special 
about hedge fund managers that would not be applied to other 
key and valued employees, such as if we are going to do this, 
that we should apply it more broadly?
    Mr. SHAPIRO. Well, I think that various key employees are 
offered deferred compensation arrangements, some of them are 
offered those by U.S. corporations that induce their employees 
to stay with them by creating deferred fee arrangements. If you 
are talking about how far and how wide should those deferred 
fee arrangements be applied, I think that it depends on each 
corporation's view of how valuable their employees are and 
whether they want to make those arrangements.
    Mr. BLUMENAUER. But they are not unique among other 
millions of valued employees who are employed by other 
    Mr. SHAPIRO. No, I agree. I think that this arrangement, 
that the hedge funds have established with offshore funds 
happens because of the structure of the way their fees are paid 
from the offshore funds. I think that it is one of the kinds of 
deferred arrangements, all of which are now subject to very 
serious regulatory rules about how those deferrals have to be 
elected at the beginning of the year and how the deferral 
arrangements have to be structured to meet various tax 
    Mr. BLUMENAUER. One of the things the Committee is 
wrestling with is to avoid the application of the alternative 
minimum tax to some 27 million American taxpaying families next 
year, which virtually everybody says was never intended to be 
the purpose. One of the reasons 27 million families are 
subjected to it is because we are now treating as a tax 
loophole that needs to be closed things like paying for your 
child's education, saving for your future, paying your state 
and local property taxes, these are tax preference items that 
get added back in in the computation. So, we are looking at 
ways to fix it. Is there any reason why we should not add back 
to the alternative minimum tax some of the tax preferences and 
benefits that accrue to hedge fund managers that mean that most 
of them are not subjected to the alternative minimum tax, is 
that a legitimate--is there any reason we should not consider 
adding back those tax preferences as opposed to somebody paying 
their local property taxes or claiming a child income tax 
    Mr. SHAPIRO. Look, I think if the effort is being made to 
deal with AMT, there are a lot of ways to get at it and one is 
to increase tax rates, the other is to change the way the AMT 
works to increase the amount that people have to earn before 
they are subject to the AMT.
    Mr. BLUMENAUER. No, I am referring specifically if today 
the child tax credit is a preference that gets added back, if 
paying your local property taxes is added back, isn't it 
reasonable that we should consider adding back some of the 
unique tax benefits that flow to hedge fund managers that in 
many cases they are not paying the alternative tax?
    Mr. SHAPIRO. But there are a variety of tax benefits that 
many kinds of investors and employees and managers have. I 
think it is all on the table for consideration. I do not have a 
particular view as to which one you should, but I think as this 
Committee thinks about how to deal with AMT, I assume 
everything is up for grabs and I assume that issue could be 
considered by you, yes.
    Mr. BLUMENAUER. Well, I appreciate, Mr. Chairman, your 
courtesy, and I do appreciate the testimony here helping us 
round out a bigger, broader picture and more nuanced because we 
certainly do not want to get into an area of unintended 
consequences. I found this very helpful. Thank you.
    Mr. NEAL. Thank the gentleman. The gentleman from Virginia, 
Mr. Cantor is recognized to inquire.
    Mr. CANTOR. I think the Chairman, and I want to thank the 
panelists too for their indulgence and for being here all day 
waiting for us to return from the floor.
    Mr. Chairman, I first of all would like to in my opinion 
set the record straight from some of the comments that were 
made earlier, particularly by the gentleman from Texas, when he 
indicated that there was no willingness on the part of the 
Republicans to try and address the AMT problem and would note 
that every year since at least I was here since 2001 there has 
been an attempt to hold harmless, if you will, or apply a 
patch. I do not think it is fair to say that we were not 
willing, I think we are all here trying to address that. 
Really, I think none of us would be here if we had not seen the 
veto by President Clinton in 1999 of the AMT fix.
    Be that as it may, we now find ourselves on a hunt for more 
revenues somehow since we in this body have a very poor track 
record of cutting spending and trying to reset the economic or 
fiscal model due to our entitlement scenario, we find ourselves 
in hunt of more revenue to address the AMT situation. In my 
opinion, we saw the Bachus-Grassley bill focus the publicly 
traded partnerships and want to somehow penalize them for the 
profits that they were experiencing and their investors were 
    Next, Mr. Chairman, you along with our colleague from 
Michigan put in a bill, which in my opinion not only targets 
one of the most innovative sectors of our economy that has 
really performed a function of being an agent for change, 
creating jobs and opportunity, but also now may very well apply 
to the mom and pop partnership millions of Americans that are 
putting their capital at risk everyday to create opportunity 
for their families and communities.
    So, my question, Mr. Chairman, with all of that, we have 
seen the partnership structure, we have seen the favored 
treatment of capital gains produce an incredible increase in 
investment and productivity in this economy. My question for 
Mr. Shapiro and then to Ms. Gallagher and Ms. McDowell, if we 
were to, as some would want, not me included, raise or change 
the character of the income on carried interest so affect the 
return that the fund managers have, would that necessarily, in 
my opinion, translate into a change in the two and 20 formula 
that most of the private equity funds have? Then would we see 
the nonprofit and the retirement funds also be negatively 
impacted by that increase in taxes? Mr. Shapiro.
    Mr. SHAPIRO. I think sitting here it is very hard to 
predict whether private equity or hedge fund managers, general 
partners, if they were faced with higher taxation would believe 
that the response should be increasing the two and 20, which is 
not always what is charged but it has sort of become the mantra 
for what most managers get in either side of the private equity 
hedge funds. It is simply too hard for me to predict that. I 
think that at some point there is a level of resistance on the 
part of investors, and I think that tax-exempt institutions in 
particular who have a lot of leverage to use, to use the often-
cited word today, would probably not be happy paying 
significantly higher fees so the result might well be, even 
though the managers would say, ``Well, look, we are paying much 
higher taxes, we need to generate more fees,'' that that cost 
would really be picked up by the managers and by the general 
partners of private equity funds.
    Mr. CANTOR. So, is it in your opinion fair to say though 
that the level of investment would continue and disregard--
given the players in the investment partnerships as well as the 
partners themselves, disregard the increased cost?
    Mr. SHAPIRO. Well, look, I think that the hedge fund and 
private equity areas, as you have said, have been incredibly 
good to this country and the creativity and the growth of many 
of the industries in this country have been fueled by the 
activity of the best and brightest who tend to go into the 
private equity and hedge fund world. I think they will continue 
to go in that world as long as there are incentives for them to 
do it. One of the incentives is they get people to invest in 
their funds. Another incentive is that they have the potential 
to get more favored tax treatment if they run their funds 
effectively and they can generate long-term capital gains. So, 
I think that the industries would be hurt, I do not think they 
would be put out of business by changes in the tax law.
    Mr. CANTOR. I would then, Mr. Chairman, if I could turn to 
Ms. Gallagher and/or Ms. McDowell to address some of the 
articles, there was an editorial in Pension and Investments 
which talked about the harm to retirees if the tax structure 
and the nature of the income to managers was increased on 
private equity funds?
    Ms. GALLAGHER. First, I would like to be clear that the 
Council does not have any position on carried interest. We are 
here strictly to discuss the section 514 unrelated debt-
financed property problem. Changes, any changes that effect 
return on investment are clearly going to be weighed by the 
investor. As Mr. Shapiro indicates, I think there would be some 
question as to how the managers would react and whether they 
would absorb those increased costs out of their compensation 
rather than pass them along to investors. No one is compelled 
to invest in hedge funds, so I think certainly what the return 
is predicted to be is the factor in what you are going to do.
    Ms. MCDOWELL. I am not really an expert in how managers 
react and so I can only guess, but I would echo what Ms. 
Gallagher has said. As far as tax-exempt investors are 
concerned, they are going to manage their money in order to get 
the best return they can consistent with prudence and their 
fiduciary duties to manage the investments of charities. The 
hedge funds are attractive because they have had such high 
rates of return. If the managers begin to take a larger cut 
which reduces the return, then of course tax-exempt investors, 
just like others, would lose interest in these funds.
    Mr. NEAL. I thank you. The gentleman from New Jersey, Mr. 
Pascrell, will inquire.
    Mr. PASCRELL. Thank you, Mr. Chairman. In a full-day 
hearing to really I believe dissect what fortunes for the 
fortunate really means, and regardless of what subject we are 
talking about here today, I find it fairly incredible that, Mr. 
Chairman, before I ask my question, that I have heard people's 
talk today about the AMT tax and that tax will become the tax 
system by 2016 if we do not do anything about that. It will 
totally become the tax system. The second thing that I have 
concluded today is that there is no doubt in my mind that the 
AMT is a mask to the true cost of the tax cuts of 2001 and 
2003. I have heard no counter-argument to that. That more than 
60 percent of the cost of the AMT represents the deferred cost 
of 2001 and 2003 tax cuts. So, we are here to give relief to 
the middle class because they have been had. On the average, 
the individual who received a $5,000 tax cut had to return 
approximately $3,000 of it at what cost? We know there has been 
a shift of who is being taxed over the last 30 years. We use to 
tax income more than assets. Now we tax assets more than 
income. What is the result of that, Mr. Shay, in your mind and 
in your thoughts today, is what I said accurate or inaccurate 
and what are the consequences if so?
    Mr. SHAY. I am not sure I fully understand what you mean by 
taxing assets more than income. My topic was really the topic 
of international taxation but tying it back to that, clearly 
the Committee has to grapple with how to address the issues of 
the AMT and frankly much bigger issues down the road than the 
AMT because of the sort of structural imbalance that we have 
fiscally between the commitments that have been made and are 
being made and the revenue base that is going to need to be 
relied on to meet those commitments.
    Mr. PASCRELL. Would anyone on the panel like to respond to 
that first question that I laid on the table. I know we are 
talking about the off shoring, and I know we are not discussing 
directly the AMT, would anyone like to respond to my question 
about the difference of taxing assets compared to income and 
who suffers from that or who gains from that and who is in a 
better position? Okay, let me ask the next question then. How 
much money is protected when one invests offshore? Always bound 
to be a compelling question. I would like to put this question 
to the entire panel. Earlier this year, the New York Times 
published an article entitled, ``Managers Use Hedge Funds as 
Big IRAs.'' According to this article, ``Many Americans 
squirrel away as much as they can into retirement investment 
accounts like 401(k)s and IRAs that allow them to compound 
their earnings tax free. The accounts also reduce what they owe 
when tax day rolls around. For the average person, however, the 
government strictly limits the contributions to about $20,000 a 
year. Then there are people who work at hedge funds. A lot of 
the hedge fund managers earning astronomical paychecks, making 
headlines these days are able to postpone paying taxes on much 
of that income for 10 years or more.'' My question is this, 
does anyone think that it is fair that hedge fund managers are 
able to defer paying taxes on a larger portion of their 
compensation than ordinary Americans? Who would like to take a 
crack at that question? Mr. Metzger.
    Mr. METZGER. Many ordinary American taxpayers defer on 
their income. For example, if someone buys a piece of land for 
$100, which appreciates in value to $250 and the person takes a 
mortgage out on it for $200, that appreciation is not being 
taxed even though the person who made that investment is able 
to take the cash out. Or, for example, you have someone who 
buys stock for $100, which appreciates to $200, then that 
person posts that security as collateral to buy other stock. Or 
you have ordinary Americans who defer their year-end bonuses 
past December 31st but get paid before March 15th of the next 
year. So, you do have deferral all across the board. You may 
have hedge fund managers deferring, as well as ordinary 
Americans. The issue is whether or not we want to tax economic 
gain when there is no cash offsetting it.
    Mr. PASCRELL. What are your thoughts?
    Mr. METZGER. I am not an expert--well, let me say that I 
believe that when taxpayers cash out their economic gain, 
perhaps they should be realization events. So, for example, if 
you hold section 1256 regulated futures contracts, they have to 
be marked to market. Whether or not you sell those contracts by 
the end of the year, you pay taxes on the unrealized gains or 
losses. You have section 475, which is mandatory for dealers, 
they have to mark to market their positions whether they sell 
them or not. So, to some extent, the Tax Code already addresses 
some of these instances where unrealized income is taxed.
    Mr. PASCRELL. Thank you.
    Mr. NEAL. Thank you, thank the gentleman. The gentleman 
from Illinois, Mr. Emanuel, is recognized to inquire.
    Mr. EMANUEL. Thank you, Mr. Chairman. I am in the same line 
of questions as it leads to the issue of deferral compensation. 
First I have legislation on this and I come from this view, 
working with and knowing a number of individuals, one is there 
is nobody cheating the system. This is an opportunity to do it. 
It is perfectly legal. What is different is nobody we 
represent, whether it is IRAs or 401(k) deferrals, actually can 
structure a way to pay for their kids' college education and 
have it in an offshore fund. There is a difference for what a 
family is allowed for their IRA and for their 401(k) than 
certain people--not just the size of a dollar but one issue is 
they are allowed to do it.
    The second is can you structure--the first question is 
actually is it fair for them to do something that others 
cannot? Second, can you structure in the Tax Code a way that 
allows I think the universities and pensions and other entities 
to invest in onshore entities so that would not be the only way 
they could do their compensation? My instincts tell me, and I 
have talked to a number of experts, is the answer to that is 
yes. I think the managers of the hedge of funds have a 
legitimate concern that they would lose that money to 
international hedge fund competitors, so what we should do is 
structure a way that they can onshore raise the capital for 
their funds from the universities, from the endowments, from 
the pensions so they can invest here but also then pay 
compensation here.
    Last, although a lot of them use the technique, that is the 
hedge funds, to retain talented employees and have them 
invested in the fund, there are other ways to do retention 
compensation that does not basically have a big gaping hole in 
my view in the equity of the Tax Code. So I want to get to I 
think the fundamental question because I think a lot of them 
have legitimate concerns, that is those who run the hedge 
funds, can you structure the law in a way, and, Mr. Metzger, I 
want to follow-up then with you since you answered the first 
time, that the universities, the pensions, the endowments, et 
cetera, can invest in funds that are based here in the United 
States and do not have to be offshore from a tax purposes?
    Mr. METZGER. Sure, if Congress makes some changes to 
section 514, the incentive that the tax-exempt investors have 
to invest offshore could disappear, particularly in the area of 
funds that employ leverage. If Congress says that the leverage 
used by hedge funds is not considered unrelated debt-financed 
income, then tax-exempt investors should lose their motivation 
to invest offshore. But bear in mind--you have not asked me 
this question but I just want to throw this in--if in fact, 
Congress were to treat all income from carried interests as 
ordinary income, some hedge fund advisers might not accept tax-
exempt money in the onshore funds. They may force them to 
invest offshore because they will want to take advantage of the 
    Mr. EMANUEL. Your answer, how would you resolve that 
problem? You do not want to put anybody at a competitive 
disadvantage but you want to deal with--because one of the 
fundamentals, besides revenue here, you have to have fairness 
in the system. If a family I represent on the northwest side of 
the City of Chicago feels like all they can put aside for 
401(k) or IRA is up to about $20,000 but other people have $145 
million of deferred income, there is a sense that not that 
somebody earned more but somebody is getting a break that they 
cannot get and never can. You fundamentally put a crack in the 
Tax Code in the sense it is not a level playing field, that is 
not a good thing not just for revenue raising, just a sense 
that we are all in this together and that we have the same 
rules that apply across the board. So, I understand that you 
are saying it may force some of the funds to only raise 
    Mr. METZGER. I am saying that if they have the opportunity 
to take tax-exempt money, they might rather take it in the 
offshore. That is assuming that all carried interest is taxed 
as ordinary.
    Mr. EMANUEL. That is assuming that.
    Mr. METZGER. That is assuming.
    Mr. EMANUEL. Okay. Second, do you have any--and this is 
open to anybody, does anybody have any sense of how much 
revenue there is here? I have seen all the articles of the top 
10, top 25 hedge fund managers, et cetera, how much from a 
revenue side if we dealt with this offshore issue in deferral, 
how much revenue would it be as it relates on the tax side, 
does anybody have a guesstimate? No? Okay. I yield back, Mr. 
    Mr. NEAL. That was a chance for them to improve their name 
recognition within the industry. The Chair would recognize Mr. 
McCrery to inquire.
    Mr. MCCRERY. Thank you, Mr. Chairman. Mr. Shay, I was very 
interested in your testimony as it regards what I consider to 
be proposals to simplify the corporate Tax Code in this 
country, the international Tax Code if you will. In your 
testimony, I did not hear you say it orally, but in your 
testimony, your written testimony, you talk about doing these 
changes with deferral and so forth in the context of lowering 
the overall corporate tax rate in this country. That to me is a 
very attractive proposal, which I think is necessary if we are 
going to stay competitive in terms of attracting capital for 
corporate investment and allowing our domestic corporations to 
compete globally. Have you thought about where there could be a 
corporate rate, assuming we keep the corporate income tax, 
where we should put the corporate rate in order to do away with 
deferral? In other words, is there a line at which corporations 
in this country would say, gee, we wouldn't mind doing away 
with deferral assuming a reasonable foreign tax credit regime 
if our corporate rate were ``X''?
    Mr. SHAY. Let me be clear that as an initial matter, the 
changes I would propose, I would propose without--independently 
of reducing the corporate rate, if one were concerned about the 
effect of those changes on the competitiveness of U.S. 
companies and wanted to devote the revenue of those changes 
instead of to the AMT to that issue, there has been some work 
on what a fairly broad amount of these changes would do and 
where you could bring the rate down to. I am not remembering it 
off the top of my head but it is I think still north of 30, the 
top corporate rate now is 35 percent, my recollection it is 
still somewhat north of 30 percent. Others can correct me on 
that. There is actually a paper on that that is cited in 
materials that goes into that issue. Sorry?
    Mr. MCCRERY. Is what you are saying that the money that we 
would recoup from doing away with deferral, if applied to the 
corporate rate would get it down to the low thirties or 
something like that, is that what you are saying?
    Mr. SHAY. I really want to be very cautious. I am trying to 
remember whether the paper I was looking at included other 
changes as well but certainly----
    Mr. MCCRERY. That is not what I am suggesting. I am not 
suggesting simply taking the revenue that we would recoup by 
doing away with deferral and applying it to the corporate rate, 
what I am suggesting is that we find a corporate rate, and I am 
thinking much lower than 30 percent, at which domestic 
corporations, those who do business overseas, who have overseas 
operations, who now use deferral in order to be competitive, a 
rate at which they would say, ``We do not need deferral 
anymore. If you are going to have the rate at this level, we do 
not need deferral, we can compete.'' That is my point. I just 
wondered if you had looked at that from a competitiveness 
standpoint and obviously you have not?
    Mr. SHAY. No, I would defer that to some of the economists. 
There have been some studies I can actually direct your staff 
to where the answer to that would be.
    Mr. MCCRERY. That would be great. Thank you. Mr. Shapiro, 
thank you and welcome. Did you come from London to be here?
    Mr. SHAPIRO. Came last night and leaving tonight.
    Mr. MCCRERY. Oh, my goodness, well, we really appreciate 
your making a quick trip to assist us here. There was some 
questioning from Mr. Cantor and maybe one or two others about 
how fund managers would react if their tax rates went up and 
all of you said, ``Well, gee, we do not know how fund managers 
would react.'' Let me ask it a different way: If fund managers 
in this country were to react to the increase in their taxes to 
35 percent from 15 percent for the carried interest by saying 
to their potential investors, ``Well, you now need to pay us 
two and 30,'' is it plausible that some of those investors 
might say, ``I can get two and 20 in London, I think I will 
take my money to London''?
    Mr. SHAPIRO. I am not sure an investor would take his money 
to London for that reason. I will say that the reason I am in 
London is because having been in this business for a long time, 
we recognize that London has become very competitive in the 
world of hedge funds and private equity funds. Taxes is only a 
part of that. I think that the difference in rates, I think 
investors, managers will not move just for a difference in 
rates but managers are mobile. We see increasingly U.S. 
managers functioning in London, albeit they all pay U.S. taxes 
and they have British taxes to pay and they get a credit 
against their U.S. taxes for the UK taxes, but it is not a good 
thing necessarily for the U.S. that highly skilled U.S. 
managers, both private equity and especially hedge fund 
managers, are functioning in London today and paying most of 
their taxes to the UK with a credit against their U.S. tax 
because even though in theory they owe U.S. tax, they get a 
full credit for the tax so that one of the things I think this 
Committee needs to be mindful of as you develop these proposals 
as it relates to managers is not to drive managers to think 
about moving to places like London and indeed managers are 
thinking of moving to Switzerland and other countries, Monaco, 
where the tax rates are significantly lower. Now if you are a 
U.S. manager and you are a U.S. citizen, you are not going to 
be changing your tax bracket as a result of that. So, taxes is 
just one of the factors I think that would come into play.
    Mr. MCCRERY. You talked more about what managers would do, 
again I asked what the money would do, might the money be 
invested--in other words, if a group of managers here said, 
``We are going to charge you more because we are having to pay 
a higher tax rate,'' might the money go to London or somewhere 
else where they would say, ``We are only going to charge 20 
    Mr. SHAPIRO. My honest view is that the institutional 
investors, who are by far the biggest and growing in scope in 
terms of where both private equity and hedge funds are raising 
their money, they are going to be investing their money not 
based on the fees that are being charged but based on the 
results. We all know that there are managers----
    Mr. MCCRERY. Well, I know that but let's assume all other 
things being equal, Mr. Shapiro----
    Mr. SHAPIRO. Right.
    Mr. MCCRERY [continuing]. If Carlyle here, considers to be 
just as good as you guys----
    Mr. SHAPIRO. Right.
    Mr. MCCRERY [continuing]. Everything else is equal, you are 
going to charge them 20 percent carried interest, Carlyle has 
to charge them 25 percent because of a higher tax rate, where 
are they going to put their money?
    Mr. SHAPIRO. I think at the margin it can make a 
significant difference. I think institutions--if the managers 
feel they have to raise their rates to be able to pay higher 
taxes, institutions will begin to resist that and look to 
places where the rates are not quite as high.
    Mr. MCCRERY. Thank you.
    Mr. NEAL. Thank the gentleman. The gentleman from Maryland, 
Mr. Van Hollen, will inquire.
    Mr. VAN HOLLEN. Thank you, Mr. Chairman. I had a few 
questions for Ms. Gallagher and Ms. McDowell to follow-up on 
your testimony. Ms. Gallagher, you said in your testimony if 
the section 514 of the debt-financed property rules did not 
apply to the hedge fund investments, the tax-exempts would be 
able to invest directly in U.S. hedge funds and use of the 
offshore blockers would end, and that you believe that that can 
be accomplished without creating new opportunities for abuse, 
the kind of sham transactions. I gather, Ms. McDowell, from 
reading your testimony that you share that view. If you could 
each just give some idea if you know what the magnitude of 
dollars we are talking about is in terms of the amount that 
would now be invested onshore instead of offshore? Number two, 
if you could just elaborate a little, Ms. McDowell, on your 
proposals on how to structure that to make sure that we do not 
allow sham transactions but accomplish the goal of putting 
these investments back onshore but without allowing abuses? So, 
I would appreciate any further elaboration that each of you 
have on that topic?
    Ms. GALLAGHER. I am sorry, Mr. Van Hollen, I really do not 
know the answer to your question as to the magnitude of the 
dollars involved. It is substantial. I do want to stress though 
that while we are using offshore blockers, the ultimate 
investment is being made by the hedge funds themselves that are 
still here in the United States largely. I can try to see if we 
have that information for our membership, and I would be happy 
to supply it to you.
    Mr. VAN HOLLEN. Okay.
    Ms. MCDOWELL. Mr. Van Hollen, in my testimony I made 
reference to an exception that is in current law for debt-
financed real estate investments made by pension funds and by 
colleges and universities, and I suggested that that exception 
might serve as a model for an expanded exception that would 
apply to all types of debt-financed property and be available 
to all types of tax-exempt organizations.
    The real estate exception has two types of restrictions. 
One set of restrictions appies to all debt-financed real estate 
transactions, and is directed at the sale leaseback type of 
transaction that was the target of the debt-financed income 
rules. So, for example, these restrictions prohibit seller 
financing, they prohibit contingent debt, they prohibit a 
leaseback of the property, all the types of things that were 
found in what is referred to as the Clay Brown transaction for 
the Supreme Court case that upheld that type of transaction.
    There is a second set of rules that deal with real estate 
investments made through partnerships. The potential abuse in 
partnerships is different than the sale leaseback--well, in 
some ways it is the same but the primary focus for partnerships 
is that they create an opportunity for tax-exempt partners to 
transfer tax benefits to taxable partners because being tax 
exempt, the tax-exempt partners are neutral about whether they 
receive income or losses for tax purposes. The rules in the 
Code today I must say are horrendously complex. The rule 
referred to as the ``fractions rule'' has been said to 
complicate even the most straightforward transactions. I am not 
suggesting that that rule be applied to non-real estate 
transactions. It is very much tailored to real estate. What I 
suggested is that Congress give Treasury regulatory authority 
so that if there are abuses of this sort, Treasury could then 
promulgate regulations. As far as I am aware, hedge funds are 
not used for the purpose of transferring tax benefits from tax-
exempt investors to taxable investors but my understanding is 
based on a couple of inquiries, not on a thorough study. So, 
that is something that I think the Committee would want to be 
aware of as a potential issue.
    Mr. VAN HOLLEN. Okay, thank you very much.
    Mr. SHAPIRO. May I just add a potential analogy that might 
encourage you to follow this line because I think that the idea 
of--and this is not MFA talking, this is a personal view as a 
lawyer in this industry, the idea of allowing tax-exempts to 
invest their money in debts and securities where they are not 
controlling the leverage, it is done by a separate manager----
    Mr. VAN HOLLEN. Right.
    Mr. SHAPIRO [continuing]. Reminds me of what happened with 
regard to the rule that I referred to before. In 1966, this 
Congress said, ``We want foreign investors through the Foreign 
Investors Tax Act to invest without taxation in the United 
States.'' However, they said then that the principal office of 
the foreign investor, if it was a corporation, had to be 
offshore and that led to a whole industry of administrators and 
directors and accountants and everybody doing things in the 
Cayman Islands and the Netherlands. About 12 or 13 years ago, 
someone finally woke up and said, ``This is ridiculous. We do 
not want to charge these people taxes. We want them all to 
invest in the United States.'' So, the rule which was changed, 
no need to have a principal office offshore. Indeed, we are 
encouraging you to have your employees, your administrators, 
your directors, all of your administration in addition to the 
management go on in the United States. There has been no abuse 
at all, and there has been a huge move of administrators and 
business to the United States away from the Caribbean Islands. 
I think there is some analogy here, as you said, and you could 
define it tightly so that it did not involve tax-exempt 
entities going out and doing their own leverage but if you said 
to the tax-exempt entities, ``We want you to invest. We just as 
soon be having you invest here in the United States with 
managers so you do not have to go offshore.'' I do not think if 
it was done correctly that there would be a huge abuse and it 
would follow the very good precedent of eliminating the 
principal office rule, which was there primarily to protect 
revenue, but I think everybody recognized that it was not 
    Mr. VAN HOLLEN. Thank you. Thank you all. Thank you, Mr. 
    Mr. NEAL. I thank the gentleman. The gentleman from New 
York, Mr. Crowley, is recognized to inquire.
    Mr. CROWLEY. I thank my friend from Massachusetts for 
yielding the time. Let me just make a couple of comments before 
I ask my question and that is some of my colleagues on the 
other side have made reference to the fact that--or at least 
one colleague has made reference to the fact that in his 
opinion that this is a ``stealth tax,'' the AMT, that somehow 
making one, like myself, to believe we did not see this coming. 
The truth be known, we have seen this coming for quite some 
time, and I would just remind my colleagues on this side of the 
aisle, for at least the previous 6 years, prior to the 
beginning of this year, they have controlled both the House, 
the Senate and the White House and really took very few steps I 
think to correct the problem of the AMT. Although we can all 
throw stones back and forth again at each other in each party, 
over the years since the assumption of the AMT, I think it is 
important to make that note, that at best there has been 
neglect and we have not done enough over the last 6 years. In 
my opinion, we have actually contributed, this Congress and 
this administration have contributed in creating even a greater 
problem to what I think are irresponsible tax cuts for some of 
the wealthiest in this country.
    Having said that, let me just move, and if the Committee 
will just abide my moving from this issue for just a moment and 
focusing on another issue of grave concern I think to the 
nation as well as pertains to the subprime mortgage industry in 
the United States. I would specifically direct my question to 
Mr. Metzger and Mr. Shapiro. As hedge fund operators or 
managers, did either of your entities purchase mortgage-backed 
securities or collateralized debt obligations or other 
mortgage-related securities?
    Mr. SHAPIRO. I am sure some of the hedge funds that we 
represent did, yes.
    Mr. CROWLEY. Mr. Metzger.
    Mr. METZGER. I do not know the answer to your question. I 
can say that I left the hedge fund 18 months ago so I do not 
know what has been in the portfolio the last 18 months.
    Mr. CROWLEY. Well, I imagine prior to 18 months ago, there 
was some involvement----
    Mr. METZGER. I do not know the answer but it is reasonable 
to assume that there were.
    Mr. CROWLEY. There probably were. You can answer in an 
assumed fashion if you like as well, Mr. Metzger.
    Mr. CROWLEY. I will get a more pointed and direct answer 
from Mr. Shapiro. Do you feel as though your entity received 
the appropriate information that there were appropriate avenues 
for knowing what was entailed in those CDOs?
    Mr. SHAPIRO. This is a complicated question that I did not 
prepare to answer.
    Mr. CROWLEY. I understand. I am also not here to put you on 
the spot.
    Mr. SHAPIRO. Not on behalf of a MFA, it is just a reaction, 
I think there were mistakes made all along the way in the 
subprime area by the investment bankers, by the mortgage 
bankers who did the loans, by the rating agencies, by almost 
everybody and obviously Congress is going to think about what 
it can do to help prevent that problem from happening in the 
future. A lot of very smart people missed signs that a few very 
smart people saw. What could be done better, I think that 
everybody who has been affected by this is going to take steps 
to now be sure that the investors and the people who package 
these loans and the people who borrow money who probably should 
not have been borrowing on the same terms are all on notice 
with much more transparency about the transactions and much 
more thought given to the risks of the whole securitization 
effort. It does not mean in my view that securitization is a 
bad thing. Quite the contrary, it is a wonderful new technique 
for financing transactions and I think it assists the economy 
and the banks because other sources of funds are there but a 
lot of questions have to be asked about how carefully it has to 
be put together.
    Mr. CROWLEY. So, it is really a question of transparency as 
far as you are concerned?
    Mr. SHAPIRO. Well, I think transparency is very important 
and maybe more due diligence and also an understanding that in 
these transactions, if there is a small part of a 
securitization that can be tainted because it is not secure, it 
can affect the whole transaction.
    Mr. CROWLEY. Are you suggesting that bank securities and 
credit rating agencies need more regulation?
    Mr. SHAPIRO. I am not suggesting that, I think that that is 
probably something inevitably that one Committee or another is 
going to look at. I do not think necessarily regulation as 
opposed to self-review of their procedures is the answer. I 
really do not know the answer.
    Mr. CROWLEY. Self-review of their procedures is how we got 
into this predicament I think in the first place.
    Mr. SHAPIRO. Well, that is something that I think--that I 
am sure you will be talking about.
    Mr. CROWLEY. Mr. Metzger.
    Mr. METZGER. With regard to credit risk, my understanding 
is that many of the funds marked--not to market but--to rating 
those investments and since they were rated triple A, they were 
marked at par.
    Mr. CROWLEY. Clearly had deficiencies in terms of triple A, 
they were triple D probably or components thereof?
    Mr. METZGER. I do not know what was in the portfolios but I 
assume that with regard to credit risk if the funds are relying 
on marking to rating, if the rating was incorrect, the 
valuation was incorrect.
    Mr. CROWLEY. Thank you. I yield back. Thank you.
    Mr. NEAL. I thank the gentleman. The gentleman from 
Alabama, Mr. Davis, is recognized to inquire.
    Mr. DAVIS. Thank you, Mr. Chairman. Mr. Metzger or Mr. 
Shapiro, let me go back to the line of questions that Mr. 
Emanuel and Mr. Pascrell pursued earlier. Both of them were 
asking you about the underlying inequities or equities with 
respect to the deferred compensation for hedge fund managers, 
and I think both of you made a similar point. Both of you 
indicated that deferred compensation is a fairly regular 
feature in at least some aspects of our economy, particularly 
for high-end wage earners. I want to make sure you got the 
point that they made in response, and I suppose everyone else 
in the room got this point. Yes, it is true that deferred 
compensation is a feature of our economy, the point that they 
were making is that there is a very limited number of 
individuals for whom deferred compensation is the heart of how 
they get paid. That would be a very narrow class of people, a 
very limited class of people making very large incomes. To put 
this in perspective, I certainly would not be bold enough to 
ask either of you your incomes, that is between you and the 
IRS, but can you give--either one of you give me some sense of 
the average amounts of money that hedge fund managers make in a 
particular year just from your anecdotal experience, what kinds 
of compensation are we talking about, what kinds of income are 
we talking about, either of you?
    Mr. SHAPIRO. Do you want me to start? These are not figures 
that one has to go too far to find because it has become common 
lore in tons of magazines how much hedge fund managers make.
    Mr. DAVIS. But would you give me just some of those 
    Mr. SHAPIRO. Millions of dollars.
    Mr. DAVIS. What is the largest hedge fund income level that 
you all are aware of just from your anecdotal experience, what 
is the highest amount of money you have heard of anybody making 
as a hedge fund manager?
    Mr. METZGER. There was an article, it was a front page 
article in the New York Times a couple of months back that 
quoted from--I do not recall which--hedge fund publication that 
listed the top 20 or 25 paid managers, that information is in 
the public domain. I do not recall it at this point.
    Mr. DAVIS. Well, I understand that but both of you were 
involved in the industry, would one of you care to give me just 
some numbers that you saw on that list just so we can put it in 
perspective? Are both of you telling me you cannot give me a 
single number the hedge fund managers make?
    Mr. SHAPIRO. I think that there probably were a few 
managers who made well over $500 million.
    Mr. DAVIS. Okay, a few who made well over $500 million. A 
substantial number who made over $100 million from your 
perspective, from what you know of the industry? You are both 
nodding your heads, you are nodding your head, yes, Mr. 
    Mr. METZGER. Yes.
    Mr. DAVIS. You would agree, Mr. Shapiro?
    Mr. SHAPIRO. Last year, yes.
    Mr. DAVIS. Alright, now, since my time is limited, let me 
tell you why I make this point. You know about the PAYGO rules 
that this institution passed, you know it is a response to 
years of spiraling deficits and spiraling debt. In effect, 
every new expenditure we make under these rules, we have to now 
behave as most American families do, either we have to raise 
new revenue or cut spending in some place. So, we have to make 
a constant set of political and moral choices about how to pay 
for things, just as most families do. We could have no doubt a 
very interesting, if somewhat esoteric, economic argument about 
the relative benefits of deferred compensation for hedge fund 
managers or the relative incentive or dis-incentivizing 
consequences or particular tax treatment but ultimately this 
Congress has to decide if we are going to fix AMT, how do we do 
it, and we have to make a decision what are the most equitable 
set of pay-for's that we could bring to the table. The point 
that I think you hear from some of my colleagues on this side 
of the aisle is that if we have to engage in the very important 
work of providing tax relief from any middle income Americans, 
frankly it makes sense for the pay-for to aim at individuals 
who are making massive amounts of money, who frankly will not 
really miss the difference. If we have to choose, well, we are 
going to change the tax structure from 15 percent to 35 percent 
for someone making $100 million per hedge fund, well, that may 
be much more defensible to the people we represent. By 
contrast, a few years ago, the old majority in Congress was 
trying to figure out a way to pay for the cost of Katrina 
reconstruction and they made a very interesting decision, to go 
to 13 million families on Medicaid and say for the first time, 
you have got to do a co-pay if you take your kid to a doctor. 
By definition, those families were making between $28,000 and 
$40,000 a year--between $14,000, I am sorry, and $40,000 a 
year, so that is the framework for this argument, that some of 
us on this side of the aisle believe if government has to 
demand extra revenue from anyone, that you logically do it from 
people who may be in the $100 to $500 million range. That is 
what this debate is really about.
    I yield back.
    Mr. NEAL. Thank the gentleman. The gentleman from 
California, Mr. Thompson, is recognized for inquiry.
    Mr. THOMPSON. Thank you, Mr. Chairman. If I could just 
follow on Mr. Davis' line of questioning, maybe Mr. Shay you 
could tell me, as are trying to figure out how to achieve 
international tax reform and recognizing the fairness and 
equity issue, as Mr. Davis pointed out, are there a set of 
principles or recommendations that you would make as to what we 
should--how we should go about considering international tax 
reform, are there things that we should or should not try and 
    Mr. SHAY. Well, as I outline in my testimony, the current 
rules have a series of exceptions or incentives that in essence 
encourage investment outside of the United States in lower tax 
jurisdictions. The one unique issue about international 
taxation is it does involve other countries, it is not all 
within one economy. Taking that into account, I still think 
that there is a substantial scope to restrict some of those 
benefits for foreign investment as to cut back on them to raise 
revenue without adversely affecting the ability of us to 
compete in the world. They basically include restricting the 
current scope for deferral of U.S. taxation on U.S. persons' 
foreign income earned through foreign corporations. While I am 
a real believer in the foreign tax credit to the point of 
eliminating double taxation so we do not discourage 
international investment, our rules now go further than that 
and actually encourage foreign investments, so I would also 
support changes to the foreign tax credit really through the 
source rules--this is starting to get technical--that would not 
result in there being more foreign tax credits say than there 
would be even if we exempted foreign income, which comes back 
to the point I made in my testimony. I think that is responsive 
to your question, sir.
    Mr. THOMPSON. Thank you very much. Ms. Gallagher, would 
tax-exempt investors invest in onshore hedge funds rather than 
offshore hedge funds if the debt-financed income rules did not 
apply to the hedge fund investments?
    Ms. GALLAGHER. Yes, sir, the only reason that people go 
offshore is to avoid the application of the section 514 rules.
    Mr. THOMPSON. So, it is just a straight tax avoidance 
    Ms. GALLAGHER. Again, as we said earlier, we do not think 
the section 514 rules were intended to cover this kind of 
investment, by using offshore blockers, foundations and other 
tax-exempt entities are able to avoid the application of that 
tax and the Internal Revenue Service has issued several rulings 
acknowledging that that is the case.
    Mr. THOMPSON. Thank you.
    Ms. GALLAGHER. But if you take away the rules, then you 
take away the reason to go offshore.
    Mr. THOMPSON. Thank you.
    Mr. SHAPIRO. May I add something?
    Mr. THOMPSON. Yes, sir. You are going to need to speak 
directly in the microphone. It is very hard to hear on this end 
of the dais.
    Mr. SHAPIRO. You are not hearing me? Okay. If tax-exempt 
entities invested in the U.S. partnerships and did not have the 
debt-financed income rules, they would actually be ahead of the 
game in this respect: when they go offshore, which they do 
legitimately to avoid what we all think is not the right 
application of the debt-financed income rules, the offshore 
entities they invest in are subject to 30 percent withholding 
tax on all the dividends those offshore entities earn whereas 
if they were invested in a partnership here, they would have 
zero tax to pay. They would not have the 30 percent withholding 
tax. So, tax-exempt entities are actually hurt by having to go 
offshore to avoid the debt-financed income problem by being in 
entities that are subject to 30 percent withholding tax on 
dividends. So, it would be an advantage to tax-exempt entities 
to bring them back onshore rather than forcing them to stay 
    Mr. THOMPSON. Somebody is shaking their head, are you in 
agreement with this? Ms. Gallagher.
    Ms. GALLAGHER. I am sorry, I was shaking my head at the 
gentleman behind me.
    Mr. THOMPSON. It is not hard to confuse me.
    Ms. GALLAGHER. It is my understanding that the offshore 
hedge funds are largely structured to avoid the dividend 
withholding but I am being told I am wrong about that.
    Mr. THOMPSON. Could we somehow get some clarification on 
that, Mr. Chairman?
    Mr. METZGER. I was also shaking my head in agreement with 
Mr. Shapiro.
    Mr. THOMPSON. Thank you. I yield back, Mr. Chairman.
    Mr. NEAL. I thank the gentleman. All Members of the 
Committee now have had an opportunity to inquire of at least 
one panel so now we are going to return to the regular order, 
and I would remind Members of the Committee that we still have 
two more panels to go. By way of discussion with Mr. McCrery, 
we would hope that Members of the Committee might consider 3 
minutes of inquiry time rather than five. We will now move to 
other side. Mr. English, the gentleman from Pennsylvania, will 
    Mr. ENGLISH. Thank you, Mr. Chairman. Mr. Metzger, in your 
testimony, you state that proposals to raise revenue to pay for 
an AMT reform bill by imposing taxes on pension funds invested 
offshore will hurt many of the very people the AMT is supposed 
to help. Can you extrapolate on that for us?
    Mr. METZGER. Yes, on May 16, 2007, the New York Times 
reported that Congress is considering closing the ``Loophole'' 
that allows tax-exempt investors to avoid paying taxes on their 
hedge funds investments. Students at NYU have suggested that if 
you tax the tax-exempt investors that make offshore 
investments, many of the beneficiaries of those pension plans 
are middle-class taxpayers. So, if Congress tries to pay for 
the AMT by taxing tax-exempts, effectively you are taking money 
out of one pocket and putting it in the other pocket.
    Mr. ENGLISH. Following up on that, Mr. Metzger, would you 
explain for us what you meant in your written statement when 
you said, and I quote: ``Singling out specific industries for 
special adverse tax legislation would be poor public policy''?
    Mr. METZGER. I think if there is an issue such as deferral, 
you ought to tax everyone's deferral. If there is an issue such 
as carried interest, you should not be singling out industries. 
In terms of public policy, the best way to solve a problem is 
not to enact what I will call a ``windfall profits tax'' but 
deal with the economic issues, deal with the policy issue.
    Mr. ENGLISH. So, in other words, equity issues when dealing 
in the real world of international tax policy are sometimes a 
little complicated. On that point, Mr. Shay, I noticed that you 
made a number of points about fairness in your testimony. I 
take it you strongly support the current U.S. system of 
territoriality in the taxation of foreign income, is that a 
fair summary?
    Mr. SHAY. Actually, sir, the U.S. currently does not impose 
territoriality in the way it is conventionally thought of.
    Mr. ENGLISH. That is correct.
    Mr. SHAY. I am not a supporter of territoriality.
    Mr. ENGLISH. You are not. Are you familiar with the 
Homeland Re-investment Act that Congress passed a couple of 
years ago that created a 1 year window for repatriation of 
foreign earnings into the U.S.?
    Mr. SHAY. I am very familiar with it.
    Mr. ENGLISH. Are you familiar with how much money was 
brought back that would have otherwise been stranded offshore 
by that Act?
    Mr. SHAY. I do not have a specific number.
    Mr. ENGLISH. Does $350 billion sound about right?
    Mr. SHAY. It is somewhere in that range, that is correct.
    Mr. ENGLISH. That money would have never made it into the 
United States otherwise, would you concur with that?
    Mr. SHAY. No, but I do think----
    Mr. ENGLISH. You do not?
    Mr. SHAY. Some of the money would have come back but it is 
fair to say that that accelerated the repatriation of money but 
the question really is did that have--that legislation was 
billed as having an economic impact.
    Mr. ENGLISH. You deny that?
    Mr. SHAY. What is not clear to me at all is the ultimate 
economic effect of money going from one pocket of the 
corporation to the other pocket of the corporation.
    Mr. ENGLISH. Well, I am out of time, Mr. Chairman, but I 
would be delighted to share with Mr. Shay some of the studies 
that have shown the economic growth that has sprung from that. 
I thank you very much.
    Mr. NEAL. I thank the gentleman. The Chair recognizes the 
gentleman from Michigan, Mr. Levin, to inquire.
    Mr. LEVIN OF MICHIGAN. Thank you and thanks to all of you. 
This has been a really useful hearing. They are long but 
necessary, and I think very helpful. On the UBIT issue, I think 
the testimony has been very succinct and a number of us have 
asked questions about it. We have been working on this issue 
for some time relating to the tax-exempt entities in the UBIT 
rules and there is legislation now ready to be introduced I 
hope today that would address this issue. So, you have 
reinforced I think the need for there to be such legislation, 
and I would urge all of my colleagues to look at this 
legislation and see if they would like to join in.
    Secondly, I think it has been useful regarding retirement 
systems, and there is a letter that was sent out yesterday from 
the National Conference on Public Employment Retirement Systems 
and it says the following, and I would like, Mr. Chairman, for 
it to be entered into the record, this letter.
    Mr. NEAL. Without objection.
    [The provided material follows:]
    [GRAPHIC] [TIFF OMITTED] 43307A.053
    [GRAPHIC] [TIFF OMITTED] 43307A.054
    Mr. LEVIN OF MICHIGAN. It states: ``While some of our 
members feel that the bills,'' they are talking about the 
carried interest bills, ``could affect the public planned 
community, the majority of our members do not share that 
opinion.'' I think Mr. Cantor was here when that was raised.
    Thirdly, I would like to say to you, Mr. Shapiro, we 
welcome your candor. You spoke, and I hope Mr. Cantor will hear 
this now or later, you were asked a series of questions and you 
gave a series of answers that the person who asked the question 
I think did not find particularly felicitous. But I hope that 
as we go forth on these issues, that we will ask questions and 
will listen to the answers. That is why we are having these 
hearings, to have an intelligent, open discussion about this 
issue, including the carried interest issue. I do think that 
your response was not what some wanted to hear, and I do not 
want to over-characterize it, it was very direct, but that is 
what we need to hear. We need to get straight answers to these 
important questions, and this panel I think has been especially 
    I finish with this, the question Mr. English asked about 
this repatriation, I would like to see the studies that show 
that this elimination of taxes in the multi-, multi-billions 
really paid off in terms of new jobs in this country because I 
think the evidence is overwhelming that that was not true and 
that the provision that there be a job creation result was 
something that was hard to trace and to the extent it has, it 
turned out to be incorrect.
    But, again, I want to thank you for your straightforward 
testimony. We are ready on this UBIT bill and I hope to have it 
introduced today, and I ask all of you to join in if you would 
like to. Thank you.
    Mr. NEAL. The Chair is going to move away from the previous 
commitment only because the gentle lady from Nevada has not had 
an opportunity to inquire. She has asked that she be allowed to 
offer her first inquiry. The Chair recognizes the gentle lady 
from Nevada.
    Ms. BERKLEY. ``Nevada'' but thank you.
    Mr. NEAL. I am from Massachusetts.
    Mr. LEVIN OF MICHIGAN. How do you pronounce Massachusetts?
    Ms. BERKLEY. How do I? Las Vegas. Thank you very much for 
being here. This has been most informative. I am new to the 
Committee and there is not a day that goes by, particularly 
today, that I did not wish I paid better attention to my tax 
professor in law school, it would have made my life a whole lot 
easier now. You have a wealth of information, and I am 
delighted that you are sharing it with us. The one thing I have 
that you do not is a vote, and somehow I am going to have to 
vote when all of this over on how we are going to have the 
requisite amount of revenue that we need for the needs that my 
constituents tell me that they are in need of.
    A couple of years ago, about 3,100 of the people that live 
in Las Vegas that I represent paid the AMT and in the 
neighboring congressional district, there were about 6,300 that 
were subject to the AMT. The next year, they do not know this 
yet, but there is going to be 30,000 people that are going to 
be subject to the AMT in my congressional district and in the 
neighboring congressional district, approximately 55,000.
    Now, I do not think the question is--I do not have a 
voracious appetite to tax anybody and I ask my constituents 
when they come and see me and when they come to Washington to 
talk to their Member of Congress and they sit in my office, if 
it is the people representing the police departments, they want 
additional funding to hire more police or to get better 
communication systems. If it is the firefighters, they want 
more equipment to be able to fight the fires in the western 
United States. Parents that come to me want to make sure that 
their kids keep getting a good education. My seniors that come 
and visit me, AARP and all the others, want to make sure their 
Social Security is going to be here when they retire and their 
Medicare is going to be there and transportation issues. We do 
not want to have another disaster like we had with the bridge 
in Minnesota, and for a district like mine, where we are laying 
as much concrete and pavement as we can to accommodate the 
5,000 new residents I have a month coming into my congressional 
district, the costs of keeping up with that are extraordinary.
    So, in the earlier panel, the first panel, they told us 
that their best advice is to get rid of the AMT, just get rid 
of it and that is going to cost us over $600 billion over the 
next 10 years. I have to come up with a way because of the 
PAYGO rules to offset that. If you were sitting here instead of 
there, and I had paid better attention in law school so I would 
be sitting where you are, what would you recommend that we do? 
Where do we get that revenue if we are going to do the AMT fix 
for people that never should have been ensnared in the AMT in 
the first place? Anybody? Thank you, Mr. Metzger.
    Mr. METZGER. I believe that Dr. Burman stated in the last 
panel that he felt that he did not see much benefit to 
preferential long-term capital-gains rates. That is a starting 
    Ms. BERKLEY. How much revenue would that bring in?
    Mr. METZGER. How much revenue would be brought in? I do not 
    Ms. BERKLEY. Me neither.
    Mr. METZGER. I do not know because I believe a lot of the 
trading tax-exempt today, a lot of trading done is actually 
done by institutional investors that are tax-exempt so actually 
I do not know how much would be raised but that is at least a 
place at which to look.
    Ms. BERKLEY. Mr. Shapiro.
    Mr. SHAPIRO. I do not know, I really think that frankly we 
are sympathetic to the dilemma, I think most of us are because 
we are U.S. citizens and we want to see equity and fairness. I 
think rather than targeting any one industry or one loophole or 
one issue that people have identified, that one would go back 
and see whether the rate reductions that took place some years 
ago should be re-visited to see if a small rate reduction 
across the board can raise enough of the revenue to meet the 
$600 million or whatever the number is.
    Ms. BERKLEY. Billion.
    Mr. SHAPIRO. I do not have the answer.
    Ms. BERKLEY. Thank you. Thank you, Mr. Chairman.
    Mr. NEAL. I thank the gentle lady. The gentleman from 
Washington, Mr. McDermott, is recognized to inquire.
    Mr. MCDERMOTT. Thank you, Mr. Chairman. I want to ask a 
question for a bricklayer in my district who is used to being 
paid wages at the end of the month and being taxed under the 
IRS. Mr. Metzger, you state that hedge fund managers will 
likely defer compensation when they manage offshore funds and 
receive carried interest when they manage onshore funds. Now, 
it seems to me that is very often managing the same pool of 
money, and I would like you to explain to my constituents 
because I am going to have to, why is one payment, carried 
interest, taxed at capital gains rates, 15 percent, and the 
other is taxed--the deferred management fees are taxed as 
ordinary income, what justification is there for that? Why 
should my taxpayer have to pay the higher rates and a manager 
can play these games and get this break?
    Mr. METZGER. That is an excellent question and before I 
address it, I just want to correct the record in that a carried 
interest is not taxed necessarily at 15 percent.
    Mr. MCDERMOTT. What is it taxed at?
    Mr. METZGER. It depends on the source of income. As I said 
in my testimony, a lot of the income, in fact in my experience, 
the majority of the income, is taxed at ordinary rates. Carried 
interest means that the adviser, or hedge fund manager, shares 
in all the tax attributes. So, for example, if only 35 percent 
of the taxable income is preferential-rate income, a 15-percent 
tax would apply to the 35 percent but the remaining 65 percent 
of income would be taxed at ordinary rates at 35 percent. In my 
experience, most of the hedge fund income is not preferential. 
So, I just wanted to----
    Mr. MCDERMOTT. So, are you saying this problem does not 
exist, that it is a fair system, there is really nothing here 
to be looked at?
    Mr. METZGER. No, no, I am going to get to your question in 
a moment.
    Mr. MCDERMOTT. Okay.
    Mr. METZGER. I just wanted to make sure that you did not 
have this idea that all of the carried interest in hedge funds 
was taxed at 15 percent. Now that might be different from 
private equity but that is not my area of expertise.
    But in terms of your question, what I think you are saying 
is the hedge fund adviser does the trading at the master-fund 
level and receives his or her compensation at the feeder level, 
and I think what you are saying is that the managers can 
choose, let's say I want to treat it as service income, so I 
will say if I receive it at the offshore level, it is a service 
income. If I receive it at the onshore level, no, that is a 
carried interest. I think that is your question. I do not think 
you will like my answer, however there is a difference and that 
liquidity--if a manager wants liquidity, the manager will 
choose to take compensation as a carried interest. If the 
manager says, ``I do not need the money for 5 years or 10 
years,'' the manager will choose deferral. That said, the tax 
law, the Tax Code permits taxpayers to, if you will, choose how 
they structure their compensation arrangements.
    Mr. MCDERMOTT. But how can it be fair if my bricklayer can 
only put $20,000 into his IRA and these managers you are 
talking about can put a half a billion dollars into essentially 
an unofficial IRA that is holding out there until some day they 
decide to bring it back in, what is the fairness in that? Why 
do you not let me put all I can put in as a bricklayer?
    Mr. METZGER. Again, that is what the Tax Code allows and 
they are following the Tax Code. If your question is should the 
Tax Code be changed, if that is what your question is, my 
answer is all types of deferred income should be treated the 
same way. You should attack the issue instead of attacking 
particular industries. Today the hedge fund industry is 
successful, if we had this hearing 10 years ago, you would not 
have been talking about hedge fund managers. Five years from 
now it may be a different industry. Instead of singling out 
industries, which is a quick fix, why do we not just attack the 
issue of deferrals entirely?
    Mr. MCDERMOTT. Thank you. Thank you, Mr. Chairman.
    Mr. NEAL. I would like to yield for a moment to the 
Republican leader, Mr. McCrery, for an unanimous consent 
    Mr. MCCRERY. Thank you, Mr. Chairman. A few minutes ago, 
our colleague from Michigan, Mr. Levin, introduced for the 
record a letter from the National Conference on Public Employee 
Retirement Systems. That letter was a follow-up to an earlier 
letter, dated August 24, 2007, from the same National 
Conference of Public Employee Retirement Systems, and I would 
like to submit for the record that August 24th letter so that 
both of these can be read together.
    Mr. LEVIN OF MICHIGAN. Reserving the right to object, I do 
not at all, I just urge that everybody read in that letter we 
argue that the bills could potentially have a negative impact 
on public pension plans, the position we took is not the view 
of NCPERS' full membership and that the majority do not agree 
with the letter that was sent earlier. I am glad to have both 
    Mr. MCCRERY. I think it would do Members well to read both 
letters. They can judge for themselves the merit of each 
    Mr. LEVIN OF MICHIGAN. No, no, I fully agree. I hope they 
will read both of them. I withdraw my reservation.
    Mr. NEAL. Just before the Chair recognizes the gentleman 
from Georgia, maybe all the members might want to think about 
the possibility of doing what we did between the first and 
second panels where we allowed members of the first panel who 
had not been able to participate in inquiry to become first in 
line for questioning the next panel, just a thought as we move 
to Mr. Lewis.--The gentleman from Georgia is recognized to 
    Mr. LEWIS OF GEORGIA. Thank you very much, Mr. Chairman. 
Let me thank the members of the panel for being here today. I 
know it's been very long for you, like it's been long for many 
of us. But we live in a complex world, unbelievable world.
    We live in a country with a sophisticated economy, and so 
some people believe, therefore, we should have a complicated 
and sophisticated tax pool. So, I want to ask you, would you 
agree that the international tax rule on hedge fund investment 
off-shore are unnecessarily complicated and the effect of 
making the Code less fair?
    If one of you could make only one change to our 
international tax law, what would it be? What would it be? 
    Mr. SHAPIRO. I haven't thought about it before and this is 
my personal view, but we talked before and I made the 
suggestion that trying to simplify the rules to allow this huge 
and wonderful, important tax exempt community that represents 
such great missions to invest their money in U.S. funds without 
being subject to tax to me would simplify a significant amount 
of the planning that goes into hedge funds.
    So, I think that suggestion was made over here and I think 
it would be a very interesting idea for you to pursue. It would 
be consistent with some very smart decisions made by this 
congress going back to 1966. Let's encourage foreign 
investment, and then 20 years later, let's get rid of any rules 
that require them to have sort of artificial, off-shore 
offices. Let's encourage the money to be managed here on a 
favored tax basis. I think that would be one of a number of 
steps that you could take to simplify the tax law as it applies 
to hedge funds.
    Mr. LEWIS OF GEORGIA. Thank you. Other volunteers?
    Mr. SHAY. Mr. Lewis, I mentioned a couple of proposals in 
my testimony, but the one that would probably have the greatest 
simplifying effect would be to not have deferral of taxation on 
foreign corporate earnings in terms of reducing some of the 
complexity that's in the Code.
    Ms. MCDOWELL. Mr. Lewis, this does not go to international 
tax overall. That's not my area of expertise. My area of 
expertise is tax exempt organizations. However, I think that 
enlarging the exception to the debt-financed income rules so 
that most debt-financed transactions could go forward without 
regard to those rules would greatly simplify investments for 
charitable enterprises.
    Mr. LEWIS OF GEORGIA. Thank you very much. Thank you, Mr. 
Chairman. I yield back. My time is up.
    Mr. NEAL. I thank the gentleman. I believe the gentleman 
from California, Mr. Becerra, would like to inquire.
    Mr. BECERRA. Yes, Mr. Chairman. Thank you very much, and I 
thank the panel for their patience as we go through all the 
questioning, but we do appreciate your comments.
    Ms. McDowell, let me ask a quick question. You just 
mentioned that you thought we should perhaps examine the debt 
finance income rule so that we could make it perhaps a fairer 
process for a lot of our not-for-profit entities that are going 
    What if we were to say that we want to provide an equal 
playing field by saying that we'll apply the UBIT tax to 
offshore investments versus not apply the UBIT tax to onshore 
    Ms. MCDOWELL. Well, in my judgment we're talking here about 
one part of the UBIT tax. We're talking about the part that 
applies to debt-financed investments. I don't see a reason to 
discourage debt-financed investments across the board. The 
current rules were enacted in 1969 to respond to a very 
specific abusive transaction, a sale lease back transaction. 
They've done that successfully, and I think that there are 
rules that are in the Code now that deal with real estate 
transactions that would continue to do that.
    Mr. BECERRA. I sense what you're saying. I think there's a 
threat of reasoning in what you're saying. You're saying that 
if we actually expanded the debt finance rule under the UBIT 
tax to offshore investments, what you'd in essence do is kill 
those debt-financed investments.
    Ms. MCDOWELL. Right, and I don't think there's anything 
wrong with many of them.
    Mr. BECERRA. Okay, great. I appreciate that answer. Let me 
ask Mr. Metzger. I think you've been asked this question 
somewhat, but I want to make sure I'm clear on this. I'm a fund 
manager, and I'm making investments onshore. I suspect my 
investors are expecting me to do certain things to invest that 
money wisely to create a good return. I am now a fund manager 
for an investment that's offshore. I expect that those same 
investors, whether they are now corporate shareholders or 
whether they were limited partners in the onshore investment, 
are expecting the same type of wise investment and similarly 
high returns.
    Mr. METZGER. Yes.
    Mr. BECERRA. Does one fund manager behave differently from 
the other fund manager if it's an onshore or offshore 
    Mr. METZGER. Now, you're talking about two side-by-side 
investments, or are you talking about the classic, master-
feeder arrangement?
    Mr. BECERRA. It's two different individuals. Do they try to 
behave similarly whether it's an onshore or offshore investment 
and to try to extract as much return for that investment as 
    Mr. METZGER. If I understand your question correctly, 
you're asking me, if you have, for example, onshore investors, 
and offshore investors, do they have different interests. The 
answer is yes. So, for example, the onshore investor prefers to 
receive preferential-rate dividend income. The offshore 
investor prefers that fund does not receive dividend income 
that is subject to withheld tax.
    Mr. BECERRA. No, I understand that.
    Mr. METZGER. So, therefore the manager of the offshore fund 
might try to use derivative financial instruments to avoid 
paying the tax. So, there might be slightly different trades.
    Mr. BECERRA. Let me try to approach it a little 
differently, because I understand what you've said, and I agree 
with you. I know my time has expired so I want to try to close 
on this.
    Say I have investors here onshore who wish to invest. I 
want to then calculate how to make the best investment based on 
their circumstance, tax-wise and otherwise. I am now approached 
by some folks who want to keep the money offshore. I then have 
to make those calculations based on their circumstances.
    If I've done a great job of investing in my history in my 
career, is there any reason why an investor would not want to 
approach me simply because of the investment being offshore or 
    Mr. METZGER. Oh, if you're saying would a U.S. investor 
perhaps not want to invest in an offshore fund?
    Mr. BECERRA. No.
    Mr. METZGER. I'm not following the question.
    Mr. BECERRA. Me, the individual; me the fund manager; I'm 
asking about the individual. I'm being judged on my 
capabilities to invest the moneys, whether it's an offshore or 
onshore investment. Correct?
    Mr. METZGER. Yes.
    Mr. BECERRA. Okay. I know there are different types of 
investments you would make based on an offshore, onshore 
investment. But if I'm a good fund manager, I'm capable of 
making investments for an onshore fund or an offshore based 
    Mr. METZGER. Yes.
    Mr. BECERRA. So, based on that then the final question is 
and similar to the question that was asked earlier, is there a 
reason to distinguish how we categorize the compensation 
received by me as a fund manager, simply because in one 
instance I'm making investment decisions for an onshore fund. 
In another situation I'm making decisions for an offshore based 
    Mr. METZGER. So the distinction is that for the investment 
in the onshore fund is, the advisers your compensation is more 
liquid, and the Internal Revenue Code tells you how to treat 
that income.
    If the investment is in the offshore fund and the advisor 
chooses not to receive it in a liquid form, the adviser follows 
the Internal Revenue Code. Economically, the activity is the 
same. Economically the income is the same. But because the Code 
allows the adviser to classify one as liquid and the other as 
illiquid, they have different tax treatments.
    Mr. BECERRA. I'll decipher what you've just said in terms 
of liquid versus not and trying to navigate the tax, what 
you're saying is you're going to try to find the best way to 
get your compensation at the lowest tax rate.
    Mr. METZGER. Yes.
    Mr. BECERRA. Thank you.
    Mr. NEIL. I thank the gentleman.
    The gentleman from Texas, Mr. Doggett, is recognized.
    Mr. DOGGETT. Thank you very much.
    I appreciate the testimony of each of you, but because of 
the very serious perversions of our international tax system 
that Mr. Shay has described today in his writings that we're 
blessed by this Committee in previous years, I'd like to focus 
specifically on that aspect and ask my questions to you, Mr. 
    First, I think it's important, as you voice your opinions, 
to make clear to my colleagues and to those who are listening, 
the expertise and background you bring to this issue. As I 
understand it, your career is based on advising multinational 
corporations on how they can legally minimize their taxes. 
Before that, you served as international tax counsel at the 
Treasury Department in the Reagan Administration. Is that 
    Mr. SHAY. That's correct. My practice in recent years is 
probably being in addition to multinationals a lot more 
investment funds, because that's where the market has gone.
    Mr. DOGGETT. Okay. If I understand your testimony, if I 
have a multinational in the United States that does business 
here and does business abroad, that multinational can deduct 
from its U.S. income for what it generated here in the United 
States. All the expenses that it can fairly, reasonably 
attribute to its foreign operations, and it can do that now. 
But with reference to income generated abroad, it may never be 
taxed on that, but certainly not until it repatriates or brings 
that income back to the United States.
    Mr. SHAY. It is correct that you can take a current 
deduction say for interest and foreign corporate stock that 
earns foreign income that's not currently taxed.
    That's correct.
    Mr. DOGGETT. We'll take your expenses now but pay later on 
your income from abroad, and that deferral system is what much 
of your writing has been about. When you combine that with 
other inequities and what is really a swiss cheese 
international holes in the international tax system, like 
transfer pricing abuse, like a pharmaceutical company assigning 
a valuable patent to a subsidiary in a low tax jurisdiction, 
what you end up with is a significant distortion of investment 
decisions growing out of the tax system itself that a 
reasonable company would make.
    Mr. SHAY. I think it's correct to say I think the current 
rules do encourage tax moving and shifting of particularly 
intangible assets. As I think you're suggesting, under current 
law, it is done legally. I mean, this is not something that's 
    Mr. DOGGETT. When you testified to us last year, you were 
with a couple of fellows who said, you know, the best thing for 
us to do on international tax is let's not have any tax at all. 
Let's go to zero through what they call the territorial system 
on foreign source income. You don't agree with that approach.
    Mr. SHAY. That's correct as reflected in my testimony.
    Mr. DOGGETT. But we have learned that if you did that, 
given the way the current international tax system is 
perverted, that if we cut it to zero and let them stop this 
deferral of the expenses, that we'd actually generate tens of 
billions of dollars of income, of revenue.
    Mr. SHAY. The revenue estimate that is associated with 
exemption, which is substantial, is partly attributed to 
expenses. It's also attributable to the fact that you would no 
longer be able to credit foreign taxes against export sales 
    Mr. DOGGETT. I should have clarified that, because you also 
pointed out in your paper that we essentially end up picking up 
effectively some of the foreign tax burden. Our taxpayers are 
lost to the Treasury here. Of course we actually, as you note 
in your paper in your testimony, we've actually experimented 
with doing away with taxes or almost doing away with taxes in 
the so-called American Jobs Act that this Committee so 
blissfully approved a few years ago.
    Some of us would really call it the Export American Jobs 
Act. But under that, some of these corporations that had 
manipulated the tax system actually got a tax amnesty where 
they were able to bring back these earnings and pay at most 
five and a quarter percent on those earnings. Weren't they?
    Mr. SHAY. That's correct.
    Mr. DOGGETT. You refer to that in footnote 16 of your paper 
as being a farce and cite two others who found it to be a farce 
like an article called ``The Great American Jobs Act Caper.''
    Mr. SHAY. I think I was citing a paper, which referred to 
it as a farce. I think the farce that was intended was that it 
was presented, I think, as an economic stimulus measure, where 
I think I'd be delighted to see the studies that Mr. English 
has raised. It's very hard to see what the economic consequence 
was that was more than essentially financial shifting.
    Mr. DOGGETT. Well, thank you. We can't export at greater 
length today, but what we had were some companies that brought 
back these earnings at essentially zero tax. When they consider 
the foreign tax credit the same day almost that they were 
cutting American jobs, and a situation where a company like Eli 
Lilly in 2004 paid an effective tax rate of 1 percent on its 
worldwide income, not considering this repatriated earnings.
    But I just contrast that with a community pharmacy down in 
Buda, Texas. It's incorporated and paying 35 percent. I think 
that's some of the inequity that this Committee has permitted 
in the past that we must remedy.
    Thank you very much.
    Mr. NEAL. We thank the gentleman.
    The gentlelady from Ohio is recognized to inquire, and I 
believe that we will then move to the next panel.
    Ms. TUBBS-JONES. To my colleagues and friends out there; 
unfortunately, I've got to go back to Ohio to a funeral. So, 
all I want to say is I think that all of you need to help us 
come up with some policy that will be fair on behalf of all the 
taxpayers there; those at the bottom of the rung of the ladder 
and the upper end of the ladder.
    There's got to be a little more equity to all the 
foundations out there. You know I'm not chairing the 
philanthropic caucus. I mean, we're looking for, me and my 
colleague are looking for opportunities to take a closer look 
at how you're able to raise funds for the non-profits that 
you're doing and the work that you're doing.
    To the next panel, all the best. I hope my colleagues don't 
beat you up too bad and I'll see you next time around when we 
hit this issue.
    Mr. Chairman, thanks for the opportunity to be here, and I 
appreciate it.
    Mr. NEAL. We thank the gentlelady, and I want to thank the 
panelists for your patience, and certainly your sound 
    Everybody offered a very good perspective, and I thought 
that in particular you took a very complicated matter and 
explained it in a manner that we could all understand.
    Thank you, very, very much.
    Mr. LEVIN OF MICHIGAN [presiding]. We'll now start with the 
third panel. We very much appreciate your patience. We're 
getting your names appropriately placed.
    All right, Mr. McCrery, I think will begin. I believe it 
was suggested that we were going to have two sets of panels and 
that the third and fourth would come here after lunch at two 
o'clock. It's now four o'clock, and I think a lot of us had 
    But we very much appreciate your patience, and so let us 
introduce all of you together. Then if you go in the same 
order, first, and I think most of you are doctors, PhDs, Peter 
Orszag, who is Director of CBO.
    Welcome Gene Steuerle, who also has been here many times. 
We welcome you back.
    Actually, next to you, if we're going to go in that order, 
is Jack Levin, who is a partner in Kirkland & Ellis in Chicago.
    Then Darryll Jones, who is a professor of law at Stetson 
University College of Law in Florida.
    Next, Victor Fleischer, who is associate professor of law 
at Illinois College of Law in Champaign, Illinois.
    Last, but as we often say not least, Mark Gergen, a 
professor of law, the University of Texas Law School, Austin.
    Now, as you know, many of you have been here before. Your 
testimony will be placed in the record. We have the 5-minute 
rule. You can be assured the full testimony will be fully 
distributed and aired. This is just the beginning of our 
consideration of these issues and so everybody is not here all 
the time. I think you can be assured, because of the tradition 
and nature of this Committee, your testimony will receive the 
fullest consideration.
    So, we'll start first with Peter Orszag, and then if we 
might simply go down the row, thank you.


    Mr. ORSZAG. Thank you. Thank you very much, Mr. Levin, Mr. 
McCrery, other Members of the Committee. Thank you for having 
me this afternoon.
    As you know, a growing amount of financial intermediation 
is occurring through private equity and hedge funds, which are 
typically organized as partnerships or limited liability 
companies and now have at least $2 Trillion under management. 
These organizational forms are growing rapidly for many 
reasons, but among the reasons is their tax treatment.
    In particular, such partnerships do not pay a separate 
corporate income tax. Instead, they pass all income and losses 
through to the partners. The manner in which that income is 
taxed is the central focus of my written testimony. The 
partnerships have two types of partners, limited partners who 
contribute capital and general partners who manage the 
partnership's investments and may contribute a modest amount of 
capital themselves.
    The general partners typically receive two types of 
compensation: a management fee that is tied to some percentage 
of assets under management and a carried interest tied to some 
percentage of profits generated by those assets. For example, 
if a fund had $1 Billion under management and the typical 2 
percent management fee, management fees would amount to $20 
Million a year and that amount would not depend on the 
performance of the underlying investments.
    That $20 Million management fee is taxed as ordinary income 
to the general partner since it reflects compensation for 
services provided. If the fund also generated $150 Million in 
profits, the general partner with a 20 percent carried interest 
would receive another $30 Million. That is 20 percent of the 
$150 Million in profits. In practice, at least within private 
equity buyout firms, carried interest often applies only after 
a hurdle rate of return is achieved. That would change the 
calculations but not the underlying analytical issues involved.
    Taxation on this carried interest is deferred until the 
profits are realized on the fund's underlying assets and are 
then taxed to the general partner at the capital gains tax rate 
to the extent that the funds underlying investments or profits 
reflect capital gains. So, at a capital gains tax rate of 15 
percent, that $30 Million of carried interest would generate a 
tax liability of $4.5 Million.
    From an economic perspective, a general partner in a 
private equity or hedge fund undertakes a fundamentally 
different role than that of the limited partners, because the 
general partner is responsible for managing the fund's assets 
on a day-to-day basis and the carried interest is 
disproportionate to financial capital invested, that is the 
general partner's own financial assets at risk, if any.
    Most economists therefore view at least part and perhaps 
all of the carried interest as performance-based compensation 
for management services provided by the general partner, rather 
than a return on capital invested by that partner. That 
perspective would suggest taxation of at least some component 
of carried interest as ordinary income rather than capital 
gains. Almost all other performance-based compensation is 
effectively taxed as labor income. For example, contingent fees 
based on movie revenue for actors are taxed as ordinary income 
as are performance bonuses, most stock options and restricted 
stock grants.
    So, too are incentive fees paid to managers of other 
people's investment assets where those fees are documented as 
such rather than in the form of carried interest in a formal 
partnership. Although there does not appear to be any solid 
analytical basis for viewing carried interest solely as a 
return on financial capital for the general partner, there is 
an analytical debate about whether it should be viewed purely 
as compensation for management services provided or as a 
mixture of compensation for management services and capital 
    My written testimony discusses some of the analytical 
issues involved in those different perspectives. It also 
examines a few recent proposals to change the taxation of 
carried interest and the pros and cons thereof. I will defer to 
your question period if you would like to ask more about those.
    In closing, I just want to emphasize that much of the 
complexity that is associated with taxation of carried interest 
arises because of the differential tax rate on capital income 
and ordinary income. In particular, because ordinary income for 
high income tax payers is typically subject to a 35 percent 
marginal income tax rate, whereas, long-term capital gains are 
subject to a 15 percent tax rate, there is a strong incentive 
to shift income into forms classified as capital gains.
    Whether carried interest represented compensation for 
services provided or a return on capital invested would be 
largely irrelevant if the tax rate on labor and capital income 
were the same.
    Thank you very much.
    [The prepared statement of Mr. Orszag follows:]
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    Mr. LEVIN OF MICHIGAN. Thank you.
    Mr. Levin.

                  STATEMENT OF JACK S. LEVIN,
                 PARTNER, KIRKLAND & ELLIS LLP

    Mr. LEVIN. Mr. Chairman and Committee Members: My name is 
Jack Levin. I teach at Harvard Law School and University of 
Chicago Law School, and I'm author or co-author of 5,800 pages 
of exciting treatises on venture capital, private equity, 
mergers and acquisitions.
    In my law practice at Kirkland & Ellis, I have long 
represented many funds and their trade associations, but today 
I appear to express my own personal views on the appropriate 
taxation of carried interests.
    First of all, we have two systems of taxation in the United 
States: a corporate system with double tax; and a partnership 
flow through system where the partners are taxed when the 
partnership earns income. The partners are then taxed on the 
income at the capital gain or ordinary income rate by 
characterizing the income in the partners' hands at the same 
characterization as in the partnership's hands.
    For many decades the Code has conferred a lower tax rate on 
gain from the sale of a capital asset held more than 1 year: 
The capital gains rate. Throughout these decades, the Code has 
never contained an absence of sweat test. For example, assume 
that Warren Buffet retires from Berkshire Hathaway and invests 
some of his money in stocks and real estate, working 8 hours a 
day at his desk. We have a videotape demonstrating that as he 
worked at his desk picking stocks and real estate in which to 
invest, he did indeed break a sweat.
    Is or should the capital gain that he would otherwise have 
earned on these long-term investments be turned into ordinary 
    Or, if an innovative entrepreneur like Bill Gates and his 
investor group start a new computer company, is or should the 
entrepreneur's long-term capital gain on sale of the computer 
company's stock be converted into ordinary income because he 
had many sweaty armpit days?
    The Code does not make, and never has made, the absence or 
presence of activity or ingenuity or even a bit of bodily 
dampness the test for a long-term capital gain. Nor should we 
now in my view legislatively adopt a test requiring IRS agents 
to poke around in Warren Buffett's or Bill Gates' dirty laundry 
searching for perspirational evidence. Rather, we should not 
tax carried interest capital gains differently than other 
capital gains.
    When Congress enacts laws picking winners and losers with 
the tax rates and rules differing by industry, for example, 
taxing carried interest in venture, private equity and hedge 
funds more harshly than other types of carried interests and 
more harshly than other investment gains, the free market is 
inevitably distorted with great risk of dire, long-term 
consequences for American economic growth.
    Another question: do Steve Schwartzman and his peers make 
so much money that they should simply be taxed more harshly?
    Let me tell you that whenever this august body has enacted 
punitive tax legislation based on vignettes rather than on 
careful, macro-economic analysis, our great country has been 
ill-served. You all recall the famous congressional hearings 
that found 21 unnamed American millionaires who paid no Federal 
income tax for 1967 and which resulted in the odious, illogical 
and counterproductive AMT, an albatross around all our necks 
ever since.
    Over the past 20 years or so, it has not been the big, 
publicly traded auto companies and airlines that have provided 
growth in jobs, exports and prosperity. Rather, venture 
capital, private equity and hedge funds which finance companies 
have made our economy the most efficient, vibrant and emulated 
in the world.
    I believe that if we now adopt a punitive carried interest 
bill, the flow of entrepreneurial investments will indeed be 
reduced. I can't tell you if it will be 10 percent, 20 percent 
or 30 percent, but I believe that it will be reduced with 
significant harm to American job growth, exports and business 
vibrancy. After all, the reason that we have a lower rate on 
long-term capital gain is to precisely encourage investment of 
entrepreneurial risk capital in American business to create the 
jobs, exports and prosperity that we have had in recent years.
    [The prepared statement of Mr. Levin follows:]
  Prepared Statement of Jack S. Levin, Partner, Kirkland & Ellis LLP, 
                           Chicago, Illinois
    Mr. Chairman and Committee members, my name is Jack Levin. I teach 
at Harvard Law School and University of Chicago Law School, am author 
of a 1,400 page treatise on structuring venture capital and private 
equity transactions, and am co-author of a 4,400 page treatise on 
mergers and acquisitions. In my law practice at Kirkland & Ellis LLP, I 
have long represented many private equity, venture capital, and hedge 
funds and their trade associations, although I appear today to express 
my own personal views on the appropriate taxation of carried interests.
    In my brief testimony, and at more length in my written statement, 
I will try to answer 6 questions:
    First question, why do we tax long-term capital gain--that is, to 
use the Code's verbiage, gain from the sale of a capital asset held 
more than 1 year--at a lower rate than ordinary income, such as wages 
or interest income?
    Several reasons: By imposing a lower tax on long-term capital gain 
than on ordinary income, Congress encourages the investment of risk 
capital in American business. I agree with this approach because the 
more risk capital invested into American business, the more our 
companies expand, create jobs and exports, and spread American 
    Another reason for the lower tax rate on long-term capital gain is 
the recognition that it frequently takes many years to realize gain 
from a capital investment, by which time inflation has reduced the 
sales proceeds' real value. Stated another way, much of the so-called 
long-term capital gain does not really represent true gain because 
inflation has reduced the proceeds' value.
    Second question, when a partnership recognizes long-term capital 
gain, why is the portion flowing to a carried-interest holder taxed as 
long-term capital gain?
    We have traditionally had two systems of business taxation in this 
country. The corporate taxation system is very complex with double 
taxation (once at the corporate level and a second time at the 
shareholder level when the corporation makes distributions), Sec. 312 
E&P calculations, Sec. 302 redemption recharacterizations, Sec. 305 
stock dividend rules, Sec. 306 tainted preferred stock, Sec. 368 
reorganizations, and 6 mind-numbing interest deduction disallowance 
    The second system, for partnerships and LLCs, uses a flow-through 
approach and is designed to be much simpler and more economically 
rational, with a single level of tax, imposed on the partners when 
income is recognized at the partnership entity level, by allocating the 
partnership's income among the partners based on each's economic right 
to receive such income, with the income allocated to each partner 
retaining its entity-level characterization as (e.g.) ordinary income 
or capital gain.
    This simpler partnership flow-through tax approach--designed to 
encourage groups of people to join forces by combining their capital, 
labor, and know-how to start, build, and expand businesses--has 
contributed mightily to the vibrancy of America's entrepreneurial 
    So if a partnership holds stocks or other capital assets for more 
than 1 year, its gain on ultimate sale of those assets constitutes 
long-term capital gain in the hands of all the partners, both the pure 
capital investor and the part-capital part-management carried interest 
    This is appropriate for a venture capital, private equity, hedge, 
or real estate fund because the general partners serve as the fund's 
principals or owners, selecting the fund's investments, sitting on the 
boards of the fund's portfolio companies, and making the fund's buy and 
sell decisions (like any owner of an investment), and generally making 
a substantial capital investment in the fund. General partners are not 
merely agents of the partnership, who have no capital at risk, merely 
making recommendations and following the dictates of their investor 
    Third question, should carried interest partners be taxed at 
ordinary income rates on their share of the partnership's long-term 
capital gain because as joint venture managers they are really 
receiving sweat equity?
    For many decades the Code has conferred the lower long-term capital 
gain rate on gain from the sale of a capital asset held more than 1 
year and throughout these decades the Code has never contained an 
absence-of-sweat test.
    For example, assume Warren Buffett retires from Berkshire Hathaway 
and invests some of his money in stocks and real estate--working 8 
hours at his desk every day, including Saturdays, to pick which stocks 
and real estate to buy, hold, and sell--and assume we have a videotape 
of his activities showing that on many days he did indeed break a sweat 
while studying reports and placing buy and sell orders. Is (or should) 
his long-term capital gain on his stocks and real estate held more than 
1 year be converted into ordinary income?
    Or if an innovative entrepreneur like Bill Gates and his investor 
group start a computer company, is (or should) the entrepreneur's long-
term capital gain on sale of the computer company's stock be converted 
into ordinary income because he had many sweaty armpit days?
    My point is that the Code does not make, and never has made, the 
absence or presence of activity and ingenuity--or even a bit of bodily 
dampness--the test for long-term capital gain, nor should we now 
legislatively adopt a test requiring IRS agents to poke around in 
Warren Buffett's or Bill Gates' dirty laundry searching for 
perspirational evidence.
    But if we tax carried interest capital gain differently than other 
capital gain, isn't that the next step? If venture capital, private 
equity, and hedge fund managers who invest substantial capital and 
contribute substantial intangible assets in the form of (e.g.) know-
how, reputation, goodwill, contacts, and deal flow are to be tainted by 
sweat, shouldn't the same rule apply to Warren Buffett and Bill Gates 
in my examples?
    Fourth question, do Steve Schwartzman of Blackstone and his peers 
make so much money that they should be taxed more harshly?
    Whenever this august body has enacted punitive tax legislation 
based on vignettes, rather than on careful macro-economic analysis, our 
great country has been ill served. Perhaps the best example is the 
famous 1969 Congressional hearings that discovered 21 unnamed American 
millionaires paid no Federal income tax for 1967. The direct result of 
those hearings is the odious, illogical, and counterproductive 
alternative minimum tax (or AMT) which has been an albatross around all 
our necks ever since, and which threatens to affect 25 million 
taxpayers in 2007 and 56 million by 2017.
    Let's not repeat our past tax-legislation-by-vignette approach. 
Just because some private equity investors, or some athletes, or some 
thespians, or some computer-company founders make substantial amounts 
of money doesn't mean it is in America's best interests to impose tax 
penalties on them without carefully examining the macro-economic 
    Fifth question, will changing the long-standing definition of 
capital gain to impose ordinary income tax on carried interests in 
long-term capital gain be harmful for the American economy?
    Over the past 20 years or so, it has not been the big publicly 
traded auto companies and airlines that have provided growth in jobs, 
exports, and prosperity. Rather it has been the venture capital, 
private equity, and hedge fund financed companies that have made our 
economy the most efficient, vibrant, and emulated in the world.
    If the carried-interest bill passes, will the flow of venture 
capital and private equity money into American business be reduced by 
10 percent? By 20 percent? By 30 percent? Will American job growth, 
exports, and business vibrancy be curtailed? I believe there is 
substantial risk the flow of entrepreneurial investments will indeed be 
reduced, with significant harm to our vibrant economy.
    So beware the law of unintended consequences and be slow to start 
down an opaque road if you don't know where it leads.
    The basic principle of our free enterprise capitalistic economy is 
that American employment, growth, and prosperity will be maximized by 
allowing the free market to operate.
    It is the antithesis of the free market when Congress enacts tax 
laws targeting specific activities and designating winners and losers, 
for example, taxing carried interest in venture capital, private 
equity, real estate, and hedge funds more harshly than other types of 
carried interest and more harshly than other investment gains. When 
Congress enacts laws picking winners and losers, with the tax rates and 
rules differing by industry, the free market is inevitably distorted, 
with great risk of dire long-term consequences for American economic 
    Sixth question, will a slowdown in venture capital/private equity 
investing hurt only fat cat venture capital/private equity 
    Among the largest investors in venture capital/private equity funds 
are pension plans and university endowments. Thus, a slow down in 
venture capital/private equity formation and investing harms not only 
new and growing American businesses that do not receive the funding 
necessary to start up, grow, and prosper, but also the millions of 
American workers whose pension plans are the single largest venture 
capital/private equity investors and also the millions of American 
students whose tuition is reduced by their university's endowment 
    I would be happy to answer any questions.
    Mr. LEVIN OF MICHIGAN. Thank you.
    Mr. Steuerle.



    Mr. STEUERLE. Mr. Chairman, Ranking Member McCrery, and 
Members of the Committee, I appreciate the opportunity to 
appear before you today. I must mention again that each time I 
appear before Ways and Means, I stand in great reverence, both 
for its history and its mission.
    Let me begin, if you will, with a story. Once upon a time 
there was a fairly rich society, and in this society was a 
fairly exclusive club of people who paid low, individual tax 
rates. Some got into this club because they didn't have a lot 
of income. Others got in because they didn't realize much of 
their income. Some belonged because the society's legislature 
decided to grant a reprieve for multiple layer taxes, but did 
it in a way that also benefited some who paid almost no tax. 
Still, others belonged because they figured out how to 
arbitrage differentials built into the tax system. This last 
group became very prolific as time went on.
    Now, there was another club in this society: those who paid 
fairly high marginal tax rates on money they actually saved. 
This club included students going to college, many welfare 
recipients, those who put their money into bank accounts, and 
some fairly successful executives. Many people belonged to 
neither club.
    One day, there arose a debate over whether one particular 
set of members, those who arbitrage both their financial 
returns and tax differentials, deserved to belong to this 
first, exclusive club of low tax rates. While there was a very 
technical debate about the consistency of membership, most of 
the debate boiled down to the following.
    Those who were threatened with loss of membership argued 
that they were as deserving of membership as other rich Members 
of the club. Their opponents argued that they were no more 
deserving than many of those already excluded. Both were right.
    Mr. Chairman, Mr. McCrery, Members of the Committee: you 
have asked that I testify on the basis of my experience as 
economic coordinator and original organizer of the Treasury tax 
reform effort that led to the Tax Reform Act of '86 and later 
as Deputy Assistant Secretary of the Treasury for Tax Analysis. 
The basic principles of taxation lead to many of the same 
conclusions today as they did then. Whenever possible, tax 
differentials should be reduced. These include differentials 
due both to double taxes and preferences. Today, tax 
professionals are extraordinarily adept at leveraging those 
differentials and applying them far and wide.
    As a matter of both efficiency and equity, capital gains 
relief is best targeted where tax rates are high, such as in 
the case of double taxation of corporate income. The case for 
providing capital gains relief for carried interest is 
relatively weak, resting primarily upon whether the 
administrative benefits of the simple partnership structure 
needs to be maintained in this arena. It does not rest upon 
arguments for favoring capital income, entrepreneurs or risk, 
which can be done in a more efficient manner.
    Many people pay high, explicit or implicit rates of tax on 
their capital income including those whose net worth is in 
interest bearing accounts, welfare recipients, kids saving for 
college, and some owners of corporate equity. Relief might be 
more efficiently and fairly targeted in their direction.
    Hopefully, Congress will 1 day turn to these broader reform 
issues. The reasons stretch beyond equity to economic growth. 
In particular, the tax arbitrage opportunities the tax system 
makes available reduce national income and product, encourage 
too much production of some items and too little of others, and 
shunt many talented individuals into less productive 
activities. Perhaps some of those talented individuals are here 
today. It substantially increases the amount of debt in our 
    Finally, I suggest that Congress engage the Treasury and 
the IRS in a much more extensive and continued effort to 
develop better data about who in society and at various income 
levels pay multiple taxes and who pay little or no tax at all.
    Thank you.
    [The prepared statement of Mr. Steuerle follows:]
  Prepared Statement of C. Eugene Steuerle, Ph.D., Co-Director, Urban-
 Brookings Tax Policy Center, and Former Deputy Assistant Secretary of 
          the Treasury for Tax Analysis, Reagan Administration
    The views expressed are those of the author and should not be 
attributed to the Urban Institute, its trustees, or its funders. 
Portions of this testimony are taken from the author's column, 
``Economic Perspective,'' in Tax Notes Magazine.
Mr. Chairman and Members of the Committee:
    Thank you for the invitation to testify before you today on the 
taxation of carried interest and its relationship to the broader issue 
of how a tax system should be designed to meet the goals of equity and 
    You have asked that I testify because of my experience as economic 
coordinator of the Treasury tax reform project leading to the Tax 
Reform Act of 1986 and, later, as deputy assistant secretary of the 
Treasury for tax analysis. In particular, I will address how we 
succeeded, at least in the view of many, in promoting equity and 
improving the performance of the U.S. economy. Note that the 1984-86 
work was not really aimed at changing revenues or the progressivity of 
the tax system. The goals were efficiency and equal justice under the 
law for people in similar circumstances.
    A succinct summary of my conclusions today is as follows:
     Any time Congress creates differentials in taxation, tax 
professionals are extraordinarily adept at leveraging up those 
differentials and applying them far and wide.
     As a matter of both efficiency and equity, capital gains 
relief is best targeted where tax rates are high, as in the case of the 
double taxation of corporate income.
     The case for providing capital gains relief for carried 
interest is relatively weak, resting primarily upon whether the 
administrative benefits of the simple partnership structure needs to be 
maintained in this arena; it does not rest upon arguments for favoring 
capital income, entrepreneurs, or risk.
     Many people pay high explicit or implicit rates of tax on 
their capital income, including those whose net worth is in interest-
bearing accounts, welfare recipients, kids saving for college, and some 
owners of corporate equity. Relief might be more efficiently and fairly 
turned in their direction.
     Hopefully, Congress will one day turn to broader reform 
issues, including corporate integration and removing many differentials 
in taxation. The reasons stretch beyond tax policy to economic growth. 
For instance, the way that debt is favored over equity not only 
provides some of the juice for private equity firm transactions, 
regardless of how they are taxed, but builds up our debt-laden economy.
Differentials in Taxation and Tax Arbitrage
    Let me get an important technical distinction out of the way 
first--the distinction between financial arbitrage and tax arbitrage. 
Financial arbitrage involves selling lower-return assets and buying 
higher-return assets. This activity is not confined to hedge-fund 
managers or private equity firms. Most households and businesses engage 
in financial arbitrage when they borrow to buy a home or equipment that 
produces a higher return than the interest rate at which they borrowed.
    Tax arbitrage also works off of leverage, but it takes advantage of 
tax differentials, not necessarily any real productive opportunities. 
In the case of normal tax arbitrage, it involves the creation of 
additional assets and liabilities to effectively transfer ownership so 
that the most highly taxed items are owned by low- or zero-rate 
taxpayers, and the least highly taxed items are owned by taxpayers 
facing higher rates. The tax system has provided enormous incentives 
for creating a debt-magnified economy, so that interest-bearing 
accounts, bonds, and even implicit debt instruments can be held by non-
taxpaying institutions and individuals, while those with higher tax 
rates then use those loans to hold onto other assets not so heavily 
    Sometimes there are also ``pure'' tax arbitrage opportunities, 
whereby the taxpayer makes money essentially by borrowing from him- or 
herself. For instance, many households borrow and pay interest to buy 
retirement assets. Tax arbitrage explains how the United States can 
have such high rates of gross deposits in accounts and retirement plans 
and still have a negative personal saving rate.
    Tax arbitrage opportunities are created and enhanced when Congress 
establishes differential rates of taxation for certain types of income. 
Some of these differentials work off of the requirement that income be 
realized before it is taxed; some reflect inaccurate accounting for 
inflation; others work off of such differentials as capital gains 
versus ordinary income, debt versus equity, corporate versus 
noncorporate forms of organization, and taxable versus tax-exempt 
    Many partnerships, including private equity firms and hedge funds, 
figure out ways to write off expenses immediately and in full, while 
declaring only a portion of currently accrued income or paying a lower 
rate on realized income. Others sell short or borrow from those in low 
or zero tax brackets, who, in turn, declare all nominal gains or 
interest receipts, including fictional income due to inflation, as 
taxable. Meanwhile, the interest deductions and short sale losses are 
fully written off by the higher bracket firm members or their clients. 
Their receipts and other positive declarations of income might be 
treated as capital gains or avoid taxation because they are not 
    One reason for the interest carried into this hearing--pun 
intended--is that tax arbitrage pervades the economy. One doesn't even 
have to think about it to perform it. Think how common it is for 
individuals to put money into 401(k) accounts, then later borrow a 
little more on the house when the cash needed for a vacation is now 
tied up in the 401(k) account. Similarly, while many hedge fund 
managers and private equity firm partners might look mainly for 
financial arbitrage opportunities, at the same time their tax lawyers 
help them find ways to avoid tax, restructure deals and the character 
of their transactions, convert labor to capital gains income, and 
transfer money into and out of different instruments and tax 
    You can quickly see how complex these issues can become. Not 
surprisingly, the issue of ``what to do'' correspondingly becomes 
complicated very quickly. If A is taxed favorably relative to B, who, 
in turn, is taxed favorably relative to C, then how can you create 
parity if you only make one change at a time? If you change the law to 
tax B like A, then C is further disadvantaged. If you instead change 
the law to tax B like C, then A is further advantaged.
    The equity issues are somewhat obvious. If my income is from widget 
making, which is favorably taxed, and yours from carpentry, which 
isn't, then the tax laws discriminate against you as a carpenter.
    But the efficiency issues are extraordinarily important as well. I 
want to be absolutely clear. The tax arbitrage opportunities the tax 
system creates reduce national income and product, encourage too much 
production of some items and too little of others, shunt many talented 
individuals into less productive and sometimes nonproductive 
activities, and add substantially to the debt and other financial 
instruments in the economy. But when money gets invested for tax rather 
than economic reasons, the economy gets too much widget making and too 
little carpentry. Elsewhere, I have attempted to show how tax arbitrage 
drives the stagnation than accompanies higher rates of inflation.
    As a result, most tax theorists, whether liberal or conservative, 
Republican or Democrat or Independent, believe that reducing and 
removing differentials helps promote a more vibrant and healthy 
economy, no matter what level of progressivity or revenues Congress 
sets. Taxing income equally regardless of source or use was one of the 
major principles accompanying the Tax Reform Act of 1986.
Capital Gains
    Taxing income the same regardless of source, however, is easier 
said than done. In particular, take the case of capital gains, which is 
partly at the heart of the debate over carried interest. In a study 
that Professor Daniel Halperin of Harvard and I conducted years ago, we 
concluded that aggregate capital gains over time could almost all be 
attributed either to inflation or the retained earnings of 
corporations. I suspect that recently the bubble market in real estate 
and stock valuations might lead to additional gains over and above 
inflation and retained earnings, though these gains could be temporary 
(and modest when considered over several decades).
    In effect, then, much capital income can end up doubly taxed if 
there are not adjustments for inflation and income already taxed once 
at the corporate level. The first can be dealt with either by keeping 
inflation rates low, indexing the tax system for inflation, which is 
somewhat complex, or, as we do under current law, taxing net capital 
gains on a realization, rather than accrual, basis. The latter can be 
dealt with through corporate integration and also taxing on a 
realization basis. At one time, the corporate integration debate 
centered mainly on dividends, but researchers have increasingly 
realized that capital gains can also be double taxed.
    In the U.S. tax system, corporate integration has been rejected in 
favor of simple relief for capital gains and dividends. The consequence 
is that some capital income is taxed at very low rates--it faces no 
corporate tax and an individual tax at a favored rate. Through adequate 
leveraging, some capital income, at least at the margin, is taxed at a 
negative rate. On the other hand, other capital income can be doubly or 
triply taxed if realized as accrued and subject to corporate, 
individual, and estate taxes--not to mention some of the myriad taxes 
like franchise taxes and property taxes on equipment that states 
sometimes employ.
    Besides inflation and the corporate tax, there is a third 
justification for capital gains relief. The U.S. tax system is mainly 
based upon the realization, not the accrual, of income. For many 
investors, then, realizing capital gains is discretionary, and the 
capital gains tax is a discretionary tax. Hence, whenever the tax on 
capital gains is lowered, people recognize more of their capital gains 
as income. This limits the revenue loss from capital gains relief, 
especially when tax rates are higher. Even if there were substantial 
revenues from higher capital-gains tax rates, people can get locked 
into holding onto their assets for tax rather than economic reasons. 
Hence, efficiency, too, argues for limiting the extent of ``lock in.''
Carried Intrest
    So what does all this mean when applied narrowly to so-called 
carried interest and, more broadly, tax reform in general? Nowhere, as 
best I can tell, do those employing their brain power to make money 
through carried interests meet the classic justifications for capital 
gains relief--the avoidance of double taxation because the corporate 
income has already been taxed or because of inflation, or the 
prevention of too much lock in.
    A very strong case can also be made that carried interest income is 
more like labor income than capital income, although this distinction 
is arbitrary for the business owner. In any case, partners can put 
their own saving aside to achieve capital gains relief on that actual 
saving. And there are a variety of ways of charging customers for 
handling their money; I have great faith in the legal community's 
ability to find ways to allocate real saving by a partnership into tax-
preferred form. Moreover, entrepreneurial labor in these types of firms 
is already favorably treated--in this case, because we do not tax the 
accrual of partnership interests until they are realized.
    Admittedly, it is often difficult to separate capital from labor 
income, which is one reason for the simplified treatment of 
partnerships. Don't forget, however, the other side of this coin: some 
entrepreneurial partners and sole proprietors in small businesses pay 
labor tax in the form of Social Security and Medicare tax on their 
capital income. Thus, we don't allow self-employed cleaning people or 
home-based computer wizards or restaurant owners to reduce their Social 
Security tax on the basis of an imputed return to their cleaning 
equipment, computers, or restaurant buildings. They stand in contrast 
to those who may pay capital gains tax and no Social Security and 
Medicare tax on some or most of their labor income.
    Some arguments against reform in this area need to be rejected. One 
is that capital taxes need to be kept moderate. There are better ways 
of keeping capital taxation at reasonable levels. One is corporate 
integration through forgiveness of capital gains and dividend taxation 
for income already taxed at the corporate level. Another is a lower 
corporate tax rate. Congress could also lower taxes for those who 
provide the real saving--the people who put money in bank accounts and 
don't borrow elsewhere.
    Another misleading argument is that we should subsidize 
entrepreneurial labor. Again, yes, we should keep tax rates at a 
moderate level, but the tax system is never very good at defining who 
provides entrepreneurial labor and who does not. My guess is that, as 
in most business, some firms are very entrepreneurial at reallocating 
capital efficiently and some are very entrepreneurial at selling bad 
products to mislead investors or consumers. Why lower tax on this type 
of business but tax other entrepreneurial small and large business much 
more heavily? Moreover, to the extent there are temporarily forgone 
labor earnings or accrued property interests due to entrepreneurial 
efforts, these already receive favorable tax treatment, as they are 
expensed. That is, if I put $100,000 worth of my labor into a firm, and 
that $100,000 generates expertise and good will that is exchanged for a 
property interest that will provide cash returns later, then I really 
have earned $100,000 currently. But the Tax Code nonetheless allows me 
to write it off as an ``investment'' and expense the forgone earnings 
until I later begin to realize the actual cash returns. This labor 
income, then, is already preferred to earnings subject to tax 
    Finally, some suggest that the Tax Code should subsidize risk. This 
is not a tax policy argument. Some risk is good, some is bad; risk is 
certainly not good in and of itself. If risk is to be favored, in any 
case, one wouldn't go into one select area with a lot of risk takers 
and throw money off the roof to them.
Taxpayers Low and High Tax Rates on Their Capital Income
    I don't want to skip over the disparities in tax rates faced by 
many different types of taxpayers. Some taxpayers do pay fairly high 
tax rates when they earn additional income:
     A taxpayer in the 25 percent tax bracket whose entire 
savings are in a bank paying 4 percent interest in a world of 3 percent 
inflation effectively pays a tax rate of 100 percent on his 1 percent 
real return.
     Asset tests and rules in many social welfare programs mean 
that a person saving a few extra dollars can lose thousands of dollars 
in benefits. Once again, this can translate sometimes to confiscatory 
tax rates on additional capital income. The additional tax on the 
saving, measured as a percentage of the return to the saving, is often 
several hundred percent.
     A student who cuts grass or babysits and saves the money 
in a bank account for college may pay not only tax on the initial 
earnings, but, more importantly, find that the loss of Pell grant 
assistance will be a substantial multiple of any interest earning on 
the saving. Thought of as a tax on capital income, it would be several 
hundred percent; thought of as a tax on entrepreneurial labor, the rate 
could be 67 percent or more.
    On the flip side, many other individuals, not just those in firms 
with carried interest or handling private equity or venture capital, 
face fairly low tax rates, thanks mainly to tax arbitrage and the 
failure to recognize income.
     Many people remember Leona Helmsley's famous quip that 
``Only the little people pay taxes.'' But what many failed to realize 
is that many owners of real estate, such as Ms. Helmsley, effectively 
achieved their low tax rate through the tax arbitrage made possible by 
highly leveraged investment. One of the more revelatory moments in the 
1984-86 reform process came when a group lobbied against tax reform on 
the basis that it wanted the progressivity made possible by high tax 
rates. It turned out that the group represented the tax shelter 
industry, which liked the high tax rates that applied to their 
deductions, such as for interest expense.
     The very rich generally pay individual tax rates that are 
effectively 10 percent or less on their accrued income, since they only 
occasionally realize this income for tax purposes. Even if capital 
gains were given no preference, their effective tax rates would remain 
very low. However, some pay significant corporate tax on their income, 
depending upon how highly leveraged they are at the individual and 
corporate levels.
     Another way that some higher-income persons pay lower 
rates (and an issue for carried interests and private equity) is 
through avoidance of that portion of the Social Security tax associated 
with Medicare--the Hospital Insurance tax. As noted, many sole 
proprietors and partnerships pay this tax on all their returns from 
these businesses, even returns that might be thought of as returns to 
capital. Meanwhile, those who get such income counted as capital or 
capital gain income avoid this tax altogether for that income.
Broader Reform Issues
    Given all the differentials in the tax system, it is easy for 
almost anyone to argue that someone is making out even better. The 
complication is that serious analysis requires recognizing that 
lowering one person's relative tax burden by definition means raising 
another's. Taxes are a price of government, and their aggregate level 
is set largely by the level of expenditures of government, not by 
current collections.
    The basic principles of taxation lead to many of the same 
conclusions today as when we were constructing major tax reform two 
decades ago:
     Whenever possible, tax differentials should be reduced. 
This is not an issue of progressivity or revenues but of efficiency and 
equal justice under the law for those in equal circumstances.
     Removal of differentials should not mean the creation of 
new differentials through double taxes. Efforts still need to be 
expended on removing double taxation of capital gains and dividends and 
avoidance of a high inflation tax or subsidy for debt.
     If the tax on capital income is to be lowered, relief 
should be concentrated broadly, as through corporate integration or a 
lower corporate tax rate.
     Labor income should be taxed similarly regardless of 
     The Tax Code should not favor debt over equity. Currently, 
this provides some of the juice can generate profits for private equity 
firms without any necessary gain to the economy from the transactions--
regardless of what tax rate the partners pay.
     Given the very high tax rates many low- and moderate-
income taxpayers face, we probably ought to pay more attention to the 
taxation of their assets and returns from capital. The reasons for the 
opposite, upside-down focus on providing relief mainly for the richest 
and most successful members of society seems driven more by lobbying 
dollars than economic considerations.
    Finally, let me offer one additional suggestion for which there is 
also an analogy with tax reform days. In the mid-1980s, the Treasury 
engaged the IRS in studies of the various ways income was being 
sheltered from tax. Congress found these data useful in considering 
what changes it would undertake. As I have noted, tax professionals 
exhibit an enormous ability to take advantage of differentials in 
taxation. I suggest that Congress ask the Treasury and IRS to engage in 
a much more serious and continual effort--combining policy, statistics, 
and enforcement personnel--to expose who, at various income levels, pay 
multiple taxes and who pay little or no tax at all.


    Mr. LEVIN OF MICHIGAN. Professor Jones.

                   UNIVERSITY COLLEGE OF LAW

    Mr. JONES. Thank you.
    So, there's going to be a lot of paperwork and documents in 
the record after this hearing is over with, and those papers 
are filled with theories, opinions and even dire predictions. 
But I'd like to point out one thing that we know absolutely for 
    We know that somewhere in America is a family, perhaps with 
a son or daughter fighting in Iraq or Afghanistan, making 
$70,000 a year and paying tax at a marginal rate of 25 percent. 
We also know for sure that there is a fund manager somewhere, 
who according to some press reports, made about $684 Million in 
1 year and paying taxes at 15 percent.
    A recent paper published by Professor Michael Knoll of the 
University of Pennsylvania suggested or concluded that if we 
taxed secured interest the same way that we taxed a regular 
worker, an average American worker, we would obtain between Two 
and Three Billion Dollars a year. In preparing for my 
testimony, I tried to come up with the starkest example of what 
that really means in human terms, and I found in Internet that 
it costs about $7,500 to fully equip a soldier or marine with 
full body armor to protect him or her against hot shrapnel 
going into her Adam's apple or into his groin, it costs about 
    That means that it costs a little bit less than $1 Billion 
per year. So, that's what it would mean if we taxed fund 
managers the same way we tax other service providers. I might 
add that it's never been the case, as Prof. Levin has pointed 
out, that sweat equity disqualifies an investor of previously 
taxed capital from the capital gains rate. But neither has it 
been the case that sweat equity alone grants you access to the 
preferential tax rates that are contained in the capital gains 
taxation system.
    You know, when I was preparing for my testimony, I really 
got indignant about some of the arguments that are being made, 
particularly by people in the fund management industry, because 
I thought that they were extremely, intellectually dishonest. I 
was prepared, really, to come in and pound the podium and call 
them a bunch of liars and so forth. But I'm heartened by some 
of the testimony I've heard today, particularly from Mr. 
Shapiro. On your next panel, Mr. Hendry and Mr. Stanfield, who 
will admit that even after their 20 years of experience they 
know that what their doing is earning money the same way you 
and I are earning money, and that is through their human 
    Closing the carried interest loophole is not an attack. 
It's not a Trojan horse attack on the capital gains rate. This 
is what Republican Senator Grassley says about the carried 
interest tax scheme. He says that this isn't the carried 
interest tax scheme is an attack on the integrity of the 
capital gains tax rates.
    If we allow the carried interest tax scheme to continue, 
we're allowing the opponents of capital gains taxation a 
legitimate opportunity to attack the integrity of the tax. 
That's what Republican Senator Grassley said. So, if there is a 
Trojan horse attack on the carried interest, the people inside 
that horse are a bunch of very dangerous fund managers, not a 
bunch of Democrats or even Republicans who are trying to attack 
the capital gains rate.
    A couple years ago President Bush appointed a Presidential 
commission to talk about tax reform. That Presidential 
commission stated that every time that we grant a special 
privilege for one group of taxpayers, it costs everybody else a 
lot of money. That's what's going on right now. The Tax Code is 
about two things: efficiency and fairness. It doesn't take a 
PhD in Economics to see how unfair it is that an average 
working family pays taxes at 25 percent and somebody who's 
making a lot more money in much nicer digs is paying taxes of 
15 percent.
    Since this issue has come to the attention of the American 
people, there's been a lot of theory and attempts at trying to 
justify this inequity [continuing]. I think that Congress will 
soon enough see through the smoking mirrors and come to the 
right conclusion and tax the carried interest as ordinary 
income just like every other worker.
    Thank you very much.
    [The prepared statement of Mr. Jones follows:]
       Prepared Statement of Darryll K. Jones, Professor of Law,
          Stetson University College of Law, Gulfport, Florida
    Chairman Rangel, Ranking Member McCrery and Members of the 
    Thank you for this opportunity to talk to the committee regarding 
an important issue of tax policy and fundamental fairness. By now, most 
people are acutely aware of the problem with which this Committee is 
rightly concerned. Most of the debate regarding the taxation of carried 
interests has been articulated in rather dry academic terms without 
focusing on the real human impact. Before I, too, launch into a 
philosophical discussion, I want to describe the obscene problem in 
terms understandable to real American families. A modest American 
family making $70,000 per year, and having one son fighting in Iraq 
with other average American men and women, pays taxes at a 25 percent 
marginal rate.\1\ Those taxes help fight the wars we decided are 
necessary to fight.
    \1\ Compare, Nancy Duff Campbell, Close Loophole Designed To 
Benefit Hedge Fund Managers, The Miami Herald, August 21, 2007, 
available at http://www.miamiherald.com/851/story/209866.html. (noting 
that something is ``deeply wrong'' when a single mother earning just 
over $40,000 per year is in a higher tax bracket than millionaire 
bosses at hedge funds).
    On the other hand, a fund manager making more than $3 or $4 million 
per year, with means plenty sufficient to keep his son or daughter out 
of Iraq or Afghanistan pays taxes at a maximum rate of 15 percent. The 
only study to date regarding the revenue loss occasioned by fund 
manager manipulations states that if fund managers were taxed just like 
average American families--not a tax hike--the government would raise 
between $2 and $3 billion dollars annually.\2\ To understand what that 
really means, consider that it cost about $7,500 (the price of a small, 
late model used car) to equip each soldier, sailor, and marine fighting 
in Iraq or Afghanistan with full body armor--armor that protects not 
only the chest and back, the base of the neck, the buttocks and the 
groin. That is less than $1 billion dollars to adequately equip our 
fighting forces against flying shrapnel. With the money obtained if 
fund managers simply paid their fair share we could save many of those 
fighting for the very system fund managers so gleefully exploit.
    \2\ Michael S. Knoll, The Taxation of Private Equity Carried 
Interests: Estimating the Revenue Effects of Taxing Profit Interests as 
Ordinary Income, University of Pennsylvania Law School Research Paper 
No. 07-32, available at http://www.law.upenn.edu/academics/institutes/
    There are three primary reasons why we tax some income (i.e., 
``ordinary income'') at comparatively higher rates than capital income. 
My testimony in this regard is neither new nor groundbreaking. Indeed, 
every person who has ever really thought about capital gains taxation 
knows of these reasons, though many people disagree that they justify a 
lower tax rate on some income than others.\3\ Assuming the reasons are 
valid, they would nevertheless not in any way justify the application 
of capital gains rates to service compensation earned by fund managers.
    \3\ Some have proposed, for example, that rather than engender the 
complexity and avoidance provoked by capital gains taxation, we should 
simply ``index'' basis so that it is adjusted by the rate of annual 
    The first reason pertains to the economic definition of income and 
the reasonable belief that only real economic gains should be taxed. 
Suppose a taxpayer earns $100 (net after tax) during a time when one 
year inflation is 6 percent. The $100 is previously taxed income and, 
of course, should not be taxed again. If the taxpayer buys property for 
$100, and after one year sells the property for $106, she will reap and 
pay tax on $6.00 nominal gain. This, despite the fact that she is no 
richer than when she invested the $100 in the property one year ago. 
She has a nominal gain under IRC 1001 but no economic gain. Because of 
inflation, her $106 one year later gives her no more purchasing power 
than she had one year earlier. Thus, taxing the $6.00 nominal gain 
amounts to an additional tax on the same accession to wealth. The 
upshot of this economic result is that the taxpayer who earns $100 is 
better off immediately consuming it, instead of saving it long term 
presumably in a manner that generates greater societal benefit. That 
is, the tax on capital encourages immediate over-consumption.
    The second reason for the capital gains preference relates to the 
taxpayer who wishes to reinvest her previously taxed income in a better 
place but declines to do so because she knows she will be taxed on the 
transition from one investment to another. If, for example, the 
taxpayer who earned and invested $100 during a period of 6 percent 
inflation decides she no longer wants to invest in eight track tape 
players because MP3's represent better technology, she would have to 
sell her investment in eight track tape players, pay a tax (largely on 
inflationary gain) and then reinvest the net amount. The tax imposed on 
the sale of the eight track investment might very well discourage her 
from withdrawing from a burned out investment and using the previously 
taxed income to invest in a more profitable and socially beneficial 
investment. That is, she might continue her original investment in the 
manufacture of eight track tape players when MP3 are better solely 
because of the tax cost occurred by shifting to a better investment. 
This latter point is referred to as the ``lock-in'' effect.
    Implicit in both of these first two examples is that there has been 
a beneficial ``savings''--referred to economically as ``investment''--
of previously taxed income. A later tax, again largely on inflationary 
gain, amounts to a second tax on the same income and some people find 
this inherently unfair for good reason.
    Neither of the first two justifications for capital gains taxation 
applies to the tax that ought to be imposed on the carried interest. In 
the typical case, fund managers have not ever been taxed on income 
subsequently invested in long term assets, such that we should be 
concerned about the deleterious effect of taxation on nominal as 
opposed to real economic gain.\4\ Fund managers invest untaxed human 
capital--what Ms. Mitchell referred to in her testimony before the 
Senate Finance Committee as ``sweat equity'' \5\--not previously taxed 
financial capital. The tax on human capital is a single tax, since we 
do not tax people on their potential to earn. If we taxed people on 
mere earning potential, and then again upon the financial realization 
of that potential, we should rightly be concerned about the double 
taxation. We do not tax earning potential so there is no double 
taxation, nor is there a prior taxing event that would encourage people 
to ``lock up'' their earning potential to avoid a second tax. We don't 
have to worry that people will not get a job, particularly when the 
market compensates them so handsomely for doing so. Clearly, then, none 
of the long accepted policy reasons justifies the application of 
capital gain tax rates to fund manager compensation.
    \4\ To the extent fund managers make capital contributions from 
previously taxed or specifically exempted income, they should be 
granted capital gain treatment on their long term yields because in 
that instance the double tax or lock-in effect applies. HR 2834 would 
provide such treatment. Senators Baucus and Grassley have introduced a 
bill to tax publicly traded fund management partnerships as 
corporations. Members should not confuse the discussion of the proper 
taxation of carried interests with the question of the taxation of a 
publicly traded management company, though some of the same people 
would be affected by both initiatives. Whether or not the publicly 
traded management company is taxed as a corporation, individual fund 
managers will continue to be compensated by means of carried interests 
in other partnerships that hold the investments that the publicly 
traded company manages.
    \5\ See http://www.senate.gov/finance/hearings/testimony/2007test/
    A third common, but less agreed upon reason for taxing the income 
from capital at lower rates is referred to as the ``bunching effect.'' 
The bunching problem refers to the fact that a taxpayer who holds an 
investment long term will pay a higher tax than if she bought and sold 
the same asset over and again on a short term basis. A simple example 
helps demonstrate the problem. Assume, for example, that a taxpayer 
pays $100 for property and the property's value increases by 10 percent 
annually. If the 10 percent increase were taxed annually, the taxpayer 
would pay a total of $6.00 in tax assuming a flat rate of 10 percent on 
annual income of less than $10 and 25 percent on annual income over 
$50. Table 1 shows the outcome:

                      Table 1: The Bunching Problem

                                                              Annual Tax
              Year                 Appreciation      Value        on

1                                10                100......  0
2                                11                110......  1
3                                12.1              121......  1.1
4                                13.3              133......  1.2
5                                14.6              146......  1.3
6                                16.0              160......  1.4

Total tax on $60 appreciation at 10 percent per year       $6
    If the taxpayer held the asset long term and sold it for $160 six 
years later, her $60 gain would be ``bunched'' and her tax would be 
$15.00, an increase of $9.00 merely because the taxpayer held the asset 
longer and realized all of her gain in one year. Lowering the tax on 
$60 long term gain to 15 percent alleviates some, but not all of the 
bunching problem. The tax in that case would be only $9.00.
    The bunching problem, too, is entirely inapplicable to the taxation 
of carried interests, primarily because bunching refers to the creeping 
appreciation in property value and fund managers are simply investing 
labor--just like most other average Americans who receive no tax break 
for an alleged bunching problem. In any event, if bunching were a solid 
justification for taxing fund managers at lower rates, it would 
necessarily require lower rates for all service providers whose income 
is taxed at more than the lowest marginal rates.
    The remainder of my written testimony debunks two commonly raised 
justifications--more like campaign slogans--used by fund managers in an 
effort to retain their special tax break. The first asserts that 
capital gains taxation is justified by the alleged risks and social 
rewards that fund managers assume and generate, respectively. The 
second attempts to justify capital gains taxation of fund managers 
because of the labor that precedes the investment of capital. Neither 
of these justifications withstands the light of close scrutiny.
    The notion that normal or even enhanced risk-taking justifies the 
application of capital gains tax rates to fund managers is both novel 
and bizarre. The notion proves too much.\6\ Every entrepreneur is a 
risk taker but only entrepreneurial investors of previously taxed 
income are taxed at lower rates, for the reasons discussed above not 
because they are risk takers. Every economic activity presupposes risk 
so the fact that fund managers undertake risk is insufficient to 
justify capital gains taxation. If Tiger Woods, for example, does not 
win (or place within the top performers), he receives no compensation 
for his efforts. When he wins, he is taxed at ordinary rates. When 
Tiger Woods' competitor wins--in an industry with much greater risk 
than venture capitalism, given the presence of Tiger Woods--the 
competitor's demand for taxation at capital gains rates would not be 
justified by the fact that Tiger Wood's presence made the investment of 
human capital by all other competitors extraordinarily risky in an 
economic sense. The market itself compensates for the decision to 
undertake the extraordinary risk--via extraordinary compensation--and 
so there is no reason to grant a tax subsidy. The more important point 
is that risk taking has nothing to do with capital gains taxation. 
Every investment--whether of human or financial capital--involves risk. 
A theory that capital gains taxation is appropriate for risk taking 
proves too much and is nothing more than a selective plea for lower tax 
rates for certain activities.
    \6\ The fact that fund managers voluntarily structure risk into 
their compensation scheme has no relevance to capital gains tax rates. 
``So are the incomes of movie actors, the royalties of authors and the 
prize winnings of golfers--none of which is treated as capital gains'' 
[nor should they be]. Alan S. Blinder, The Untaxed Kings of Private 
Equity, New York Times, Section 3, page 4 (July 29, 2007).
    The latter assertion is refutable only to the extent capital gains 
taxation is conceptualized as a subsidy (rather than as a remedy) and 
then only to the extent a subsidy is necessary to spur ``irrational'' 
but nevertheless socially necessary economic behavior.\7\ Two examples 
demonstrate the inappropriateness of a subsidy rationale as a 
justification for taxing fund management compensation at capital gains 
rates. The first pertains to the research and development tax credit. 
The financial cost (i.e., the risk) of research and development is so 
high that rational people ought to spend their labor and money 
elsewhere.\8\ The research and develop tax credit effectively lowers 
the tax rate--and thus the risk--on labor and income directed towards a 
certain needed and socially beneficial activity that would otherwise 
not occur in the market. Providing a lower tax rate via a credit 
encourages highly risky but nevertheless socially necessary labor and 
capital not sufficiently provided by market incentives. A closer 
example involves serving in combat. The tax rate on combat pay (zero 
percent) is lower than the tax rate on other services.\9\ Going to 
combat is a risky, irrational behavior with such little hope of 
financial reward that we should expect it never to occur without 
something to offset the risk. I am here speaking only in the economic 
terms the proponents of capital gain taxation have used in the debate; 
I am not referring to the higher callings that motivate my younger 
brothers, my niece and others like them to engage in combat. 
Nevertheless, in an economic sense, there is insufficient hope of 
market reward to motivate combat services. It is only when we can make 
that conclusion--that the market insufficiently provides needed 
services--that non-ordinary taxation on services such as that performed 
by fund managers is justifiable. We cannot make that assertion to 
service as a fund manager because the hope of financial reward is so 
high that the socially beneficial behavior will inevitably occur in 
sufficient quantities.
    \7\ There are various assertions that capital gains taxation 
subsidies greater wealth for the wealthy. I take no position on these 
assertions but instead accept the notion that capital gains taxation 
remedies the double tax and lock-in effect.
    \8\ IRC 41 (1986). ``The intent of the R&D tax credit was to 
encourage R&D investment by the private sector. Congress believed that 
the private sector was not investing enough in research and 
development. Legislative history indicates that Congress believed that 
the private sector's lack of investment in research and development was 
a major factor in the ``declining economic growth, lower productivity, 
and diminished competitiveness of U.S. products in the world market.'' 
Belinda L. Heath, The Importance of Research and Development Tax 
Incentives in the World Market, 11 MSU-DCL J. Int'l L. 351, 352-53 
    \9\ RC 112 (1986).
    Moreover, removing market risk that fund managers take--if indeed, 
they really are at risk--by granting tax preferences would distort the 
market by causing more people to seek jobs as fund managers rather than 
performing services in other areas in need of human capital. Softening 
that potential risk punishment via a tax break encourages irrational 
risk-taking and ought to be tolerated only when there is a demonstrable 
societal benefit not otherwise provided via the market. As fund manager 
compensation figures show, the market more than adequately spurs the 
risk-taking that fund managers indulge when they put their service 
compensation at the demonstrably benevolent mercy of investment funds. 
Any losses incurred by fund managers serve only to discipline the 
market by discouraging too much risky behavior that would harm the 
    Ms. Mitchell's testimony during Carried Interest I can be 
characterized as sentimental sophistry at best. It reminded me of 
Reagan's ``morning in America,'' Bush, Sr.'s ``a thousand points of 
light,'' and just to be bipartisan about it, Clinton's ``don't stop 
thinking about tomorrow.'' She described such wild successes as Google, 
YouTube, FedEx, and Ebay as evidence of the legitimacy of capital gains 
taxation for services. In each of those examples, though, there was 
sufficient hope of astronomical market reward such that any non-
confiscatory level of taxation would be appropriate. Unlike research on 
new drugs, or service in combat, the real risks were far outweighed by 
the potential reward. There was at least enough hope that the true 
investors of previously taxed capital could easily attract the sweat 
equity--previously untaxed, by the way--necessary to put other peoples' 
previously taxed capital to work. Some of the witnesses during Carried 
Interest II conceded this point but responded by arguing that in the 
absence of U.S. capital gain treatment, investors of previously taxed 
capital would invest their money in offshore funds where fund manager 
compensation is cheaper. The easy answer to that is, ``all well and 
good.'' If investors can find the same labor at cheaper prices, 
domestically or overseas, it is not the Tax Code that is diverting 
capital to foreign markets. It is instead the overpriced demands made 
by domestic fund managers. Chyrsler, Ford, and GM have to compete with 
cheaper sources of labor, why shouldn't fund managers have to do the 
same, and in doing so, they save more of their pension fund or 
charitable foundation for their intended purposes. The argument, then, 
that capital gains taxation is necessary to maintain domestic capital 
domestically is both anti-competitive and protectionist. At bottom, the 
capital gain preference is plea subsidize the investment management 
industry. A tax subsidy, though--either via exemption or merely lower 
tax rates--is unnecessary when the rational hope of getting rich is 
sufficient to spur the services upon the industry is dependent. The 
rational, realistic ``hope,'' not the guarantee, of market rewards, 
spurs needed economic service and renders tax preferences superfluous. 
If the risk of reward outweighs the risk of loss, such that the 
activity will occur in optimal quantities anyway, a tax subsidy is an 
extremely unwise use of tax dollars. Indeed, providing a tax subsidy 
when the market provides the sufficient hope of reward so that the 
behavior would have occurred in sufficient quantities is against 
societal interest. They generate an oversupply of the thing subsidized. 
Moreover, tax subsidies are not limitless. The tax subsidy--the 
unnecessary tax subsidy--spent to encourage labor already in sufficient 
supply could have been better spent for more research and development 
or higher combat pay.
    Finally, and with due respect, Mr. Solomon's example during Carried 
Interest I regarding a business built with the combination of labor and 
capital proves the opposite of what he intended because it omits 
necessarily implicit facts. The example states:
    Entrepreneur and Investor form a partnership to acquire a corner 
lot and build a clothing store. Investor has the money to back the 
venture and contributes $1,000,000. Entrepreneur has the idea for the 
store, knowledge of the fashion and retail business, and managerial 
experience. In exchange for a 20 percent profit interest Entrepreneur 
contributes his skills and know how [i.e., human capital or services]. 
Entrepreneur and Investor are fortunate and through their combination 
of capital and efforts, the clothing store is successful. At the end of 
5 years, the partnership sells the store for $1,600,000, reflecting an 
increase in the going concern value and goodwill of the business. 
Entrepreneur has $120,000 of capital gain and Investor has $480,000 of 
capital gain.\10\
    \10\ http://www.senate.gov/finance/hearings/testimony/2007test/
    Note that the example asserts that the appreciation is attributable 
solely to the increase in going concern value and goodwill. Going 
concern value and goodwill could not possibly have been generated 
without previous realization and recognition of ordinary income via the 
sale of inventory and the performance of services. If the partnership 
is sold with inventory or accounts receivable [e.g., for services] on 
hand, the first part of the gain will be correctly taxed at ordinary 
rates, regardless of whatever value the parties ascribe to going 
concern or goodwill.\11\ If instead, the store previously sold all of 
its ordinary income assets--haute couture clothing and services, for 
example--without having ever distributed a portion of the gains to the 
service partner, the service partner would have nevertheless recognized 
ordinary income,\12\ before being granted access to the capital gains 
rates applicable to the sale of the partnership interest.\13\ This 
would, of course, be appropriate because the undistributed, previously 
taxed ordinary income would be economically analogous to previously 
taxed income invested in long term property.
    \11\ IRC 751 (1986).
    \12\ IRC 702(b) (1986).
    \13\ Mr. Solomon's example actually only demonstrates a timing 
issue--whether the service partner should recognize ordinary income 
upon receipt of the partnership profit interest, or as profits are 
actually earned. I have stated elsewhere that it is at least tolerable 
to defer recognition until profits are actually earned by the 
partnership. Darryll K. Jones, Taxing the Carry, 115 Tax Notes 501 
(2007).  Other commentators have made convincing arguments that 
ordinary income should be recognized upon the grant of the profit 
interest. See Lee Sheppard, Blackstone Proves Carried Interests Can Be 
Valued, 2007 TNT 121-2 (June 20, 2007).  In any event, there is no 
conversion tolerated in this example.
    In the most fanciful of all desperate attempts to retain an 
unjustified tax break, David Weisbach opines that capital gains 
taxation of carried interest is justified because of the labor that 
goes into the decision where to invest one's previously taxed capital. 
Weisbach states that fund managers should continue to enjoy capital 
gain treatment for services because:

      the labor involved in private equity investments is the 
same type of labor
      that is intrinsic to any investment activity. Sponsors 
[Weisbach avoids the more accurate label, ``managers'' for good reason] 
select the investments, arrange the financing, exercise control rights 
inherent in ownership of the portfolio companies, and eventually decide 
when to dispose of the assets. If the performance of these tasks were 
sufficient to deprive sponsors of capital gains treatment, capital 
gains treatment would not be available to any investor.\14\
    \14\ Weisbach's paper can be found at http://
interests-07-24-07-final.pdf. The paper was ``funded'' by the Private 
Equity Council and should therefore not be mistaken for disinterested 
academic discussion.
    This argument, like that pertaining to risk assumption, proves 
entirely too much. It is indeed true that investors of capital aren't 
``deprived'' of capital gains preference merely because they labored to 
find a good place to invest previously taxed capital. It is just that 
the argument is wholly beside the point. Of course the expenditure of 
labor is insufficient to deprive the yield from previously taxed wealth 
of capital gains tax rates, but so too is the expenditure of labor 
insufficient to obtain capital gains taxation. We are talking about the 
right to obtain, not retain capital gains taxation.\15\ It is only the 
investment of capital that obtains and retains capital gains rates, for 
the reasons stated above; all labor preliminary to that investment is 
wholly irrelevant and indeed insufficient. That's why the same type of 
labor involved in the selection of a job by a plumber or the 
determination of which inventory a mom and pop grocery store should buy 
wholesale does not make compensation from the job or retail profit from 
the sale of inventory taxed at capital gains rates.
    \15\ If an investor places his capital at risk and then personally 
rides roughshod over her managers, she is not thereby ``deprived'' of 
capital gains rates on the gains derived from the investment of her 


    Mr. LEVIN OF MICHIGAN. Thank you.
    Professor Fleischer.


    Mr. FLEISCHER. Thank you for inviting me here to present my 
    The current tax treatment of carried interest is 
problematic because it treats labor income as if it were 
investment income. By taking a portion of their pay in the form 
of partnership profits, fund managers defer income derived from 
their labor efforts and convert it from ordinary income into 
capital gain.
    This quirk in the tax laws is what allows some of the 
richest workers in the country to pay tax on their labor income 
at a low rate.
    I will make three quick points. First is to elaborate on 
this idea that carried interest properly understood is labor 
income and not investment income. Carried interest is incentive 
compensation received in exchange for managing other people's 
    From a business point of view, carried interest works well. 
It aligns the incentives of the fund managers and their 
investors. If the fund does well, the managers share in the 
treasure. This alignment of interest concept, which works well 
for business purposes, does not magically transform that 
compensation into capital gain. It is still compensation for 
services rendered. Fund managers share in the appreciation in 
the fund, but they bear little downside risk. Carried interest 
thus diverges from the tax treatment of other compensatory 
instruments. Carried interest is treated more favorably than 
partnership capital interest, corporate stock or stock options.
    Carried interest is the single most tax efficient form of 
compensation available without limitation to highly paid 
    The second point is that the partnership tax rules were 
designed with small business in mind, not billion dollar 
investment funds. I will talk a second about how I think we got 
to where we are today.
    Various changes in the capital markets have taken a modest 
subsidy from mom and pop businesses and turned it into a 
subsidy for large investment firms. These changes in the 
capital markets include massive inflows of capital into the 
private equity sector, an increase in the number of tax exempt 
investors, adoption of new investment strategies that have 
increased demand for these alternative asset managers, and the 
aggressive conversion of management fees into carried interest.
    Congress should respond to these changes in the investment 
world by bringing the law up to date.
    My third and final point is that there is widespread 
agreement among tax professors and economists that the status 
quo is problematic. There is ample room for disagreement about 
the scope and mechanics of different reform alternatives, but 
most of us view current law as troubling. It offends basic 
principles of sound tax policy like seeking a broader tax base 
which allows for lower tax rates overall. That is something 
that most tax professors and economists agree on, broad-based 
lower rates overall.
    By taxing asset management activities at a low rate, we 
must tax other activities of equal social and economic value at 
higher rates. This is neither fair nor efficient.
    Among the various reform alternatives, H.R. 2834 makes a 
lot of sense. It provides a simple baseline rule that would 
treat carried interest as ordinary income; by taxing carried 
interest like other forms of compensation, it will improve 
economic efficiency and discourage wasteful gamesmanship.
    These changes would also reconcile private equity 
compensation with our progressive tax rate system and widely 
held principles of distributive justice.
    Obviously, there are a lot of details that I have written 
about elsewhere and are in my testimony. I look forward to 
answering your questions. Thank you.
    [The prepared statement of Mr. Fleischer follows:]
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    Mr. LEVIN OF MICHIGAN. Thank you very much.
    Professor Gergen.


    Mr. GERGEN. Thank you for inviting me. I am going to 
abbreviate my remarks because I think there is no serious 
policy or fairness argument against a taxing distributive share 
that is compensation as compensation.
    All the policy and fairness arguments you hear are rhetoric 
or special interest pleading.
    There is one serious argument against it, and that is what 
I want to talk about. That is that the change is going to 
increase complexity without raising revenue.
    We all want a tax system that is workable. What I want to 
tell you is that argument, while it is a serious argument, is 
finally not a good reason to reject this change.
    First, H.R. 2834 will simplify tax law on one important 
dimension. It will clarify the relationship between partnership 
tax and the rules in section 83 on the taxation of receipt of 
property for services.
    In one direction, it is simplification. This now is a 
problem for tax lawyers and it is a problem for the Treasury, 
which is trying to figure out how these two different rules fit 
    Second, many of the technical problems that are raised by 
H.R. 2834 are easily dealt with in existing Subchapter K. I 
talk about this in my prepared statement. I will not repeat it 
here. We have rules in section 704 and section 737 that make 
sure we tax compensation when a partner liquidates their 
interest or when the interest is sold.
    Subchapter K is there to make the solution work. Complexity 
is increased only on one dimension. There is one new issue that 
H.R. 2834 raises, and that is identifying the part of the 
distributive share that is compensation. That is a new issue. 
The law is going to be more complex on that dimension.
    For many partnerships where partners contribute equal 
capital and take equal distributions or where they all 
contribute equal labor, it is not going to be an issue. The 
issue does not arise. It only arises in those partnerships 
where some contribute capital and some contribute labor.
    In those partnerships, they know the deal they are 
negotiating. I contributed capital. You contributed labor. You 
are going to get a smaller return, or part of your return is 
going to be for labor.
    The argument that the bill will not be effective, that it 
will not raise revenue, is that there are various things people 
in the industry can do to avoid having their income 
characterized as a return on labor, to treat it as a return on 
    Victor Fleischer has talked about one of them. They will 
make an interest free non-recourse loan to create a capital 
    Another possibility in the venture capital context is they 
will say I actually contributed capital in the form of a zero 
basis intangible called goodwill. A third is they might try to 
say that some of this carried interest is really return on 
whatever my capital contribution was in return for bearing 
greater risk or taking a deferred return.
    I talk about these matters in my paper. Two points we can 
take away from it, you will get some income. You will identify 
some of this as compensation, not all of it. You are not going 
to be over taxing the return to labor. At the end of the day, 
whatever you are going to do, you are going to be under taxing 
the return to labor because of these various possible evasions.
    Finally, these are the sort of issues we deal with on a 
daily basis in the income tax. Most of these can be dealt with 
in a very general way in the statute and then you turn it over 
to the Treasury.
    I think this bill is a no brainer. Finally, I would fix 
H.R. 2834 by expanding it. You are attracting a lot of 
criticism because you are targeting investment services. You 
should not limit this to investment services. It should apply 
to any partnership where somebody is contributing labor and in 
return getting a return from somebody else's capital.
    Thank you.
    [The prepared statement of Mr. Gergen follows:]
        Prepared Statement of Mark P. Gergen, Professor of Law,
          The University of Texas School of Law, Austin, Texas
    How to Tax Carried Interests
    Mark P. Gergen*
    There is a fairly simple solution to the problem of the taxation of 
carried interests: amend Section 702(b) to treat a partner's 
distributive share as ordinary income when the partner receives the 
distributive share as compensation for services rendered by the partner 
to the partnership.\1\ The capital accounts system, which is the core 
of modern Subchapter K, makes it possible to identify compensation. 
This change would also solve some other substantive and technical 
problems under current law.
    \1\ Section 1402 also should be amended to make this income subject 
to the self-employment tax.
The Carried Interest Problem
    Managers of private equity funds typically are compensated for 
their services by being paid a base fee of 2 percent of the fund's 
assets plus 20 percent of the fund's profits after investors receive a 
specified return. The 2 percent is ordinary income to the manager and 
an expense to the fund. The 20 percent is taxed as if it was an 
investment return. If the profits are in the form of capital gains, 
then this part of the manager's compensation is taxed at the capital 
gains rate (15 percent) and not at the ordinary rate (35 percent or 
more with phase outs). If it is interest income, then the manager 
avoids the self-employment tax (the 2.9 percent Medicare or Hospital 
Insurance tax has no ceiling). If it is tax exempt income, then the 
compensation is tax free. The unfairness of this is evident.\2\ It may 
also be inefficient as it may distort contract design and resource 
    \2\ David Weisbach, The Taxation of Carried Interests in Private 
Equity Partnerships, 2007 TNT 122-77 (July 30, 2007), argues to the 
contrary that similarly situated taxpayers who profit from managing 
their own money are treated as having capital gains. Of course, fund 
managers are different because they profit from managing other people's 
money. Weisbach elides this important difference by analogizing to the 
case where a taxpayer profits from intelligently managing investments 
made with borrowed money. It is an inapt analogy. A taxpayer who 
invests borrowed money would have to pay interest (putting to the side 
investments made on a margin account). Investors in a fund have a 
preferred return, they do not have a guaranteed return. There is little 
economic difference between a carried interest and an alternative 
structure where investors fund a manager's capital account with a 
nonrecourse loan. I will come back to this point. But there is an 
important tax difference. If adequate interest is not charged on the 
loan, or if charged interest is foregone when a manager's share of a 
fund's profits is insufficient to pay the interest, then interest will 
be imputed as ordinary income under Sec. 7872.
Current Law
    The question of how to tax a partner who receives a profits share 
as compensation for services is an old one. It has long been settled 
that a partner who receives a capital interest in a partnership as 
compensation has ordinary income, generally when the interest no longer 
is subject to forfeiture. Regulations proposed in 2005 would settle two 
open questions.\3\ One question regards the measure of income. The 
choices are between the market value of the interest (what a buyer 
would pay for the interest in an arms-length transaction) and the 
liquidation value of the interest (what the partner would receive if 
the partnership sold all of its assets for their fair market value, 
repaid its debts, and then liquidated). The market value of an interest 
may be lower than the liquidation value because of such factors as 
illiquidity or a minority discount. The other question regards the 
treatment of other partners. In particular, if the partnership has 
appreciated assets, then do the other partners recognize gain on the 
exchange of the interest for services, as they would have recognized 
gain had they exchanged the underlying assets for the services? The 
proposed regulations provide the service partner is taxed on the 
liquidation value (assuming an election is made) and that other 
partners do not recognize gain or loss on the underlying assets.
    \3\ See Notice 2005-43, 2005-24 IRB 1221.
    Debates over how to tax a partner who receives a profits interest 
for services generally have focused on the possibility of taxing the 
service partner on receipt of the interest. Two cases that are staples 
of the partnership tax course, Diamond \4\ and Campbell,\5\ hold that a 
service partner has income on receipt of a profits interest. In the odd 
circumstances of Diamond (and maybe of Campbell), the result made 
sense. But there is little support for generalizing the rule. It is not 
in Treasury's interest to try to tax profits interests on receipt for 
several reasons. The value of an interest often will be speculative, 
taxpayers have an informational advantage, and the government always 
loses at the margin on valuation as only a substantial undervaluation 
is likely to attract challenge and a penalty. Also an interest can be 
structured in ways that minimize its value on receipt. The experience 
with family limited partnerships is instructive in all of these 
regards. Further, typically a partner's right to profits will be 
contingent on the partner performing services during the period the 
profits are earned. The risk of forfeiture gives a partner the right to 
elect whether to be taxed on receipt. This election combined with 
valuation problems invites strategic behavior.
    \4\ Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974).
    \5\ Campbell v. Commissioner, T.C. Memo 1990-162, reversed 943 F.2d 
815 (8th Cir. 1991). The government conceded on appeal that the tax 
court erred in holding a service partner had taxable income on receipt 
of profits interest. The Court of Appeals side-stepped the issue (while 
questioning the tax court's decision on the point) by holding 
Campbell's interest was of speculative value.
    Treasury responded to Campbell in 1993 with a ruling that a partner 
was not taxed on receipt of a profits interest for services, except in 
three limited situations not relevant here.\6\ The 2005 proposed 
regulations maintain this position while integrating it with Section 
83, which generally governs the taxation of compensatory transfers of 
property. Under the proposed regulations, to avoid tax on grant of a 
profits interest, the partnership agreement must provide for something 
called a ``safe harbor election.'' \7\ On the election the interest is 
valued based on its liquidation value at the time of grant, which is 
zero in the case of a profits interest. In addition, if the profits 
interest is subject to a substantial risk of forfeiture, which 
typically is the case, the service partner must make a Section 83(b) 
election so that the profits are not taxed as compensation when the 
right to them vests.
    \6\ Rev. Proc. 93-27, 1993-2 C.B. 343. The exceptions were (1) an 
interest in a substantially certain and predictable stream of income; 
(2) the partner sells the interest within two years; and (3) a limited 
partnership interest in a publicly traded partnership. Under the 
proposed regulations, the safe harbor election is not available in 
these situations. Rev. Proc. 2001-43, 2001-2 C.B. 19, clarified that 
when a partner was granted a nonvested profits interest he would be 
treated as receiving the interest on the date of grant so long as he 
was treated as a partner from that date.
    \7\ As an alternative to making the election in the partnership 
agreement the partners may make the election individually so long as 
all do so. A global election is required to prevent partners taking 
inconsistent positions.
    This is not a happy resolution of the matter for reasons 
independent of the problem of carried interests. It is not clear what 
tax consequences follow if people do not make the elections. If general 
Section 83 principles apply, then a service partner would have ordinary 
income equal to the market value of a right to partnership profits when 
her right to those profits is no longer subject to a substantial risk 
of forfeiture. The other partners would include the service partner's 
share of profits in their income and get a deduction equal to the 
amount of the service partner's income when her right to the profits 
vests. This may temporarily shift income from the service partner to 
the other partners if her right to the profits vests in the year after 
they are earned. And, if the right to profits is valued at either a 
discount or a premium, this creates offsetting built-in gains and 
losses between the service partners and the other partners.\8\ While it 
is hoped that taxpayers will make the required elections to avoid these 
problems, it is odd to require taxpayers to make two elections to avoid 
a trap.
    \8\ Consider an example. Assume A manages assets worth $1 million 
and the partnership earns $100,000 in year one. Her share of profits is 
$20,000. Assume that her right to these profits is worth only $15,000 
(this could well be the case if the profits are undistributed, A does 
not have the power to compel a distribution, and the interest is 
illiquid). Under general Section 83 principles, A would have $15,000 
ordinary income and the other partners would have $85,000 income (their 
share of profits, plus A's share, minus an expense equal to A's 
income). Comparing the basis of the interest and the capital account, A 
would have a $5,000 built-in gain and the other partners a $5,000 
built-in loss. If A's right to the profits vested in a year after they 
were earned, then the other partners would have $20,000 income on 
profits that probably would ultimately go to A and an offsetting 
deduction of $15,000 when A's rights to the profits vests.
    The proposed regulations also leave the carried interest problem 
uncorrected. Treasury is not to be faulted for it does not have the 
statutory tools to solve the problem.\9\ But a solution is available 
within the general framework of Subchapter K.
    \9\ Section 707(a)(2)(A) is not a reliable tool. It empowers 
Treasury to issue regulations to recharacterize allocations and 
distributions to a partner for the performance as services as a 
transaction with a nonpartner if they are properly so characterized. 
This rule is alongside and was enacted with the rules on disguised 
sales in 1984. The concern was that a partnership might avoid 
capitalizing an expense by giving a service provider a temporary, low-
risk interest in partnership income. To solve the problem of carried 
interests using Section 707(a)(2)(A) Treasury would have to take the 
position that a fund manager was not truly a partner. This is untenable 
unless one is willing to take the position that to be a partner in a 
capital-based partnership a person must contribute and risk capital. 
See Mark P. Gergen, Reforming Subchapter K: Compensating Service 
Partners, 48 Tax L. Rev. 69, 75-81 (1992).
The Solution Available in the Capital Accounts System
    Congress could take an important step towards solving the problem 
of carried interests by amending Section 702(b) to provide that a 
partner's distributive share shall be treated as ordinary income when 
it is compensation for services rendered by the partner to the 
partnership. Section 1402 also should be amended to make this income 
subject to the self-employment tax.
    This is only a partial solution for it creates subsidiary problems. 
The capital accounts system in Subchapter K helps to solve these 
problems. Under current law, the capital account measures the value of 
assets contributed by a partner to a partnership, plus the partner's 
distributive share of income, minus the partner's distributive share of 
losses, and minus the value of distributions to the partner. In 
addition, when there is a non pro rata contribution or distribution 
from a partnership, assets generally are booked up or down to their 
fair market value and partners' capital accounts are adjusted 
accordingly. The capital account system is a linchpin of the rules on 
special allocations, built-in gain or loss, basis adjustments, and 
more. It is the conceptual framework of modern Subchapter K.\10\
    \10\ I discuss the evolution of the system in Mark P. Gergen, The 
End of the Revolution in Partnership Tax?, 56 S.M.U.L.Rev. 343 (2003). 
Later I discovered that the principal creator of Subchapter K proposed 
a similar system to deal with precontribution gain and loss and related 
problems. See Mark P. Gergen, The Story of Subchapter K: Mark H. 
Johnson's Quest, Business Tax Stories 207 (Foundation 2005).
    The capital account makes it possible to identify when a 
distributive share is compensation. A simple rule would characterize a 
distributive share as compensation if the partner performs services for 
the partnership to the extent the distributive share is in excess of 
the partner's pro rata share in partnership capital. There are more 
fine-grained ways to identify compensation that would enable partners 
who contribute both capital and labor to take a preferred return on 
capital without having it characterized as compensation.\11\ The 
capital account system also supplies a mechanism for handling the sale 
or liquidation of an interest by a service partner when the interest 
bears unrealized profits that would have been taxed as compensation to 
the service partner when realized. The solution is to treat the partner 
as having compensation equal to the amount of compensation the partner 
would have had if the partnership had sold its assets for their fair 
market value immediately prior to the sale or liquidation. The handling 
of a sale follows Section 751(a). The handling of a liquidating 
distribution follows Section 737. The Section 704(c) regulations 
preserve the attribute of booked built-in gain as compensation through 
various events in the life-cycle of a partnership.
    \11\ Any such rule should cap the amount of the preferred return 
and require that the yield on the service partner's capital account, 
including the preference, not be greater than the yield on other 
    Different approaches are possible under the capital accounts system 
in the case of an asset revaluation. Assume A performs management 
services in a partnership with $1,000,000 assets in return for 20 
percent of the profits. The assets grow in value to $1,500,000, which 
is unrealized appreciation. At this point $500,000 new capital is 
contributed to the partnership. Under current law, the partnership may 
elect to book up its assets and give A a capital account of 
$100,000.\12\ At some point A should have $100,000 income treated as 
compensation. One possibility is to recognize the income at the time of 
the revaluation. But this creates a troubling disincentive for non pro 
rata contributions and distributions, which generally trigger 
revaluations. Managers would become loathe to permit non pro rata 
contributions and distributions if it triggered a substantial tax 
liability to them. Another possibility is to tag A with that much 
built-in gain on the assets, which will be treated as compensation when 
A liquidates or sells the interest. It is a mistake to push recognition 
past when A receives a liquidating distribution for this would permit A 
to take property as compensation without paying tax. This violates 
Section 83.
    \12\ Some think this is required. Such adjustments are standard in 
partnership agreements, which often are drafted to track tax law rules.
    At a deeper level, the capital accounts system is consistent in 
principle with recharacterizing a fund manager's share of capital gains 
as compensation. The capital accounts system embraces the aggregate 
theory of partnership tax. The carried interest problem exists because 
Section 702(b) follows the entity theory--the character of income is 
determined at the partnership level. From the perspective of the fund 
income is a return to capital. From the perspective of the manager it 
is compensation.
Distinguishing ``Sweat Equity'' and the Issue of Scope
    Capital gains earned by a fund manager or a venture capitalist have 
been likened to the capital gains realized by a sole proprietor or a 
partner who builds up a business, such as a veterinary clinic or a 
bagel shop, and then sells it. An entrepreneur, such as the vet or the 
bagel store owner, will have capital gain on sale of the business on 
amounts paid for good will or going concern value. Capital gains earned 
by a fund manager or a venture capitalist are quite different from an 
entrepreneur's sweat equity. The entrepreneur will earn ordinary income 
in creating good will. In addition, the entrepreneur can convert good 
will into capital gain only by selling the business and, typically, 
structuring the sale to allocate price to good will, which often 
diminishes the tax benefits to the purchaser.
    The simple solution I propose would change the treatment of good 
will in a business where partners made unequal capital contributions. 
For example, if A and B went into a partnership to open a bagel shop, 
with A contributing capital and B labor, B's gain on the sale of the 
shop would be ordinary income. The current treatment of good will can 
be preserved by excepting from the definition of compensation capital 
gain attributable to good will on sale of a business or liquidation or 
sale of a service partner's interest.
    This raises the larger question of the appropriate scope of a rule 
characterizing as ordinary income a partner's distributive share of 
income that the partner earned by performing services for the 
partnership. The Levin bill comes at this question from one direction, 
characterizing as ordinary income a partner's distributive share only 
insofar as the interest is received for the performance of investment 
management services. Under the Levin bill, a partner who provides 
services in return for an interest in a real estate development project 
or in an oil and gas venture might not have his distributive share 
recharacterized as ordinary income. I say might because the definition 
of investment services could cover some service partners in real estate 
and oil and gas partnerships. This points up two problems with the 
approach taken in the Levin bill. ``Investment services'' is an 
amorphous category that has uncertain application outside the targeted 
case of an investment fund manager. Another objection is that it is 
difficult to justify treating a fund manager differently than a partner 
who receives an interest for contributing managerial or operational 
services to a real estate development project or an oil and gas 
    The approach I propose comes at the question from the other 
direction, characterizing as compensation any part of a distributive 
share received by a partner who performs services for a partnership 
that is in excess of the partner's pro rata share of partnership 
capital. This gives rise to a different type of problem. It makes it 
necessary to carve out exceptions for cases where it is thought 
inappropriate to characterize a distributive share of capital gains as 
compensation. For example, an exception probably should be made for 
capital gain attributable to the sale of patent rights and similar 
intellectual property. This preserves consistency in tax treatment with 
the case of an individual who sells such property created by her 
personal efforts.\13\
    \13\ The rule in Sec. 1221(a)(3) excluding from the definition of 
capital assets property created by a taxpayer's personal efforts 
applies only to ``a copyright, a literary, musical or artistic 
composition, a letter or memorandum, or similar property. . . .'' This 
has been held not to cover patent rights and trade secrets. The reason 
for the different treatment is not clear.
Is the Game Worth the Candle?
    Under the Levin bill (and the approach I propose) fund managers may 
use various strategies to avoid having their distributive share of 
profits characterized as compensation. These include: 1) Make a capital 
contribution with funds provided by the investors through an interest-
free nonrecourse loan secured by the manager's partnership interest. 2) 
Take the position that the manager makes a capital contribution in the 
form of intangibles. 3) Take the position that the carried interest is 
a return on capital contributed by the manager.
    The nonrecourse loan strategy should be permitted. Existing law 
generally treats a nonrecourse loan as equivalent to a cash investment 
though it is well-known that a nonrecourse loan is unlike a cash 
investment or a recourse loan because the lender, and not the taxpayer, 
bears the risk of loss on the investment securing the loan. Standing 
alone this strategy leaves a fund manager with compensation equal to 
the imputation rate under Section 7872. There is an argument that this 
approximates the theoretically correct amount of compensation.\14\ The 
gist of the argument is that returns in excess of (or lower than) the 
risk-free return on the share of capital committed to a manager in 
return for services are returns to risk-taking and not returns to 
    \14\ See Two and Twenty: Taxing Partnership Profits in Private 
Equity Funds, forthcoming NYU L. Rev (2008). The paper is available on 
    The other two strategies are more problematic, particularly if they 
are combined with the nonrecourse loan strategy. It would be difficult 
for the government to challenge an arrangement where cash investors 
agreed to credit a fund manager with having contributed intangibles, 
such as good will. While the intangibles would have a zero basis their 
assigned value would be credited to the manager's capital account. 
Under the Levin bill (and the approach I propose) that fraction of the 
manager's distributive share would not be characterized as 
    \15\ Under Sec. 704(c), a manager might be allocated ordinary 
income equal to annual depreciation of the good will as this is the 
amount book depreciation of the good will would exceed tax 
depreciation. However, this would happen only if the partnership 
elected a method other than the traditional method or if the 
partnership was required to use the remedial allocation method under 
the anti-abuse rule. If a partnership was required to use the remedial 
allocation method, then the manager would have ordinary income and the 
other partners an ordinary deduction, which would reduce the advantage 
to the managers of characterizing part of their contribution as 
intangible assets.
     Insofar as the law recognizes that returns to capital may be non 
pro rata when differential allocations are made to suit partners risk 
and time preferences, the possibility exists for managers to 
characterize what in truth is a return to labor as a return to capital. 
A concrete example is useful. Assume manager (``M'') contributes 5 
percent of the capital to a venture and limited partners (``LPs'') 
contribute 95 percent. Profits (net of M's guaranteed compensation) are 
allocated first to the LPs until they receive an 8 percent return. 
Thereafter profits are allocated 20 percent to M and 80 percent to the 
LPs. M will take the position that more than one-quarter of its 20 
percent share of profits is a return on its investment of 5 percent of 
partnership capital because part of the premium is compensating it for 
bearing greater risk of return on its 5 percent. How aggressive M can 
be in characterizing the 20 as a return to capital depends on the rule 
policing such matters. One could imagine a rule of thumb developing 
that permits a return to be treated as a return to capital up to a 
stipulated multiple of a partner's relative capital account balance, 
such as 140 percent.\16\ This rule of thumb would allow M to treat 7 of 
its 20 percent as a return to capital. M could increase the amount of 
its 20 percent return that is treated as a return to capital by using 
the nonrecourse loan and intangible contribution strategies to increase 
its capital account. Assuming a 140 percent rule of thumb, for example, 
M could treat its entire 20 percent as a return to capital by ginning 
up a capital account totalling slightly more than 14.3 of partnership 
capital with a combination of real capital, intangibles, and a 
nonrecourse loan. M's compensation would be the interest imputed on 
that fraction of the capital account funded with the interest-free 
nonrecourse loan.
    \16\ I use this number for illustrative purposes.
    This simple illustration suggests that claims that the Levin bill 
(or the approach I propose) create complexity without changing results 
are overblown. Some fraction of a fund manager's 20 percent share will 
be taxed as compensation. The size of the fraction depends on details, 
in particular the rule delimiting what will be treated as a return to 
capital, and on how people respond to the change. Measures can be taken 
to increase this fraction. For example, a capital contribution funded 
with an interest-free nonrecourse loan may be allowed to be treated as 
bearing a return no greater than the imputation return. And the 
government could announce a policy of scrutinizing contributions of 
zero-basis intangibles. Such measures add complexity but it should be 
Side Benefits
    The proposed change solves some other problems. It makes it 
possible to exclude profits interests from Section 83. The receipt of a 
right to profits need not be treated as a receipt of property to be 
taxed as compensation when the profits themselves will be taxed as 
compensation when they are earned. This eliminates the need under the 
proposed regulations to make one or two elections and avoids the 
problems that arise in the absence of an election. Remaining is the 
question of how to handle the case where retained profits are subject 
to a substantial risk of forfeiture. Consistent with Section 83, the 
partner could make a Section 83(b) election and be taxed on the 
distributive share\17\ or the partner could forego the election and 
wait and be taxed on the value of the profits accumulated in her 
capital account when the interest vests. If the election is not made, 
then the distributive share would be taxed to the other partners, who 
would get an off-setting expense when the service partner takes the 
profits into income, bringing the other partner's tax position and 
capital accounts into line. This leaves some differences between the 
taxation of a compensatory grant of a profits interest and the taxation 
of a compensatory grant of an option, which can be economic 
equivalents. This is a more general problem that results from the 
reluctance to treat an option holder as a partner until the option is 
exercised. The option arrangement enables the service partner (or any 
other option holder) to defer recognition of income on its distributive 
share until the option is exercised.
    \17\ In the event the interest is forfeited, it is necessary to use 
either a deemed guaranteed payment or a side-agreement requiring the 
partner to forfeit his partnership interests to the other partners. 
From the perspective of the service partner, the deemed guaranteed 
payment is preferable because it provides an ordinary deduction to 
offset the ordinary income.
     The proposed changes foreclose some other troublesome 
possibilities under current law. In the 1980s I heard rumors of a film 
deal where an actor took a profits interest. The plan was that the 
partnership producing the film would buy property to be used in the 
production. When the film was done, the actor received the property in 
liquidation of his interest without paying tax. Current law on profits 
interests allows people to evade the rules on equity compensation. For 
example, if an employee is given a stock appreciation right, then he 
will have ordinary income on the amount of any appreciation. Instead 
put a block of the same stock in a partnership and give the employee a 
profits interest in its appreciation. After the stock appreciates, 
distribute to the employee stock equal in value to her share of the 
appreciation. The employee will be taxed on only part of the gain under 
Section 731(c) and it will be capital gain. Under the rules I propose 
the actor and the employee would have taxable compensation on the 
    Some of the problems addressed by Section 707(a)(2)(A) would not be 
solved. Section 707(a)(2)(A) is primarily directed as cases such as 
where an established partnership that develops and holds real estate 
gives an architect a short term interest in its rental income in return 
for services designing a new building. This allows the partnership to 
get a result equivalent to a short-term write off of the architect's 
fee and to avoid capitalizing the expense. Changing Section 702(b) 
would treat the rent as compensation to the architect. But it would not 
require the partnership to treat it as an expense and to include the 
architect's share of rents as income to the other partners.\18\
    \18\ A partnership would have the ability to treat the compensation 
as an expense by actually paying profits-based compensation or by 
making a guaranteed payment. If the profits are to be retained within 
the partnership, then the service partner would recontribute the 
    * Fondren Chair for Faculty Excellence, University of Texas School 
of Law. This significantly revises and supplements testimony I 
presented to Senate Finance Committee in July 2007.


    Mr. LEVIN OF MICHIGAN. Thank you very much.
    Under the rules that were used for the last panel and Mr. 
McCrery has agreed that we will follow them, we will do this. 
Those who did not ask questions the last time, the last panel, 
will go first. In view of the hour, we will limit our back and 
forth to 3 minutes. I think that is only fair. We have another 
panel to go.
    First, following that rule, will be Mr. Tanner. You are 
    Mr. TANNER. Thank you, Mr. Chairman. I like this rule.
    I have just one question. I want to thank all of you for 
your participation and for your most provocative comments.
    Mr. Orszag, I read your testimony last night before Senate 
Finance and then today's, and I am intrigued by the implicit 
loan perspective. May I ask if you would elaborate on that for 
the panel and how you would treat the non-recourse loan 
basically as ordinary income and so on?
    Mr. ORSZAG. Sure. I would note that since Professor 
Fleischer is on the panel, this idea has been discussed in some 
of his work. Let me just describe it briefly.
    Mr. TANNER. Yes, whoever.
    Mr. ORSZAG. I can do it.
    Very quickly, providing a 20 percent carried interest is 
equivalent to providing a non-recourse loan from some 
perspectives, equivalent to 20 percent of the fund's capital. 
So one could at least view the carried interest as equivalent 
to that implicit loan, for example, with no hurdle rate, a zero 
interest rate, on that implicit loan.
    The tax treatment that would follow from that would tax at 
the bond rate of return or the Treasury rate of return, the 
interest on that implicit loan as ordinary income, and anything 
above that as capital income.
    That is one of the perspectives that would lead to a kind 
of mixed outcome, somewhere between ordinary income and the 
current treatment for capital gains generated income.
    I would note, however, that implementation could become 
quite complicated.
    Mr. LEVIN OF MICHIGAN. Mr. Fleischer.
    Mr. FLEISCHER. I would just add there is an easier way to 
think about this implicit loan concept. Instead of getting all 
capital gain on the back end, the fund managers take some 
ordinary income up front as the income accrues and then get 
capital gains on the back end.
    This is a lot like taking cash salary every year. If the 
fund managers just took cash salary and then re-invested in 
their own funds, we would give them--if they pay tax on the 
cash salary, they are going to get capital gains treatment on 
the back end, just like any other investment. Nobody has been 
talking about trying to do away with the capital gains 
preference generally. If you actually make a real investment, 
you get capital gains treatment on the back end.
    The implicit loan concept is just taking a portion and 
taxing it, ordinary income, like an accrual method, and then 
giving capital gains on the back end.
    I think this reaches a reasonable policy result.
    Mr. LEVIN OF MICHIGAN. Go ahead.
    Mr. TANNER. Just one follow up. In practicality, you 
mentioned maybe the complexity of enforcement and so forth. 
Could you give us some idea of what you mean by that 
    Mr. ORSZAG. Sure. For example, I mentioned that the 
implicit interest rate would be presumably, at the Treasury 
bond interest rate. There is a broader set of questions about 
whether risk should be taken into account because obviously 
that loan, basically that transaction, has different 
characteristics than a Treasury bond.
    Changing that with regard to this particular example would 
then raise lots of questions for the broader set of loan 
subsidies and their treatment in the Tax Code. There also are 
issues that could potentially arise with regard to loan 
forgiveness and other things.
    The point is there is not an actual loan being made, so the 
construct is useful analytically, but implementing it as an 
actual tax procedure could become quite difficult quickly.
    Mr. LEVIN OF MICHIGAN. Mr. Camp.
    Mr. CAMP. Thank you. Mr. Levin, there is legislation that 
would subject holders of carried interest to ordinary income 
tax treatment, and if carried interest is taxed at that level, 
should there not also be an offsetting deduction to the capital 
investors to account for their payment of compensation to the 
    If it is income, should there not be a countervailing 
business deduction?
    Mr. LEVIN. Yes, under any rational system of taxation if 
you were to view the fund as paying compensation to the general 
partners, then the limited partners should get an equal and 
offsetting deduction, but the bill that is pending now does not 
call for that.
    Mr. CAMP. Does not do that. Therefore, the score, as 
everyone around here looks for money, the score on the bill 
would be much less because the offsetting deduction was not 
taken into account in the scoring of the bill.
    Is there any other place in the Tax Code that income is 
characterized based on the identity of the recipient as opposed 
to the source of the income?
    Mr. LEVIN. There is no comparable place in the Internal 
Revenue Code where gain from the ultimate sale of a capital 
asset held for more than 12 months is transmuted into ordinary 
    As other witnesses have said, we have a partnership system 
of taxation utilizing a flow through approach. Where a 
partnership recognizes a long term capital gain on an asset, 
that gain flows through to all the equity owners as capital 
gain under our existing system. That is designed to encourage 
people to invest in entrepreneurial businesses and to help 
American business and employment grow.
    The same set of rules should apply to a person investing in 
stocks and real estate, as I talked about in my testimony, even 
if that person devotes serious labor every day, 8 hours a day, 
studying what stocks and real estate to buy and sell, so he or 
she is taxed as capital gain when the stocks and real estate 
are sold, because he or she has purchased a capital asset and 
held it more than 12 months. I do not see a reasoned 
distinction when you turn instead to an entrepreneur, such as 
Bill Gates, who starts a business along with investors, and Mr. 
Gates has a higher percentage of the common stock than his 
capital would have purchased. His gain at the sale of the 
company should be taxed as capital gain.
    Then we move to a third example, which is a private equity 
fund, and perhaps the private equity general partners put in, 
e.g., 10 percent of the capital, but perhaps get 20 or some 
higher percentage of the gains. They are the principals. They 
are the owners. They make the buy and sell decisions. They act 
for themselves, not as agents. Therefore, if we were to take 
capital gain treatment away from private equity general 
partners because they produce sweat, whether we should take it 
away from Mr. Gates when he starts the computer company and 
works at it for 10 years before selling at a capital gain or 
from Mr. Buffett who buys stocks and real estate and works at 
it 8 hours a day for several years.
    Until now, our Internal Revenue Code has made the test 
whether you are an owner or part owner of a capital asset held 
for more than 12 months. The Code has not asked us to get into 
subjective issues like is there any sweat involved.
    Nor have we had a law that differentiated between 
industries, designating the investment advisory industry or the 
real estate industry as tainted, so that carried interest from 
those, in capital gain generated by those tainted industries is 
taxed as ordinary income, but the oil and gas industry or 
manufacturing or distribution are not tainted industries.
    This approach takes an otherwise over complicated Internal 
Revenue Code, badly over complicated, and makes it even more 
complicated. While people talk about this bill as if it were 
simple and just said capital gain becomes ordinary income if 
you have a carried interest in capital gain generates by 
certain industries in reality, this bill is ten pages long, 
adds another ten pages to the Internal Revenue Code.
    Every time we do that with special legislation, singling 
out industries, singling out taxpayers, seeking to designate 
sweat as a tainting factor, we make the Internal Revenue Code 
more complex and less administratable.
    Mr. LEVIN OF MICHIGAN. Thank you.
    Mr. CAMP. Thank you, Mr. Chairman.
    Mr. LEVIN OF MICHIGAN. Mr. Larson.
    Mr. LARSON. Thank you, Mr. Chairman. I am working up a big 
sweat over here. There is a lot of sweating going on.
    I saw Mr. Orszag's consternation as Mr. Levin was answering 
this. I would like to ask him if he would like to rebut Mr. 
Levin's response.
    Mr. ORSZAG. I am not in the business of rebutting, but let 
me offer some comments on the sweat equity issue.
    I actually think the Joint Committee on Taxation's document 
that was prepared for this hearing treats this issue quite well 
and in some detail on pages 57 and 58.
    CBO's testimony has a box on sweat equity. As the Joint 
Committee notes, the better analogy to the sweat equity for Mr. 
Gates may be what happens to the management fund itself, the 
general manager, that is, when the general manager or the fund 
in particular goes public.
    I do not think anyone would argue that a capital 
appreciation on that fund, which is typically organized as a 
partnership, as opposed to the investment fund itself, that 
should not be given capital gains treatment under current law.
    That is not really what is at question. The question is 
what should happen to the flow of income to the general partner 
in the intervening period while you are sort of building up 
that capital asset, which is then sold when the management fund 
goes public.
    That is a different question.
    Mr. LARSON. Reclaiming my time on the question----
    Mr. ORSZAG. Sure, I'm sorry.
    Mr. LARSON. One of the common criticisms we have heard 
about the Levin bill is that essentially what this is going to 
do is drive hedge fund managers offshore, as we heard this 
morning in testimony, that is already going on.
    If the Levin bill were to become law, would there be a mad 
rush for these firms to go offshore, in your opinion?
    Mr. ORSZAG. There may be some pressure. Again, I would note 
that the general managers themselves, ultimately you have to 
tie this back to an individual. U.S. individuals are generally 
taxed on their worldwide income regardless of where they 
reside, and therefore, it is very difficult to escape U.S. 
    The fact that there is so much activity abroad already 
suggests--I will leave it at that. The written testimony 
discusses this.
    Mr. LARSON. Mr. Levin, just a quick question for you, is 
there a policy or public policy reason why hedge funds and 
private equity managers should be treated differently than 
those in any of the big investment firms, outside of the sweat?
    Mr. LEVIN OF MICHIGAN. If you would answer quickly because 
the 3 minutes are up and Mr. McCrery has to leave and wanted to 
ask a few questions.
    Mr. LEVIN. The answer is there is. In this country, we have 
two systems of taxation, the corporate system of taxation, 
under which employees of a corporation who receive compensation 
from that corporation are taxed as ordinary income.
    We have a second system which is a partnership or flow 
through system under which you look at the nature of the income 
recognized by the entity, the partnership.
    In those years when the partnership is operating a business 
and earning $100 of ordinary income, when that flows out, 
either as carried interest or capital interest, to the 
partners, it is taxed as ordinary income.
    So many people have erroneously stated that carried 
interest is taxed as capital gain. It is not. Carried interest 
in ordinary income is taxed to them as ordinary income.
    When the partnership ultimately sells the business and 
recognizes a long term capital gain, gain from an asset held 
for more than 12 months, and that capital gain flows out under 
our partnership system, which was adopted in order to encourage 
people to put labor, capital, know-how and goodwill together 
and build businesses, under that system, when the capital gain 
ultimately is recognized, it flows out as capital gain, it 
retains its character.
    There is a thus a profound difference between the corporate 
system and the partnership system. If this Committee would like 
to reform the Code and adopt one integrated system, not a 
corporate system, not a partnership system, but one system, 
that would simplify the Code.
    I so testified in front of the President's Tax Reform Panel 
2 years ago, that it was desirable to go to one integrated tax 
system. That is not going to happen now.
    Mr. LEVIN OF MICHIGAN. Thank you, sir. Mr. McCrery.
    Mr. MCCRERY. Thank you, Mr. Chairman.
    One example that you did not use, Mr. Levin, is something 
that happens all the time in my hometown of Shreveport. You 
have two guys that get together, maybe two brothers. One of 
them might be a banker. The other one is a carpenter. They get 
together and buy a house. The banker gets the money. He 
provides the money, buys the house. His brother gets in there 
and rehab's the house, and then 18 months later, they sell it. 
Is that a capital gain? Of course, it is.
    Mr. LEVIN. What their enterprise realizes is a long term 
capital gain----
    Mr. MCCRERY. It is a capital gain. Does the brother who got 
in there and did the work, does he pay ordinary income on that? 
    Mr. LEVIN. If this bill applied----
    Mr. MCCRERY. No, current law.
    Mr. LEVIN. Under current law?
    Mr. MCCRERY. He does not pay ordinary income, does he? He 
    Mr. LEVIN. Under current law, if the entity recognizes a 
capital gain----
    Mr. MCCRERY. Because the capital asset was sold. You have 
two guys. One with money, one with sweat.
    Mr. GERGEN. Mr. McCrery, that house is not a capital asset. 
It is like inventory. They are holding it to sell in the 
ordinary course of trade and business.
    Mr. LEVIN. If this is the only house they bought, it would 
not be inventory.
    Mr. GERGEN. If you were in the business of subdividing land 
and selling it off, that is treated as inventory and it is 
ordinary income. If you are in the business of developing 
houses and selling them, that is ordinary income, at the entity 
level as well as the individual level.
    Mr. MCCRERY. You are telling me that if these guys buy a 
house and they hold it, they fix it up----
    Mr. GERGEN. Not as an investment. They hold it to develop 
it, improve it and sell it, that should be an ordinary asset in 
their hands if they are complying with the rules distinguishing 
capital assets from ordinary assets.
    Mr. LEVIN. If I may just disagree and qualify. If they buy 
one house and rehab it and sell it, that is clearly capital 
gain after 18 months. On the other hand, if they buy 100 
houses, it becomes inventory to them because they are in a 
regular trade or business of selling rehabed houses.
    I believe that the example we were given is two brothers 
buy a house. That would be capital gain.
    Mr. MCCRERY. That is the example I gave. However, I will 
say in fairness, Mr. Gergen brings up an interesting point. I 
am still learning this stuff. That is something we should 
consider if these guys are in the business.
    Another distinguishing factor, I think, with respect to 
private equity partnerships, in most arrangements, it is my 
understanding that there is a claw back provision in which if 
there is not a certain level of gain realized for the 
investors, the partners do not get as much return; is that 
    Mr. LEVIN. That is correct.
    Mr. MCCRERY. Is that not far different from just the 
examples that some have given of it is sweat equity so it ought 
to be ordinary income? That is risk, is it not?
    Mr. LEVIN. It is risk.
    Mr. MCCRERY. That is the whole point behind preferential 
treatment for capital gains, encouraging people with money to 
take a risk and invest that money in productive endeavors.
    Thank you.
    Mr. LEVIN OF MICHIGAN. My guess is we will get back to that 
when my turn comes. Thanks, Mr. McCrery. We will go back to our 
regular line here. We are asking people who did not have a 
chance last time, and then we will go back.
    Mr. Kind, you are recognized for 3 minutes. We will try to 
stick to that, all of us, and also all of you. This is an 
important subject and I know it is hard to do that. Let's try.
    Mr. Kind.
    Mr. KIND. Thank you, Mr. Chairman. I want to thank the 
panelists for your testimony here today. It is important and it 
is somewhat complicated.
    Let me try this. I am going to ask you each the same 
question. I am afraid it is going to require a longer perhaps 
complicated question. I think it is important to ask, in light 
of the carried interest issue that we are dealing with.
    If we were to take the carried interest issue and treat it 
as ordinary income, can you think of any significant adverse 
economic consequences of us doing that, the impact it would 
    Do you want to take a shot at that, Mr. Gergen? We will go 
right down the line. If you think there is a more detailed 
answer that you need to have, maybe you can supplement your 
response a little later for the Committee.
    Mr. GERGEN. I can think of no long term adverse economic 
    Mr. FLEISCHER. I think the adverse consequences would be 
minimal, they would occur just at the margins.
    Mr. KIND. Mr. Jones.
    Mr. JONES. I would agree. I would add the investors are not 
just passive people. They are not going to just succumb to 
demand for higher salaries in order to make up for the tax.
    Mr. STEUERLE. Generally, I am asked to think about these 
questions in a revenue neutral manner. I could take the 
revenues from this particular bill, apply it more equitably 
across capital income, especially to the highest taxed assets, 
and actually improve efficiency in the economy.
    Mr. KIND. Thank you. Mr. Levin.
    Mr. LEVIN. I do believe there would be adverse economic 
consequences in several respects. First of all, right now, we 
attract the best and the brightest, many of the best and the 
brightest in our society to private equity and venture capital 
and in making investments that better our economy, that create 
    Inevitably, when you reduce the take home pay for any job, 
you lose some of those best and brightest. There turns out to 
be another profession that is more attractive. That is the 
first thing.
    The second thing is that inevitably, your best funds who 
have been content with 20 percent up until now, are going to 
say if it is going to be taxed more heavily, I would like to 
have 25 percent or 30 percent carried interest. You are going 
to get into negotiations between the general partners and the 
limited partners when you have this smaller pie to split up, 
that are going to be disquieting negotiations.
    The better funds, some may get it. Some may not. You are 
going to inevitably in my view because of these two reasons 
reduce the efficacy of private equity and venture capital 
investing in our society.
    Right now, we have venture capital and private equity 
driving our society to a more entrepreneurial job creating, 
prosperity creating society. I think it is the law of 
unintended consequences that if you are not careful and you do 
not know what you are achieving in terms of economics, you will 
find some surprises.
    Mr. KIND. Thank you. Mr. Orszag.
    Mr. ORSZAG. I think there may be some short term 
complexities that are created and some short term effects as 
people who did not anticipate the change when they first made 
arrangements for a particular fund to have to adjust to the 
fact that there are changes.
    Over the longer term, I think most of the effect will be on 
the return that the general partners receive. I would suspect 
that most of the effect would be on that component.
    I am somewhat skeptical that there would be very 
substantial effect on the labor supply of people into the 
private equity and hedge fund industry as a result. I think the 
biggest effect is likely to be on the after tax returns for the 
general partner, basically.
    Mr. KIND. Thank you. Thank you, Mr. Chairman.
    Mr. LEVIN OF MICHIGAN. Next, following our rules, Mr. 
Tiberi. We are doing those who did not question the last panel. 
We agreed on that.
    Mr. Tiberi. You do not have to.
    Mr. TIBERI. I will go ahead and yield my time back to you, 
Mr. Chairman.
    Mr. LEVIN OF MICHIGAN. Ms. Schwartz.
    Ms. SCHWARTZ. Thank you very much, Mr. Chairman.
    I appreciated your comments on the last question. One of 
the other issues or one of the other concerns in terms of 
harmful effects if we make changes into the carried interest is 
on our public pension funds. This is a question for the next 
panel, but I thought I would ask your opinion about this as 
    With what some of the fund managers are saying, the public 
pension funds in particular, and as you know, as a state 
senator, I advanced the change in Pennsylvania to move from a 
legal list to a prudent person standard that ended up being 
hugely successful, lucrative for the Pennsylvania State 
Retirement System, which is great.
    I fully support that. I think they have been responsible 
and it has reduced the amount of money that school districts in 
the state have had to pay into their state and teachers' 
retirement funds.
    You said they are saying they are going to be hurt if we go 
ahead and make a change on this, that the fund managers will 
behave differently or they will not take on the pension funds 
or there will be an adverse consequence, or that they will 
somehow pass along the costs to those pension funds, and that 
the pensioners themselves will have to pay it somehow.
    Could you speak to whether you in fact think that would be 
the effect and what has been successful would in fact be harmed 
by any change we might make in the carried interest?
    I will ask which of you would like to take that on or if 
each of you would like to take that on, and again, I understand 
it has to be done briefly.
    Mr. Fleischer.
    Mr. FLEISCHER. Thanks. I think the concern is really 
overblown. Pension funds have a lot of different assets in 
their portfolio. I am not sure what the data is on 
Pennsylvania's fund. Typically, 5, 10, maybe as much as 50 
percent in alternative assets.
    We are only talking about a portion of the portfolio, and 
then we are talking about raising the tax rate only on the 20 
percent upside that general partners take. We are talking about 
a subset of that portfolio.
    Then you have to try to figure out if general partners can 
unilaterally raise their fees in response to the tax fee. It is 
pretty clear in a competitive market that they cannot do that.
    Ms. SCHWARTZ. That has been the suggestion, that they would 
have to raise their fees and somehow that would be so 
significant to really have a broad impact. It is hard to 
imagine it would be that significant. That is really my 
    Mr. ORSZAG. Can I actually add on that? Over on the other 
side, the Senate Finance Committee also had a hearing on this. 
Professor Alan Auerbach from Berkeley answered this question 
directly. I am just going to quote to you from his written 
    ``If half of the tax increase were shifted to investors,'' 
and I want to note I actually think that is too high, ``the tax 
burden would imply a reduction of at most two basis points in 
the annual return on these pension funds' assets and quite 
possibly much less.''
    To translate that, that is instead of a return of 7.02 
percent per year, that would be 7.00 percent per year. Again, 
he thinks it could be quite possibly much less.
    Ms. SCHWARTZ. I do understand the pension funds initially 
wrote a letter saying it would be a problem and then took it 
back. California, in particular, the retirement fund there said 
they do not really see it as having much of an effect.
    Mr. STEUERLE. Ms. Schwartz, just a couple of other quick 
comments. If we are worried about the impact on pension funds, 
there are also the managers of mutual funds, the managers of 
the pension funds themselves who pay ordinary tax rates.
    We are encouraging those managers to move. If you are 
worried about incentives, we are encouraging those managers to 
move over and join the hedge funds instead.
    You have a lot of these types of shifts. One can also worry 
about the taxes that are implicitly or explicitly paid by the 
pension funds. I again remind the Committee that we should be 
looking at the corporate tax rate, which is where the tax on 
capital income is much higher than it is in the case of capital 
gains taxes.
    Thus we are concerned about the taxes the pension funds pay 
or the amount of money they have to pay their managers, there 
are a lot more efficient ways to get at that issue than trying 
to worry about what tax might be paid by a very narrow set of 
managers within hedge funds.
    Ms. SCHWARTZ. Mr. Jones, did you want to add to that?
    Thank you very much. It is reassuring to hear that. Thank 
you, Mr. Chairman. I yield back.
    Mr. LEVIN OF MICHIGAN. Following our rules, we will go this 
way. Mr. Cantor, you will go next. I will go last. Mr. Becerra, 
Mr. Doggett, Mr. Thompson, Mr. Emanuel, Mr. Blumenauer, and Mr. 
Pascrell. I will go at the end.
    Mr. Cantor, you are next.
    Mr. CANTOR. Thank you, Mr. Chairman. Mr. Chairman, again, I 
want to thank the panelists for your indulgence and being here.
    I respectfully want to say first of all that some of the 
testimony given today in my opinion does not really reflect the 
true nature of an entrepreneur who may be operating out there 
today that wants to employ the partnership structure in order 
to invest in.
    There has been a lot of discussion about private equity, 
about the richest Americans, about fund managers, about special 
interest rhetoric.
    I think that the proposal that is on the table in the House 
at least, the Levin-Rangel bill, would have such a broad sweep 
to pull in the brothers that Mr. McCrery was talking about, 
assuming it was not their every day ordinary business, it was 
not characterized as inventory, and it was just an ownership 
interest in a partnership that was doing one house or that 
    To me, the nature of carried interest emanates from the 
need for partners, general and limited, to align their 
interests, and that when one takes a risk with his capital and 
is the money investor or the limited partner, that partner 
wants to have a general in there in the partnership with the 
same interest to see that deal, to see that investment through 
to the end with a similar interest.
    Therefore, to me, I do not care how much investment or 
monetary investment, as Mr. Levin has said, you have sweat 
equity, you have a risk of your time that certainly has value, 
that may not pan out.
    To me, it is the speculative nature of that capital that 
would qualify it or at least make it consistent with 
Congressional policy for decades, as was said earlier, that we 
want to prefer that investment because that is the way we can 
continue to see growth in our economy through entrepreneurial 
    When we say--I think it was you, Mr. Jones, who may have 
said it is not fair to allow somebody making all this money to 
not pay taxes and to then tax the wage earner, I am looking at 
the mom and pop, the mom and pop partners that are out there. 
They are getting the same kind of treatment.
    I do not know. Mr. Jones, if you want to take a stab at 
responding to me. I would like to hear some others as to the 
real nature of the interest we are talking about.
    Mr. JONES. Every employer wants to align employees' 
interest to take into account the----
    Mr. CANTOR. It is an ownership, and that is the difference.
    Mr. JONES. Every incentive compensation scheme is designed 
to make the employees or the service providers' motivations 
more similar to the owner's motivation.
    Mr. CANTOR. Is there not liability on the other side as 
well? If you have an employee, that employee is not at all 
liable in terms of being an owner the way a partner is.
    Mr. JONES. Neither is the general partner in a venture 
capital fund. He is not liable for any losses.
    Mr. LEVIN OF MICHIGAN. We are going to try to adhere to the 
3 minute rule so we can get through this. If someone has to 
leave, we may ask indulgence that he or she go before.
    Next is Mr. Becerra.
    Mr. BECERRA. Thank you to all the witnesses for your 
    Let me pick up on the last series of questions and 
comments. Is there a case--and I would ask you to please be 
brief so I can try to get more than one question in--is there a 
case to be made that carried interest should be treated 
differently based on the type of investment or the industry 
    We have been approached by folks who are publicly traded 
partnerships. We have had folks who are in real estate 
investment who have said there might be a difference between 
what a private equity firm does in that industry and what these 
other industries might do.
    Is there a reason to consider treating an industry or a 
particular investment in those types of industries differently 
for purposes of carried interest?
    Mr. GERGEN. Can I answer that?
    Mr. BECERRA. Yes.
    Mr. GERGEN. I think there are two, if you took my global--
    Mr. BECERRA. If you do it briefly.
    Mr. GERGEN. One is the genuine sweat equity. The people who 
buildup a business, maybe one only contributed labor, and then 
they sell it and they have capital gains goodwill on the sale 
of the business.
    We should preserve taxing that at a capital gains rate. The 
Joint Committee on Taxation report explains how that is 
different from carried interest. It is fairly clear why it is.
    The other, which is one you might overlook, is if somebody 
is building up intellectual property in the nature of patent 
rights. If you as an individual create a patent right, unlike a 
copyright, you have capital gains when you sell it. We should 
preserve that just to preserve continuity between the treatment 
of partnerships and individuals.
    Mr. BECERRA. Appreciate that. Do investment fund managers 
that are able to take advantage of carried interest today have 
differing levels of risk in what they do as general partners 
based on the type of investment that is made?
    Do some investment managers who are general partners--let 
me ask this question of Mr. Orszag--carry different levels of 
risk in what they do as opposed to other fund managers who are 
general partners in a different type of investment?
    Mr. ORSZAG. Sure; yes.
    Mr. BECERRA. Let's say there is a different level of risk. 
If a general manager carries risk, does that enhance the 
argument that that fund manager should be allowed to treat any 
compensation received as capital gains?
    Mr. ORSZAG. I do not think that necessarily follows. Again, 
as I said in my oral remarks and in the written testimony, 
there is a whole variety of performance based compensation. A 
movie actor with a take on the movie revenue faces a different 
degree of risk than I do as a public servant on my income, 
hopefully. Yes, so far.
    Yet that movie actor's compensation is taxed as ordinary 
income. The presence or lack thereof of risk, I do not think is 
the issue. The issue really is returns on capital invested and 
capital income, just because human capital faces risk does not 
mean it should necessarily be accorded capital income 
    Mr. LEVIN OF MICHIGAN. All right.
    Mr. BECERRA. Thank you.
    Mr. LEVIN. I have to make a comment.
    Mr. LEVIN OF MICHIGAN. Wait. My colleagues have told me not 
to allow that. We will come back to you.
    Mr. LEVIN. I want to make a comment on risk.
    Mr. LEVIN OF MICHIGAN. Okay. I think others might, too, 
including me. There are so many of us on the majority side. I 
am going to do two for one. I think it is fair.
    Mr. Doggett, you are next.
    Mr. BECERRA. Thank you, Mr. Chairman, for yielding the 
time. I yield back. I thank the panel.
    Mr. DOGGETT. Professor Gergen, I would like to explore with 
you the portion of your testimony that focused on how folks 
might try to circumvent the Levin bill.
    Do you feel there is a need for any modification to it or 
other sections of the Code that it may not address to deal with 
someone who would claim goodwill as capital or would use these 
interest free loans as a way to get around the bill?
    Mr. GERGEN. I think you should not try to fix the interest 
free loan. The problem is woven too deeply into the Code. I 
would not fix it, it is woven too deeply, and you do pick up 
some ordinary income and compensation if they go that route. 
They are really opting into Professor Fleischer's approach as a 
way of avoiding uncertainty.
    On over valuation, you just say it has to be reasonable. 
That is about all you can say in legislation. Let Treasury 
write regulations.
    On zero basis intangibles, again, I would just have 
Treasury say if you put in substantial intangibles with a zero 
basis, we are going to come look at you, and then trust that 
people will be conservative in trying to over value 
    Mr. DOGGETT. Separate from the Levin bill, is there any 
action that we need to take to address circumvention by moving 
    Mr. GERGEN. I would defer to somebody who knows more about 
international tax than I do.
    Mr. DOGGETT. Any of the others of you want to respond on 
the offshore issue?
    [No response.]
    As far as what the impact of this bill is in terms of 
economic stimulation, I think I understood your testimony, Dr. 
Steuerle, to be that it could have positive impact to approve 
the bill so long as the benefits are distributed to others that 
would be engaged in economic activity.
    Mr. STEUERLE. Yes, Mr. Doggett. I was asked to testify with 
reference to the principles we apply to tax reform in general. 
Whether with respect to either capital income or labor income, 
we should try to provide a level rate of taxation. Where we tax 
some people very high and some people very low, as opposed to a 
more even level, assuming they are at the same income level, we 
actually make the economy less efficient.
    Mr. DOGGETT. Thank you. Professor Gergen, you suggested 
that we needed to go beyond investment services. What other 
types of partnerships do you think the same principle should be 
applied to?
    Mr. GERGEN. I think the right approach is to make it global 
and then back out what still should be capital gains. I just 
said goodwill on the sale of a business or liquidation or sale 
of an interest and capital gain from the sale of patents and 
similar rights.
    I may have missed something, but be global and then back 
out. The other thing I would do is just write an exception for 
partnerships that are below a certain value of assets or income 
level. There is not going to be that much revenue there and 
then those small partnerships do not have to worry about the 
    Mr. DOGGETT. You and Mr. Fleischer and Mr. Jones then agree 
that the Levin bill is ready to go as it is written?
    Mr. GERGEN. No, I would broaden it. There are some 
technical defects that I do not want to bore you with.
    Mr. DOGGETT. Mr. Fleischer.
    Mr. FLEISCHER. Minor details aside, I think it is ready to 
    Mr. DOGGETT. Mr. Jones.
    Mr. JONES. I do agree that to single out the service 
partners in one industry is probably not a good idea. We need 
to fix the whole topic of service partners. The Treasury 
Department has proposed some regulations which are not simple 
at all. This bill, if it applied more globally, I think that is 
what Professor Gergen means, should apply to all service 
partners regardless of the industry.
    Mr. DOGGETT. Thank you. Thank you, Mr. Chairman. I think my 
time is up.
    Mr. LEVIN OF MICHIGAN. Mr. Ryan. Then it will be Mr. 
Emanuel and Mr. Pomeroy.
    Mr. RYAN. Thank you, Mr. Chairman.
    Let me just ask you down the line, Peter on down, accepting 
for argument sake that we will tax carried interest as ordinary 
income on the private equity partners, the limited, would it 
not be appropriate tax principle and policy to then deduct that 
tax that is paid to the managers by the other partners?
    Mr. ORSZAG. In general, yes. That would be the traditional 
tax policy.
    Mr. STEUERLE. Yes.
    Mr. JONES. Yes.
    Mr. FLEISCHER. Yes.
    Mr. GERGEN. It does not necessarily follow that you would 
    Mr. RYAN. Come on, we are on a roll. Everybody else is 
saying yes.
    Mr. GERGEN. There is a strategy people could use where if 
you did not give them a deduction, they could get it anyway, 
called the circle of cash.
    Mr. RYAN. Yes, I am familiar with it.
    Mr. GERGEN. Even if you do not go get the deduction, you 
might as well give it to them.
    Mr. RYAN. I realize the bill does not do that but let me 
ask you, Dr. Orszag, if this bill were to be amended as most 
people agree it ought to be if we want to follow regular tax 
principles and policy, what would happen to the score of this 
bill if this tax was deductible for the other partners?
    Mr. ORSZAG. As you know, the score will be determined by 
the Joint Committee on Taxation.
    Mr. RYAN. I know.
    Mr. ORSZAG. I would just note the treatment of taxable--
most limited partners, the ones who put in the financial 
capital, are not taxable entities in the United States. For 
those that are, it is a little bit complicated because it will 
have the deduction but then there are various limitations on 
the value of the deduction that Congress has adopted, including 
a floor and an overall limit, and then we have the alternative 
minimum tax.
    Mr. RYAN. Sure.
    Mr. ORSZAG. I have to defer to the Joint Committee on 
Taxation. Obviously----
    Mr. RYAN. It would dramatically reduce the revenue raised 
by this bill if you applied----
    Mr. ORSZAG. In general, a deduction that actually 
successfully flows through to the taxable limited partners 
would reduce the revenue effect.
    Mr. RYAN. Mr. Levin, you seem to want to comment. I will 
give you a little bit of my time if you want.
    Mr. LEVIN. No, I am in agreement with that.
    Mr. RYAN. Let's go to the tax principle of taxing the money 
and not the man. Taxing the source of the income and not the 
individual of the income. By introducing this policy, does it 
not set a new precedent of taxing the recipient rather than the 
type of income from which it came?
    Mr. ORSZAG. Again, I would be interested in the tax 
practitioners and the tax lawyers, but what I would say is I 
think the issue here from an analytical perspective is the 
characterization of the services that are provided by the 
general manager, and whether that is more in the form of 
compensation for services provided and not a return on capital. 
That is what I see as the key issue.
    Mr. RYAN. Go ahead, Mr. Levin.
    Mr. LEVIN. Yes, I think it does. If you broaden the bill as 
the Professor has proposed to cover all carried interest, or 
even to be broader and cover all sweat, what you are going to 
find is there are an awful lot of people whose capital gain is 
then converted to ordinary income. For example, Sally starts a 
business and her father finances it and puts the money in and 
Sally has a carried interest.
    Bill Gates starts a business and investors put money in but 
Bill Gates gets more of the stock than the money he put in 
would draw. He has a carried interest.
    If we broaden the bill, we are going to find that carried 
interests arise throughout our economy. If we do not broaden 
the bill and we leave it like it is, then only certain carried 
interest, that is private equity, venture capital, real estate, 
are covered, and there is no reasoned rational distinction 
between those industries and the other industries.
    Mr. RYAN. Thank you.
    Mr. LEVIN OF MICHIGAN. I hate to do this, and we need to 
talk about that, but we need to follow the 3 minute rule.
    Mr. Emanuel.
    Mr. EMANUEL. Mr. Chairman, I will try to be quick here. 
First of all, having worked a little in this industry, I just 
want to note if you were writing a book, economic book, about 
America's economic history of the last 50 years, I do not think 
you could write just a chapter alone on the last 20 years about 
the role of both venture capital funds, hedge funds, and 
private equity and their contribution to making the American 
economy dis-competitive.
    It has been all three of those sectors, venture capital, 
private equity, hedge funds. They have been enormous 
contributors to the competitiveness of the American economy as 
it stands worldwide.
    Without going into a series of questions as it relates to 
carried interest, I have wrestled with this issue. I do think 
some of the activity has risk involved but also has capital 
risk involved. Some of the partners of those actually put their 
capital into the fund.
    On the other hand, there is a recognition that they are 
getting paid a fee for a service they are providing as a 
general partner, which is what I think led to--I find this 
almost intriguing, and I know I am going to mispronounce it--
Greg Mankiw's position, President Bush's former economic 
advisor, who said deferred compensation, even risky 
compensation, is still compensation and it should be taxed as 
such. The administration is on the wrong side of this issue.
    Another economic advisor, the Chairman of the CATO 
Institute, economic advisor to President Reagan--I would be 
more than willing to have these guys as witnesses--said the 
share of investment profits are basically fees for managing 
other people's money.
    Having worked with my own fair share of economic advisors 
to Presidents, they are scholars.
    What I found more intriguing in all this is when Blackstone 
filed their IPO, the Blackstone IPO, and I quote from it, ``We 
believe,'' and this is in their own words, obviously lawyers 
and accountants helped write this, ``We believe that we are 
engaged primarily in the business of providing asset management 
and financial advisory services and not in the business of 
investing, re-investing or trading in securities.
    We also believe that the primary source of income from each 
of our businesses is properly characterized as income earned in 
exchange for provision of services.''
    This is what they filed with the Securities and Exchange 
Commission when they were doing their IPO, which somewhat 
acknowledges that they are getting paid a fee for a service, in 
their own words. Nobody asked them to do this. This was for the 
    I think the other two economic advisors noted there was a 
fee for a service. I do think what are the unintended 
consequences, what is going on in London, what is going on in 
Europe, what is going on in Asia as it relates to private 
equity, hedge funds, the ability of capital to move.
    I think what we have here is a situation where the 
compensation for fund managers does reflect--one of the reasons 
we are trying to untangle this--is both activities. There is 
risk and there is also being paid for a service.
    How you come up with a structure, a tax number, that 
reflects that activity is what we are trying to untangle here.
    I was wondering if anybody would want to comment on do you 
really see this as a pure play that is a fee for service, do 
you see some risk, a la (a) the tradition of what we described, 
capital at risk, and (b) do you see that the only choice is one 
or the other and there is no other way to come up with an 
    Mr. LEVIN OF MICHIGAN. Let's do this because we are going 
to follow the 3-minute rule, if it is okay.
    Mr. EMANUEL. Can we go to a three and a half minute rule? I 
got it, Sandy.
    Mr. LEVIN OF MICHIGAN. You are already beyond three and a 
half minutes.
    Mr. EMANUEL. Thank you for my Rosh Hashanah blessing, 
another half hour. Thank you, Sandy.
    Mr. LEVIN OF MICHIGAN. Following general rules as best we 
could. These are good questions. I think now, Mr. Pomeroy, and 
then Mr. Tiberi, you are next.
    Mr. Pomeroy, under this procedure, you are next for 3 
minutes, without a blessing otherwise.
    Mr. POMEROY. Thank you. I will try to follow up on the 
question very well posed by my colleague.
    Mr. Steuerle, you indicate as a principle of taxation, 
labor income should be taxed similarly regardless of source. 
That would indicate along the line of what Mr. Emanuel was 
    Income related to a fee charged for a service, that is 
labor income. The rationale to have that taxed at capital gains 
or corporate dividend rates versus ordinary income rates does 
not exist.
    Would you care to elaborate?
    Mr. STEUERLE. Yes, Mr. Pomeroy. It seems to me there are 
two things going on that are causing the conflict here. One is 
that the Congress has decided at various stages to try to tax 
capital income different than labor income. The second is we 
have adopted in the partnership and sole proprietorship world a 
simplification that says we often cannot distinguish capital 
from labor income, so for certain purposes, we are going to 
treat them the same.
    Those two are coming into conflict, and that is part of the 
    I would just remind the Members of the Committee that on 
the flip side of that simplification, there are many people who 
are sole proprietors and partners who are very entrepreneurial, 
who are not only paying full labor tax on their labor income, 
but in fact on their capital income from investments, the 
equipment they buy actually flows through income on which they 
pay Social Security tax.
    Thus on the one side in this partnership form, we have some 
people who are paying 45 percent tax rates on their capital 
income and on the other side, we have some people who are 
paying 15 percent tax rates on their labor income.
    That is the conflict that you are trying to deal with here.
    Mr. POMEROY. In the district I represent, we have a lot of 
people that fall in that latter category that you speak of.
    At the time the differential was created, I was on this 
Committee. We were told the national savings rate was going to 
go up because people suddenly saved to invest. We heard this 
morning that the national savings rate has been negatively 
impacted to the tune of better than 1 percent by those very 
reforms creating the differential, and now we have a 
differential that people are gaming.
    In the last 30 seconds of my time, Mr. Orszag, what is the 
budgetary impact from this, basically, taxation of labor at the 
capital gains rate?
    Mr. ORSZAG. As I said before, the score for any change in 
that current tax treatment would come from the Joint Committee 
on Taxation, which has not yet released an analysis. I will 
leave it to them for that.
    Mr. POMEROY. Thank you, Mr. Chairman. I yield back.
    Mr. LEVIN OF MICHIGAN. Mr. Tiberi.
    Mr. TIBERI. Thank you, Mr. Chairman.
    Mr. Levin, you had tried to make a point earlier regarding 
partnership risk, and you were unable to further make that 
point. If you could clarify that, and the second question is, 
can you comment on how this is taxed, how carried interest is 
taxed in competing countries, where capital obviously might 
flow if we tax it here, in Europe, in Asia, primarily?
    Mr. LEVIN. Yes. First, the point I wanted to make on risk 
is that risk is essential for capital gain; when you look at 
the capital gain sections of the Code, it is gain from the sale 
of an asset, capital asset, held more than 12 months. That is 
stocks, real estate, things you invest in and take a risk on.
    Risk is essential to capital gain, but risk is not always 
sufficient. There are circumstances if you are an executive at 
a company, at a corporation, and you are given a bonus that is 
contingent on sales, you have a risk, but that does not give 
you capital gain.
    The key in the Code has always been a capital asset held 
for more than 12 months, and what this bill seeks to do is to 
change that rule. Once you change it, there are ever so many 
other changes you can make. You put a lot of things at play, 
and you are not sure where you are going to come out.
    Secondly, you asked about other countries. In the vast 
majority of countries that I am familiar with, there is a 
differential between capital gain and ordinary income, higher 
rate for ordinary income than capital gain.
    In the vast majority of the countries that I am familiar 
with, where you have a partnership arrangement, like a private 
equity fund, with capital gain flowing through to the people 
who run the fund, they get capital gain. U.K. is one of those.
    One can point out that since this country began its careful 
re-examination of this, other countries such as the U.K. have 
announced they are going to re-examine it. It does not mean 
they are going to change it any more than we are going to 
change it, but it would be, I think, a pity for us to change 
it, tax capital gain carried interest as ordinary income if 
other countries do not.
    I think there will be some leakage then of money into funds 
in other countries. That is a complex issue of where do the 
general partners pay tax, where is the fund formed, but there 
will be some, in my opinion, leakage of money out of this 
    Mr. TIBERI. Dr. Orszag.
    Mr. ORSZAG. I would just add very quickly that the issues 
facing many other countries are different from the ones facing 
the United States because of the way that we tax U.S. citizens. 
That differs from the way, for example, the United Kingdom 
taxes its citizens, and the tradeoff's that the U.K. Government 
may face in changing its tax treatment differ from those that 
the United States faces.
    Mr. LEVIN OF MICHIGAN. By the way, England is also facing 
this issue. We are not the only ones.
    Mr. CAMP. If the gentleman will yield, Mr. Tiberi.
    Mr. LEVIN OF MICHIGAN. His time is up. If we might, Mr. 
Thompson is next.
    Mr. THOMPSON. Thank you, Mr. Chairman. Thank you to all the 
    Mr. Levin, I have heard from folks, and I think we are 
going to hear in the next panel from the real estate community, 
that the issue, the tax treatment of carried interest is an 
incentive to revitalize areas that are poor or economically 
disadvantaged or under served.
    If we do in fact alter this carried interest or do away 
with it, what is the impact going to be, in your view?
    Mr. LEVIN. I think it is the same as I talked about for 
private equity and hedge funds and venture capital, that is, if 
you increase markedly the taxation on the general partners, who 
devise the projects, operate the funds, make the investments 
and act as principals, and only give capital gain to the 
passive investors, it seems to me that it is almost upside 
down, and you do give a disincentive as compared to where 
things are now for people to redevelop or make investments.
    I cannot tell you that there is going to be a 90-percent 
reduction, but I can tell you I believe there will be a 10- or 
20- or 30-percent reduction in some of these investments, and 
that alone is enough to harm the growth of our economy.
    Mr. THOMPSON. We have heard it argued that fund managers 
can easily convert their fee income into carried interest, and 
this is a question for anyone who wants to take a shot at it.
    How easy is it really for such a fee to be converted and 
how often is this being done?
    Mr. LEVIN OF MICHIGAN. Professor Fleischer.
    Mr. FLEISCHER. You can look in Mr. Levin's book for a 
guideline on how to do it. It has become quite common. The fund 
managers do have to take some economic risk in order to get the 
tax treatment that they want, but it is not as much risk as you 
might imagine. They take a priority allocation of the next 
year's profits, so they have to wait a few more months, instead 
of getting their management fee in 1 year, they have to wait a 
few more months, and then they get it in capital gains terms in 
the next year.
    Mr. THOMPSON. Anyone else want to take a shot?
    Mr. LEVIN. I would just comment that I think it is 
substantial risk.
    Mr. STEUERLE. May I just add there is no principle in the 
Tax Code for subsidizing risk per se. Risk can be good or bad. 
Risk is not good in and of itself.
    Mr. THOMPSON. Thank you. I yield back.
    Mr. LEVIN OF MICHIGAN. Who is next? I think it is Mr. 
    Mr. BLUMENAUER. Thank you, Mr. Chairman.
    First, on behalf of my friend, Mr. Emanuel, I wanted to 
indicate that if any of you folks wanted to make a reaction to 
this question and have it entered in the record, he would 
appreciate it.
    We have heard from Mr. Levin about the negative potential 
impacts on these extraordinarily highly skilled people who are 
managing these investments if we change the rules of the game 
and tax them more like most Americans are taxed, that it would 
have some effect on their behavior.
    I guess I am more interested about what are the effects on 
the millions of Americans, and Dr. Steuerle, you alluded to it 
in your testimony, lots of people are paying actually much 
higher marginal rates, under more difficult circumstances with 
less resources to cope with.
    I am curious if you have any thoughts about are they less 
sensitive to price signals? Are they less bright, that they do 
not know about it? If you multiply these millions of people who 
are presumably productive, at least at some level, paying these 
very high marginal rates, does that not have some impact on our 
society, as well in terms of the economy and what happens to 
them, not in a moral sense, but in practical dollars and cents, 
in terms of how the economy behaves?
    Mr. STEUERLE. Yes. One of the principles of tax policy is 
that some of the greatest inefficiencies or distortions are 
caused when the rates are the highest. That means that often 
the people we want to look at most, if we are trying to provide 
relief, are the people who pay the highest marginal tax rates 
on their investment.
    I alluded to several of them in my testimony, including the 
kid who is putting money in a savings account to pay for 
college. That person is taking risk. He might be an 
entrepreneur. There are also small businesspeople. There are 
cleaning ladies. There are people who provide all sorts of home 
services. They are in businesses and they are undertaking 
entrepreneurial risk.
    It is very difficult to justify subsidizing some groups at 
very low rates just simply because they have high incomes and 
therefore can afford a bit better some lobbyists to favor them.
    Mr. BLUMENAUER. Mr. Chairman, at some point, as we move 
forward with this discussion as a Committee, I would like to 
see if there is a way to frame this, about the people in 
society who are at the edge, who are paying higher marginal 
rates, and the impact that the tax system has on them. I hope 
at the end of the day we are able not to pick winners and 
losers; to the contrary, that we are able to even this out in 
some fashion.
    I appreciated the reference that Dr. Steuerle had, and I 
would hope there would be a way for us to focus in on that, 
maybe gather a little more information and actually talk about 
    Mr. LEVIN OF MICHIGAN. I hope we will. This is not an 
effort to pick winners or losers.
    There has been general agreement that we are going to go to 
the next panel before we lose it, except Mr. McCrery has 
agreed, and he will go next.
    Mr. Pascrell, I understand you have a 30-second question. 
Go ahead.
    Mr. PASCRELL. Mr. Chairman, before I do that, I know our 
back sides are sore, but our spirits are liberated. This is 
such a refreshing thing that has happened in the last 6 years. 
We have reporters at the table. We have firemen at the table. 
We have money managers and laborers at the table.
    We are going to get a fair shot here down the road.
    Mr. Levin, in your book on pages 10-15 (of the 2007 
    Mr. LEVIN OF MICHIGAN. Which book?
    Mr. PASCRELL. The book is ``Structuring Venture Capital and 
Private Equity'' et cetera.
    Mr. LEVIN OF MICHIGAN. I only say that because I have five 
books. Sorry.
    We have just limited time.
    Mr. PASCRELL. You describe a situation in which an 
investment fund manager can waive a portion of its management 
fee in exchange for an increased allocation of the fund 
profits, stating that ``This technique should convert 
management fee income which would have been taxed as ordinary 
income into long-term capital gain.''
    Does the ease with which the author describes the 
investment which can be converted for compensation income into 
capital gains trouble anybody on this panel?
    Mr. Gergen.
    Mr. GERGEN. Yes.
    Mr. PASCRELL. How does it trouble you?
    Mr. GERGEN. Fairness and efficiency. We have talked about 
it the last hour and a half.
    Mr. LEVIN OF MICHIGAN. We are going to go down the row very 
quickly. Mr. Fleischer.
    Mr. FLEISCHER. It is quite troubling, and the economic risk 
that the fund manager has to take is not in many cases so 
substantial because the fund manager knows the assets in the 
portfolio that might be realized in that next year.
    Mr. PASCRELL. Mr. Jones.
    Mr. JONES. That is right; what Victor just said is 
absolutely correct. Risk has nothing to do with it in any 
event, but there is no real risk. They wait until they about 
know what their profits are going to be and then they exercise 
their options.
    Mr. PASCRELL. I want to thank each of the members of the 
panel, everybody; you guys did a fantastic job, and I really 
appreciate it. Thank you very much.
    Mr. LEVIN OF MICHIGAN. With that note, and I think we all 
agree, thank you very, very much. This has been really 
    Now, our last panel, the most patient people in Washington, 
let's go. As you come forth, I am going to introduce you.
    Leo Hindery, who is the Managing Director of InterMedia 
Partners in New York. Mr. Stanfill, who is the founding partner 
of TrailHead Ventures in Denver. Orin Kramer of the New Jersey 
State Investment Council. Jonathan Silver, Managing Director of 
Core Capital Partners. Adam Ifshin of DLC, and Bruce Rosenblum.
    It may not be in that order. We will take you in the order 
you are seated.
    Mr. LEVIN OF MICHIGAN. Each of you has 5 minutes now. I do 
not think we need to apologize. I think you probably know, some 
of you are veterans of these battles, that being the fourth 
panel meant it might be a less prominent place, but it really 
is not.
    We are going to do two things, make sure everybody sees 
your testimony, and we will distribute it through the Committee 
directly, and secondly, this is just the first of our 
discussions, and we will probably be tapping you in the future.
    I introduced you as you were walking up. Each take your 5 
minutes. We will go from there.
    Mr. Hindery, we are going to start with you.


    Mr. HINDERY. Thank you, Mr. Chairman, and Members for 
convening this important hearing, as late in the day that it 
is, its importance justifies our being here.
    As many of my colleagues have commented today, at the 
onset, I speak only for myself and certainly not my firm. As 
you will hear from my comments, many would think I do not speak 
for my industry as well.
    I am the Managing Partner of InterMedia Partners, which is 
a private equity firm I formed in 1988, and I ran continuously 
until 1997 when I became the chief executive officer of 
Telecommunications, Inc. or TCI, and later, its successor, AT&T 
    I returned full time to private equity in 2001, and my 
business career includes nearly 20 years of direct and indirect 
involvement with investment partnerships. As a consequence, I 
am intimately familiar with their history, their realities and 
their economics.
    As we have heard often today, hundreds of thousands of 
Americans throughout the U.S. economy work hard every day 
managing things for other people, ranging from grocery stores 
to gas stations to money.
    All of these managers earn a base level of compensation and 
in addition, most of them earn some form of performance fee. 
Except for one group of individuals, all of them pay ordinary 
income taxes on their personally earned management income.
    I am here today to talk about the management income being 
earned by that one particular group, namely those women and 
men, of whom I am one, who use special purpose investment 
partnerships to manage money belonging to others.
    The management income which we earn, which we call 
``carried interest,'' is taxed as capital gains, when I and 
others believe it should instead be taxed as ordinary income.
    Of course, because the 15 percent capital gains tax rate is 
less than half, the 35 percent maximum ordinary income tax rate 
paid by virtually every other manager and by regular Americans, 
how this issue is resolved will have an enormous impact on the 
nation's tax receipts on the order, as we have heard, of $12 
billion a year.
    The reason this tax loss figure is so high is simply 
because of the magnitude of the earnings which are now escaping 
ordinary income taxation.
    To fully appreciate this, all this Committee has to do is 
reflect on the fact that in 2006, the top 20 hedge fund and 
private equity managers in America earned an average of $658 
million a piece. That is 22,255 times the pay of the average 
U.S. worker, and of course, most of these earnings were taxed 
at just the 15-percent rate.
    I should note that my concern today is not about the 
taxation of the operating income earned by any of these special 
purpose partnerships, although there is very substantial 
inconsistency and thus abuse in how income from operations is 
currently being taxed from one type of partnership to another.
    I should further note that while much of the public's 
attention to this issue has been directed at hedge funds and 
private equity managers, the management income earned by 
managers of all investment partnerships needs to be scrutinized 
alike, hedge funds, private equity, oil and gas, real estate 
and timber.
    It really is not all that hard to decide how to properly 
tax carried interest. Is carried interest income which a money 
earns on his or her personal investments or instead is it the 
performance fee earned for managing other people's investments?
    If carried interest is personal investment income, then it 
is properly entitled to capital gains treatment. However, if it 
is a performance fee, and my 20 years of firsthand experience 
clearly tells me it is, then it should be taxed as ordinary 
    Simply put, Members, a very bright line needs to be drawn 
between investor type partners who invest their own money and 
are thus entitled to capital gains treatment on the investment 
income they earn and manager type partners who contribute only 
their services.
    A prominent private equity manager recently contended to 
this Congress that investment manager earnings are ``Capital 
gains in every technical and spiritual sense.''
    All I can say in answer is no church or synagogue I know 
would consider it very spiritual to each year selfishly 
characterize as capital gains literally billions of dollars of 
management income that has absolutely no down side risk to the 
managers, especially when doing so comes at such a great 
expense to the rest of our Nation's taxpayers.
    On the issue of risk, about which much has been said today, 
I would note that there is a very, very big difference between 
the risk of losing one's money, which is real risk, and the 
risk of not making as much as you hoped, which is not risk in 
any meaningful way.
    Some of my fellow investment partnership managers also say 
that this hearing is nothing more than a vindictive singling 
out of their firms because of their extraordinary success, and 
they say that increasing the tax rate on their earnings to the 
ordinary income level will create an investment tax of sorts 
with dire, dire unintended consequence for the entities whose 
money is being managed and for the American economy.
    These conclusions are self serving and they are poppycock. 
Congress is not considering changing the tax rates on the 
investments made by investors. Congress is only considering 
restoring fairness in how the women and men who manage these 
investments are individually taxed compared to other managers 
and to regular workers.
    It is beyond disingenuous to predict dire unintended 
consequences when no consequences at all will occur.
    A tax loop hole the size of a Mac truck is right now 
generating unwarranted and unfair windfalls to a privileged 
group of money managers and to no one's surprise, these 
individuals are driving right through this $12 billion a year 
    Congress, starting with this Committee, needs to tax money 
management income, what we call ``carried interest,'' as what 
it is, which is simply plain old ordinary income.
    I hope, Mr. Chairman and Members, that my comments have 
been helpful. I look forward to your comments and your 
questions. Thank you, Mr. Chairman.
    [The prepared statement of Mr. Hindery follows:]
 Prepared Statement of Leo Hindery, Jr., Managing Director, InterMedia 
                      Partners, New York, New York
    Thank you, Mr. Chairman and Members, for convening this important 
hearing on the taxation of carried interest for investment 
    I am Leo Hindery, and I am the Managing Partner of InterMedia 
Partners, a private equity fund which I formed in 1988 and ran 
continuously until 1997 when I became CEO of Tele-Communications, Inc. 
(TCI) and later its successor AT&T Broadband. I returned full time to 
private equity in 2001. My business career includes nearly 20 years of 
direct and indirect involvement with investment partnerships, and I am 
intimately familiar with their history, realities and economics.
    Hundreds of thousands of Americans throughout the U.S. economy work 
hard every day managing things for other people, ranging from grocery 
stores to gas stations to money. All of these managers earn a base 
level of compensation, and in addition, most of them earn some form of 
performance fee. And except for one group of individuals, all of them 
pay ordinary income taxes on their personally earned management income.
    I am here today to talk about the management income being earned by 
that one particular group, namely those women and men, of whom I am 
one, who, using special purpose investment partnerships, manage money 
belonging to others. The management income which we earn, which we call 
carried interest, is taxed as capital gains, when I and others believe 
it should instead be taxed as ordinary income.
    And of course because the 15 percent capital gains tax rate is less 
than half the 35 percent maximum ordinary income tax rate paid by 
virtually every other manager and by regular Americans, how this issue 
is resolved will have an enormous impact on the nation's tax receipts, 
on the order of $12 billion a year.
    This reason this taxes loss figure is so high is simply because of 
the magnitude of the earnings which are now escaping ordinary income 
taxation. To fully appreciate this, all this Committee has to do is 
reflect on the fact that in 2006, the top 20 hedge fund and private 
equity managers in America earned an average of $658 million each, 
which is 22,255 times the pay of the average U.S. worker. And of course 
all of these earnings were taxed at just a 15 percent rate.
    I should note that my concern today is not about the taxation of 
the operating income earned by any of these special purpose 
partnerships, although there is very substantial inconsistency and thus 
abuse in how income from operations is currently being taxed from one 
type of partnership to another.
    And I should further note that while much of the public's attention 
to this issue has been directed at hedge fund and private equity 
managers, the management income earned by managers of all investment 
partnerships needs to be scrutinized alike: hedge fund, private equity, 
oil-and-gas, real-estate, and timber.
    It really isn't all that hard to decide how to properly tax carried 
interest. Is carried interest income which a money manager earns on his 
or her personal investments, or, instead, is it the performance fee 
earned for managing other people's investments? If carried interest is 
personal investment income, then it is properly entitled to capital 
gains treatment--however, if it is a performance fee, as my 20 years of 
first-hand experience clearly tells me it is, then it should be taxed 
as ordinary income.
    Simply put, a very bright line needs to be drawn between investor-
type partners who invest their own money and are thus entitled to 
capital gains treatment on the investment income they earn, and 
manager-type partners who contribute only their services.
    A prominent private equity manager recently contended to this 
Congress that investment managers' earnings are (and I quote) ``capital 
gains in every technical and spiritual sense'' (unquote). All I can say 
in answer is that no church or synagogue I know would consider it very 
``spiritual'' to each year selfishly characterize, as capital gains, 
billions of dollars of management income that has absolutely no 
downside risk to the managers, especially when doing so comes at such a 
great cost to the rest of our nation's taxpayers.
    Some of my fellow investment partnership managers also say that 
this Hearing is nothing more than a vindictive singling out of their 
firms because of their extraordinary success. And they say that 
increasing the tax rate on their earnings to the ordinary income level 
will create an ``investment tax'', of sorts, with dire unintended 
consequences for the entities whose money is being managed and for the 
American economy.
    These conclusions are similarly self-serving, and they are complete 
    Congress is not considering changing the tax rates on the 
investments made by investors. Congress is only considering restoring 
fairness in how the men and women who manage these investments are 
individually taxed compared to other managers and to regular workers. 
And it is beyond disingenuous to predict dire unintended consequences 
when no consequences at all will occur.
    A tax loophole the size of a Mack truck is right now generating 
unwarranted and unfair windfalls to a privileged group of money 
managers, and, to no one's surprise, these individuals are driving 
right through this $12 billion-a-year hole. Congress, starting with 
this Committee, needs to tax money management income, what we call 
carried interest, as what it is, which is plain old ordinary income.
    I hope my comments have been helpful. Thank you very much for this 
opportunity to speak with you today, and I welcome your questions.


    Chairman RANGEL. [Presiding] I apologize for not being 
here. We really want to thank this panel. We had no idea that 
the hearing was going to last this long. We thank you so much 
for your patience.
    I want to make it abundantly clear that it came to the 
attention of this Committee, both the Ranking Member and I, 
that we had a moral, political, legislative obligation to 
eliminate the alternative minimum tax. We agreed to that.
    Our problem was how do you do it and how do you pay for it. 
In the course of these hearings, anyone that has said that the 
Chair or any Members were out to raise taxes or to attack, yes, 
we said loop holes, yes, we said we want to simplify the Tax 
Code. Yes, we want to say we want to make it revenue neutral.
    I am really amazed as to people who believe that the 
difference between 15 percent in capital gains tax rate and 35 
percent tax rate, that we should leave it alone or that we are 
attacking people, I have never seen anyone that is not even on 
the agenda, except that we are looking at everything in the 
Code, scream so loud when no one even mentioned their names.
    Naturally, we want experts like you to share your opinion 
so that we do not do anything dramatically, but it is not the 
intention of this Committee to continue to be just a revenue 
raising Committee.
    We want to simplify the Code. We want to make certain that 
economically it provides incentives necessary for the economy, 
and we have to have it perceived as being fair and equitable by 
all taxpayers.
    I only say that because we just left a meeting where people 
said we wanted to tax the rich and all of that. I just want to 
get us back on target. It started out how do you eliminate the 
alternative minimum tax on 23 million people, and the answer is 
with great difficulty.
    We are moving. I want to thank you once again for your 
    William Stanfill, founding partner of TrailHead Ventures. 
Thank you for being here.


    Mr. STANFILL. Chairman Rangel, Ranking Member McCrery, and 
Members of the Committee, as the Chair noted, my name is 
William D. Stanfill, founding partner and head of the Denver 
office of Trailhead Ventures, a private venture capital 
partnership investing in information technology.
    At the outset, I would like to make clear that I speak not 
on behalf of my firm, and certainly not on behalf of the 
industry. Rather, I speak as a private citizen who has been 
involved in venture capital for 25 years.
    Beginning in 1982, I was responsible for a fund of funds 
that invested in 30 venture partnerships. In turn, those 
partnerships invested in some 600 to 700 venture backed 
companies. These portfolio companies were scattered across the 
U.S. from coast to coast, from Massachusetts to California. I 
have read the earlier Senate testimony about the wonderful 
things that we venture capitalists do. I think this is an 
idealized version of our industry, a vision of the Wizard of Oz 
comes to mind.
    Those venture capitalists and I do the same kind of work. 
We just come to different conclusions about what is appropriate 
tax treatment for our earnings.
    All workers add value to a greater or lesser extent. Randy 
Testa is a gifted teacher. He inspired and challenged our son, 
David, and his third grade classmates, developing and enriching 
human capital. Yet, the tax rate on my carried interest is less 
than the tax rate on his salary.
    There has been more than a hint of Chicken Little in the 
dire predictions of the havoc this tax change will cause. In my 
judgment, they will not come to pass any more than the end of 
the automobile industry, which was predicted when seat belts 
and emission standards were mandated.
    I do not think many if any firms will move offshore or if 
they do, they will be motivated by investment opportunity as 
opposed to tax treatment. We have always found plenty of 
investment opportunities in our own backyard.
    Or that limited partners will stop investing. This change 
does not affect their taxes. Most of them are tax exempt 
entities anyway.
    I do not think losing the carried interest tax break would 
drive other venture capitalists out of the field. We get ample 
compensation, financial and psychic, for the work we do and the 
risks we take with other people's money, by the way, in the 
form of a share of profits.
    I have been in the business for 25 years and the basic 
compensation structure of 2 and 20 has survived all of the tax 
changes over that time.
    How long will we tolerate the ever widening gap between 
rich and poor? Although my preference is for major tax reform, 
I do believe it is fair, equitable and appropriate to work on 
the issue of tax equity where we can.
    We should not do nothing because we cannot do everything. I 
am especially disturbed by suggestions that we cannot afford to 
provide health insurance for low income children or first rate 
medical care for our injured soldiers.
    I am disturbed that these and other human priorities are 
unaddressed, while we pretend we can afford to continue these 
tax breaks.
    In conclusion, our earnings are compensation and should be 
taxed the same way the compensation of everyone else is in the 
country. It is neither fair nor just for teachers and 
firefighters to subsidize special interest tax breaks that cost 
billions of dollars each year. It is unacceptable that those 
tax breaks also rob the Medicare system of much needed revenue. 
We and our representatives in Congress have a choice. We can 
change the Tax Code in favor of equity and fairness or we can 
come to the same conclusion reached by Walt Kelly and his mouth 
piece, Pogo. We have met the enemy and he is us. I would be 
happy to entertain your questions.
    Thank you.
    [The prepared statement of Mr. Stanfill follows:]
Prepared Statement of William D. Stanfill, Founding Partner, TrailHead 
                       Ventures, Denver, Colorado
    Chairman Rangel, Ranking Member McCrery, and Members of the 
Committee, my name is William Deming Stanfill, founding partner and 
head of the Denver office of Trailhead Ventures, a private venture 
capital partnership whose investment focus is information technology. 
At the outset, I would like to make clear that I speak not on behalf of 
my firm and certainly not on behalf of the industry. Rather I speak as 
a private citizen who has been involved in the venture capital industry 
for 25 years.
    I joined the Centennial Funds of Denver in 1982 and was responsible 
for a fund of funds activity wherein we invested in thirty venture 
partnerships around the United States. The venture partnerships 
collectively invested in 600-700 portfolio companies including 
telecommunications, medical, and information technology. Those 
portfolio companies were scattered across the U.S., from Massachusetts 
to California, Florida to Oregon, Colorado and Utah, Arizona, Texas, 
and New Mexico, Alabama and Georgia, Idaho and New Hampshire.
What We Do
    In 1995, I left the Centennial Funds, purchased the fund-of-fund 
activity and formed Trailhead Ventures to invest directly in early 
stage information technology enterprises. By industry standards we are 
a small fund. Our advantage is our ability to provide seed and early-
stage capital of $2-4 million to start-up companies. A $500 million 
partnership, by contrast, cannot manage 125 to 250 investments of $2-4 
million each. Our limited partners include state and corporate 
retirement funds, university endowments, and the occasional high net 
worth individual.
    Basically we back entrepreneurs who have good ideas and an 
obsession to bring them to market. We help surround the entrepreneur 
with a world-class management team. If the team performs well, we have 
the good sense to stay out of their way. The last thing most venture 
capitalists want is for the management team to hand them the keys to 
the enterprise. That said, we serve on boards, assist with business 
strategy, help interview and select members of the senior leadership 
team, and introduce the entrepreneurs to professional and other service 
providers who can bring value to the enterprise.
How We Are Compensated
    We receive a management fee, based on a percentage of committed 
capital, to cover salaries and expenses. After payback, when limited 
partners have recouped their investment, we then share in the profits 
on an 80/20 split. This is the ``carried interest.'' Both the 
management fee and the carried interest represent compensation for the 
work that we do. The general partners also invest at least 1 percent of 
the fund's capital. The earnings on that 1 percent are, of course, not 
compensation, but qualify for capital gains treatment along with our 
investors' earnings.
How Our Compensation is Taxed
    Our management fee is taxed as ordinary income. However, the 
carried interest, even though it is compensation, is primarily taxed at 
capital gains rates. I can understand why many in my industry want to 
preserve this special tax advantage. Clearly, it has served U.S. and ME 
well. The tax subsidy each year to private equity fund, hedge fund, and 
venture capital fund managers is in the billions of dollars. But I 
think this special tax break is neither fair nor equitable.
    All workers add value--to a greater or lesser extent. Randy Testa 
is a gifted teacher--he inspired and challenged my son David and his 
third grade classmates--enriching human capital. But the tax rate on my 
carried interest is less than the tax rate on his earnings. Or how 
about the veterans of the Iraq war, in particular the 26,000 
casualties? Do I deserve a tax break more than they do? Ben Stein 
doesn't think so. Nor do I.
    Many Americans invest sweat equity in their jobs and their 
businesses, take risks, contribute to the economy, and may have to wait 
a long time before their hard works pays off. But they still pay 
ordinary income tax rates on their compensation. To the extent we take 
risk, we take it with other people's money. As Bill Gross, the managing 
director of PIMCO Bond Fund noted, ``[w]ealth has always gravitated 
towards those that take risk with other people's money but especially 
so when taxes are low.''
    In addition to the lower income tax rate on the compensation earned 
in the form of carried interests, this income is also earned free of 
payroll taxes. The revenue cost to Medicare is estimated to be about a 
billion dollars a year. This is unacceptable at a time when the aging 
American population depends increasingly on the services provided by 
Medicare and when the Hospital Trust Fund is expected to experience 
substantial shortfalls in just a few years.
Consequences of Changing the Tax Treatment
    I don't think that changing the tax law to require me and other 
managers of venture capital firms, private equity firms, and hedge 
funds to pay tax on our compensation like other working taxpayers would 
have the dire consequences that some are predicting.
    Many predict that firms will locate overseas, taking jobs and tax 
revenue out of the country. My firm is too small to play in the 
international field--the learning curve is too steep and the expenses 
are too high. And if you are doing seed investing, we've always found 
sufficient deals in our own backyard. And my accountant advises me 
that, even if we did move our fund offshore, as a U.S. citizen I would 
still be subject to U.S. tax on my income.
    I don't see why my limited partners would stop investing in our 
fund just because my tax treatment changes. It doesn't affect their 
taxes--most of them are non-taxable entities anyway. If my investors 
ask me what this tax change means to them, I'm going to tell them 
``nothing.'' And I'd still have a strong incentive to do the best for 
my investors. After all, I don't earn profits until they do. I have 
been in the business for 25 years and the base compensation structure 
of 2 and 20 has survived all of the tax changes over that time.
    What limited partners should expect from a venture capital 
investment is a 500 basis point (5 percent) premium over a portfolio of 
publicly-traded securities. And that premium is not a risk premium, but 
a premium for illiquidity. Why? Because we are a 10-year partnership. 
But in addition to that premium, the investor gets a lottery ticket and 
the results can be substantial. In the first Trailhead Fund, we have 
produced a 54 percent internal rate of return net to the investor and 
if we liquidated the remaining public securities today, we would return 
10 to 11 times our partners' capital.
    I have read the statements by others in my industry defending the 
special tax treatment of our earnings by talking about the wonderful 
things we venture capitalists do. I think this is an idealized view of 
our industry--a vision of the Wizard of Oz comes to mind. We don't lead 
every deal in which we invest. Occasionally we are followers, along for 
the ride. Am I the only one who finds these claims just a bit self-
    What is interesting about early-stage venture investing is the 
rewarding collaboration between the limited partners who bring dollars 
and trust, the venture capitalist who brings judgment and experience, 
and the entrepreneur who brings an idea and a fire in his or her belly. 
That combination can create wonderful, profitable results. But there is 
a first among equals here that we should never forget, and is the key 
to the equation, and that is the entrepreneur.
    I have loved my work over the last 25 years and I would not stop 
doing it because my tax rate was adjusted to the level of other 
citizens'. And I don't think losing the carried interest tax break 
would drive other venture capitalists out of the field. We like the 
excitement and satisfaction of assisting management in transforming 
good ideas into successful businesses. We get ample compensation, 
financial and psychic, for the work we do and the risks we take, in the 
form of a share of the profits. There is more than a hint of Chicken 
Little here. But our industry won't end or be significantly disrupted 
if this legislation is enacted any more than the auto industry's dire 
predictions of doom came to pass after mileage standards, seatbelts, 
and air bags were mandated.
Does Venture Capital Deserve Special Tax Breaks?
    I could make a public policy case for excluding venture capital 
from this legislation. For unlike private equity and hedge funds, the 
venture capital industry does create jobs. We fund small start-ups 
rather than restructure huge companies. And we don't use leverage to 
pay ourselves back and leave the portfolio companies saddled with debt. 
But I won't. I still think our earnings are compensation and should be 
taxed the same as the compensation of everyone else in this country--
from teachers and firefighters to athletes and movie stars. I don't 
think it is fair for those teachers and firefighters to subsidize 
special tax breaks for me and other venture capitalists. Or for private 
equity and hedge fund managers.
Wealth Inequality
    How long will we tolerate the ever-widening gap between rich and 
poor? Though my preference is for major tax reform--increased standard 
deductions, a base rate for all income: wages, salaries, dividends, 
royalties, and capital gains with some progressivity built in--major 
tax reform is not on your agenda. However, I do believe it is fair, 
equitable, and appropriate to attack the issue of tax equity at the 
margins. We should not do nothing because we can't do everything. I am 
especially disturbed by suggestions that we can't afford to provide 
health insurance for low income children, first rate medical care for 
our injured soldiers or fund--at the Federal level--the mandates of No 
Child Left Behind. I am disturbed that these and other human priorities 
are unaddressed while we pretend we can afford to continue these tax 
    I'm delighted to be part of the venture capital business--it's been 
a wonderful 25 years. We funded a lot of companies--many of them 
successful. We've worked hard and I think we've earned our 
compensation. My point simply is that fairness and equity dictate that 
we pay ordinary tax rates on that compensation.
    Was Ben Franklin prescient when he warned us that our republic 
would fail because of corruption, greed, and, dare I say it, special 
interests? Doesn't gross inequity in our Tax Code, maintained by the 
very people who benefit from it, come close to the same thing? We and 
our representatives have a choice. We can change the Tax Code in favor 
of equity and fairness. Or we can come to the same conclusion reached 
by Walt Kelly and his mouthpiece, Pogo, ``we have met the enemy and he 
is us.''
    Thank you and I would be pleased to answer any questions.


    Chairman RANGEL. Thank you so much. Now it is my pleasure 
to welcome an old friend, and he will have to share with me how 
the New Jersey State Investment Council is located in New York, 
New York, but as long as it is there, it is okay with me.
    Chairman Kramer, welcome.

                       INVESTMENT COUNCIL

    Mr. KRAMER. That is where your office found me, Mr. 
Chairman. Mr. Chairman, Mr. Ranking Member, Members of the 
Committee, can I ask in the interest of time, which has to be a 
priority of yours, that my brief comments be entered into the 
record, and I will just summarize.
    Chairman RANGEL. Thank you. Without objection, and for all 
of those that have been patient, as you have been, again, I 
apologize for the lateness, but your entire statements will be 
in the record. Please feel free, if there are additional 
remarks that you would like to bring before the Committee, we 
would welcome them.
    Mr. KRAMER. I am happy to answer any questions. Briefly, I 
am Chair of the Oversight Board of the Jersey Pension System. 
It is an $80 billion system. I think it is the ninth largest 
pension fund in the United States.
    In my private life, I manage a hedge fund, and therefore, I 
benefit from the lower capital gains treatment, which I try to 
get as much of as I can, on carried interest.
    I am happy if you want during Q&A to go into the broader 
philosophical issues, but I have been asked to address the 
narrow question of whether higher tax rates for private equity 
and hedge funds would be detrimental to public pension funds 
and therefore to those retired teachers and police officers and 
so forth.
    Leaving aside the question of what the appropriate tax 
treatment is and how we should think about capital gains versus 
ordinary income, in simple terms, in competitive markets, 
basically firms cannot automatically pass their costs on to 
their customers, and it is actually no different in the money 
management business than in any other business, whether it is 
higher rents or higher costs of recruiting somebody away from 
his firm, or higher taxes, whatever creates higher operating 
    The fees are essentially set by the market. There are some 
firms that charge more than the standard 2 and 20. The firms 
that charge more than the standard 2 and 20 do it because (a) 
they want to and (b) there is some pool of investors for them 
who say I think I am going to get a high enough return that it 
is worth paying 3 and 40. I suspect there are more people who 
would charge 3 and 40 if there were more investors who were 
willing to pay 3 and 40.
    If people get enamored of the returns, maybe someday 
people, a lot of people, will be paying 3 and 40. If returns go 
south, maybe someday people will be paying 1 and 10.
    I think it is a function of market forces and not where you 
set your tax rates. Actually, having worked in this city when 
Chairman Rangel was already an important Member, when I was 
working up the street 30 years ago, and actually back then, the 
capital gains rates were higher. The marginal rates on the top 
income earners were higher than they are today. Money managers 
made much less money than they make today.
    Today, we have much lower rates, marginal rates, my top 
rate. We have lower rates on capital gains. We have this record 
number of money managers who are charging fees that were 
inconceivable when I last worked in this city.
    Actually, if we look at history, we say there must be this 
inverse relationship between the level of fees and the level of 
tax rates because they have gone in the opposite directions, 
but enough.
    [The prepared statement of Mr. Kramer follows:]
   Prepared Statement of Orin S. Kramer, Chairman, New Jersey State 
                 Investment Council, New York, New York
    My name is Orin Kramer. I am chair of the New Jersey State 
Investment Council, which is the fiduciary board overseeing the state's 
$80 billion public pension system. At last count, New Jersey was the 
ninth largest public pension fund in the United States. In my private 
life, I manage a hedge fund. I have served on the boards of various 
financial services firms and on presidential commissions and task 
forces. I have also been Executive Director of gubernatorial 
commissions in California and New York, spent four years on the policy 
staff of the Carter White House, taught at Columbia Law School, and 
published a variety of policy studies. The views expressed here are 
mine alone and should not be attributed to other members of the State 
Investment Council.
    I have been asked to address the question of whether higher tax 
rates for private equity and hedge fund managers would be detrimental 
to public pension funds and their beneficiaries. As I understand it, 
the argument is that higher taxes are a cost which asset managers will 
pass on to clients, thereby diminishing client returns.
    Thirty years ago when I worked in this city, tax rates on high 
income earners and capital gains were higher than today and fee levels 
generated by the top money managers were lower than today. Now we have 
lower marginal tax rates and an unprecedented number of people 
generating record fees from money management. So from a purely 
historical perspective, there seems to be an inverse relationship 
between tax rates and the fees clients permit us to charge for managing 
    In my experience, private equity and hedge fund managers tend to be 
highly sophisticated about business economics, and they know that firms 
in competitive markets cannot automatically pass higher operating costs 
on to customers. I would be reluctant to entrust capital to an 
investment manager who did not share this view. Today the standard 
compensation arrangement for private equity and hedge firms is a 2 
percent management fee plus 20 percent of profits, or the incentive 
fee. A small number of managers charge higher fees. They do so because 
it is their choice, and because there exist for those managers pools of 
investors who believe that their returns net of fees will justify the 
higher payments. Since the capitalist instinct among money managers 
appears to be robust, if asset managers believed that the institutional 
investor community would accept fees above the 2/20 arrangement, I 
suspect those fees would rise. But if asset managers choose to increase 
their level of personal consumption, or if they incur higher operating 
costs such as higher taxes, fees do not rise because the after-tax 
savings of money managers diminishes. Fees rise when the return 
expectations of limited partners increase, justifiably or not, to 
levels which warrant higher fees.
    I can imagine two scenarios where this analysis would be incorrect. 
The first is that money managers operate under cartel-like industry 
structural conditions which would create greater price elasticity. I 
don't believe this is true. If it is true, there are other policy 
implications. The second possibility is that public fund fiduciaries 
are not financially sophisticated, and that they believe that fees 
should be driven by the after-tax income of managers rather than risk-
adjusted expected returns. If we do live in a world where managers can 
dictate fees in a manner disconnected from higher expected investor 
returns, then arguably public funds will and do deserve to pay higher 


    AFTER 6:00 P.M.
    Chairman RANGEL. Thank you. The Chair would now like to 
recognize Jonathan Silver, Managing Director of Core Capital 
Partners. Thank you for your patience.


    Mr. SILVER. My pleasure, Congressman. Thank you.
    Mr. Chairman, Ranking Member McCrery and Members of the 
Committee, my name is Jonathan Silver. I am the founder of Core 
Capital Partners, a Washington, D.C. based venture capital fund 
with about $350 million under management.
    Core is a Member of the National Venture Capital 
Association, and I am here today representing the 480 member 
firms which together comprise about 90 percent of all the 
venture capital under management in the United States.
    Thank you for the opportunity to be part of today's 
discussion. As part of your analysis, we believe it is 
important to understand the unique and valuable contribution 
venture capital investment makes to America's long-term 
economic growth, why the venture community believes that the 
current capital gains tax treatment on a venture fund's carried 
interest is both correct and necessary, and how H.R. 2834, as 
drafted, could damage the entrepreneurial ecosystem in the 
United States.
    Literally thousands of companies would not exist today were 
it not for the venture capital support they received early on. 
Federal Express, Starbuck's, Google, e-Bay, Genentech, Amgen, 
and countless other companies were all at one time just ideas 
that needed startup capital and guidance.
    Last year, U.S. based venture capital companies accounted 
for more than 10.4 million jobs and generated over $2.3 
trillion in revenue. This represents nearly one out of every 
ten private sector jobs and almost 18 percent of U.S. GDP.
    What is particularly important is these are new jobs, and 
in fact, often new industries. It was venture capital that made 
the semiconductor industry possible. We also saw the commercial 
possibilities of the Internet before others, and we jump 
started the biotech industry.
    Where will the next wave of new businesses come from? No 
one knows. That is why venture capitalists look for 
opportunities in all 50 states. It is why venture funds have 
backed Music Nation in New York City, Incept Biosystems in Ann 
Arbor, Michigan, Interface 21 in West Melbourne, Florida, 
Boston Power in Westborough, Massachusetts, and Click Forensics 
in San Antonio, Texas, as examples.
    Simply put, these jobs did not exist before venture 
capitalists started these companies. This is organic job 
growth, not financial engineering. This is sweat equity on the 
part of the entrepreneur and his or her backers, all working to 
create something valuable out of nothing. No other asset class 
shares this distinction.
    The economic importance of these new companies cannot be 
understated. They are a critical part of our National economic 
engine. Over the last 5 years, the employment growth rate of 
all U.S. based venture backed companies was more than two and a 
half times that of non-venture backed companies.
    In many important ways, we work exactly like the founders 
and entrepreneurs we back. Our startup companies almost all 
begin with an entrepreneur and a VC agreeing on an idea. There 
is no strategic plan, no senior management team, no customers. 
There is just our collective belief that the initial idea can 
potentially be turned into a viable and profitable business.
    The underlying technology is developed by the entrepreneur. 
We get involved in building out the company. The combination of 
their technical knowledge and our business knowledge is equally 
responsible for the company's success.
    We see no cash returns until the company we build together 
goes public or is acquired. If we co-found the company, work 
equally hard, and make intellectual contributions of equal 
value, why should the founder's share of the sale of the 
company be treated as a capital gain and ours viewed as 
performance for service and ordinary income?
    I believe it is important to understand that venture 
capitalists are not just financiers. Along with the 
entrepreneurs, we are really co-founders. Without our active 
ongoing involvement, many of these companies fail or fail to 
launch, and potentially important innovations remain in the 
garage, incubator or lab.
    As you have heard from earlier witnesses, venture firms are 
generally structured as partnerships and usually receive the 
right to receive 20 percent of the cumulative net profits of a 
    In order to be treated as a long-term capital gain, venture 
capital carried interest must satisfy many requirements. It 
cannot be guaranteed in any form.
    If the venture capital fund loses money or just breaks 
even, we do not receive any carried interest. Carried interest 
must also be attributable to the sale of a capital asset that 
has been held for over a year, making the payment very 
different from the year end bonuses that look at performance 
during a single year rather than over the long term.
    Carried interest must also be attributable to the sale, as 
an IPO or acquisition of a capital asset to a third party. This 
is what makes carried interest different from other performance 
based compensation, which takes money and value out of a 
company's coffers. This is also what makes carried interest 
different from a lawyer being paid on a contingency fee basis 
or from an author being paid royalty income for a book or 
sales. In those cases, the lawyer and the author did not give 
up a capital asset to someone else.
    Many venture capitalists supply tremendous effort and skill 
in helping their companies grow and still never receive carried 
interest compensation, but it is the possibility of earning 
carried interest that is a primary incentive for the venture 
capitalists to commit to the risky task of starting and funding 
new companies, just as it is an important incentive to the 
entrepreneurs to start those companies.
    H.R. 2834 as written would change the venture capital 
entrepreneur limited partner paradigm; specifically, there are 
several ways in which the bill could result in fewer U.S. 
companies receiving venture capital.
    First, if the carried interest tax on the industry were 
doubled, our ability to take financial risk will shrink. 
Because we rely on the profits from our successful investments 
to offset the losses on the companies that fail, an increase in 
the tax rate requires funds to generate more successful company 
exits; companies that are now fundable may no longer constitute 
an acceptable risk, and would cease to attract venture 
    The net result is that venture funds will tend to favor 
later stage companies in order to reduce the effort, risk and 
time required to exit. Early stage companies will be harder to 
start and to fund, hurting the lifeblood of the entrepreneurial 
    Finally, you should expect that some venture capital 
activity will move offshore. Many countries are actively 
promoting venture capital activity through tax and regulatory 
friendly environments in order to compete directly with the 
United States. This is already happening.
    A significant number of successful experienced venture 
funds have shifted their focus to new funds in China and India 
and are actively working there.
    As you continue the examination of capital gains policy and 
partnership tax law, we urge you to recognize the immensely 
important contribution venture capital has made in promoting 
investment and generating both job creation and economic 
growth, and to consider the potential harm H.R. 2834 could 
    By acknowledging that venture capital plays a special role 
in the U.S. economy, you underscore our long national interest 
in promoting innovation and job creation, and you re-affirm the 
necessary and important role that risk taking has played 
throughout our history.
    Thank you.
    [The prepared statement of Mr. Silver follows:]
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    Chairman RANGEL. Thank you.
    Next is Adam Ifshin, President of DLC Management 
Corporation in my hometown in New York, Tarrytown. Thank you.


    Mr. IFSHIN. Thank you, Chairman Rangel, Ranking Member 
McCrery, Members of the Committee. My name is Adam Ifshin and I 
am the co-founder and President of DLC Management Corporation, 
an owner, developer and redeveloper of shopping centers 
headquartered in Tarrytown, New York.
    DLC specializes in revitalizing older shopping centers in 
first tier suburbs, cities, and some small towns.
    I am appearing today on behalf of the 70,000 members of the 
International Council of Shopping Centers, the Real Estate 
Roundtable, and other real estate organizations whose members 
will be significantly impacted by proposals to tax the return 
on all carried interest as ordinary income.
    We understand and appreciate that H.R. 2834 is intended to 
improve tax fairness and the income disparity gap. However, we 
believe that H.R. 2834 is not the proper tax policy for real 
estate and would not accomplish these goals.
    We believe the legislation would hinder real estate 
entrepreneurs at all levels and particularly those in earlier 
phases of building their businesses.
    Therefore, we urge Committee Members to proceed very 
cautiously, as the real estate industry and the communities it 
serves across the country have much at stake.
    While current law is far from perfect, we believe that H.R. 
2834 would result in the most sweeping and potentially most 
significant tax increase on real estate since the retroactive 
application of the passive loss rules in 1986.
    I started DLC when I was 26 years old. Since starting with 
nothing, my company has grown to become one of the nation's 
preeminent owners and mid-sized operators of retail shopping 
centers, with 72 such assets in 25 states.
    Over the past 16 years, my firm has focused on rejuvenating 
under served markets by investing hundreds of millions of 
dollars in commercial real estate. DLC is dedicated to creating 
value, primarily through the redevelopment of older distressed 
properties in challenging environments, which often include 
older suburbs and cities, such as Peekskill, New York, 
properties like Levittown Mall in Tullytown, Pennsylvania, and 
underserved rural and multi- ethnic city neighborhoods in 
Carbondale, Illinois and inner city Baltimore, Maryland.
    We re-invest most of our capital gains into new projects to 
make long-term investments in communities that may not 
otherwise see revitalization. I can unequivocally state that my 
company as it exists today could not have been built if the 
taxation on gains was at the ordinary income rates proposed by 
H.R. 2834. The returns simply would not have justified the 
    The carried interest is the return on the entrepreneurial 
risk that makes a project happen. Embedded in my business plan 
and virtually every other real estate partnership over the last 
several decades, is the concept that a material component of 
the general partner's compensation will be capital gain.
    Of course, that assumes there is long-term appreciation 
that results in a capital gain. Many real estate developments 
never get off the ground, still others fail or fall short of 
their goals. In these cases, the general partner gets nothing 
and frequently loses money. Most real estate projects take 5 to 
10 years to fully mature from concept to stabilization. This 
long-term investment is risky and the returns have to justify 
that risk.
    If H.R. 2834 were to be enacted, returns would go down as 
the tax burden goes up. Some development would certainly still 
occur, but the material shift in the risk/reward tradeoff for 
the developer/operator would mean that fewer projects would be 
built. Those that would be built would tend to be high end 
developments in wealthy communities and central business 
districts where there tends to be less risk.
    What H.R. 2834 proposes for real estate makes under served 
and given up for dead locations far less appealing to 
developers. Those projects are harder to put together and 
generally entail much greater risks. The net result will be to 
cause the greatest harm to those communities that need 
development and revitalization the most, communities where we 
have done work, like Newburg, New York, Spring Valley, New 
York, and the west side of Baltimore City, where there is a 
fundamental lack of shopping alternatives for predominately 
minority consumers.
    A lack of retail options leads to higher prices for basic 
commodities like milk and bread for those people who can least 
afford to pay.
    In the context of real estate, H.R. 2834 is based on a 
flawed premise, the notion that a carried interest is a proxy 
for a fee, particularly a fee for investor money management. 
The real estate general partner is a manager and developer of 
an asset, not a money manager.
    Properties require intensive work. You cannot just buy them 
and do nothing and sell them years later. A carried interest is 
not granted for typically routine services like leasing and 
property management, but for the value the general partner will 
create beyond routine services. It is granted for bringing the 
    It is for committing to the venture alongside the investors 
in something that will be highly illiquid. It is granted 
because the general partner is subordinating his return to that 
of his limited partners.
    The carried interest is also granted in recognition of the 
risk exposure that a general partner has in a venture. 
Typically, a general partner is responsible for all partnership 
liabilities such as environmental contamination, lawsuits, and 
often explicit guarantees, matters such as construction 
completion, operating deficits, and a mortgage on those 
    In the case of development, a carried interest recognizes 
development risks and opportunity costs borne by the real 
estate entrepreneur, both before and after the admission of the 
financial partner.
    Bottom line, we are asset managers of hard assets, not 
money managers.
    In conclusion, almost one-half of all partnership tax 
returns are filed by real estate entrepreneurs. Over $1 
trillion in equity is invested in real estate through 
partnerships leveraged on another 30 to 40 percent.
    At the end of the day, this is not a Wall Street issue; it 
is a Main Street issue. At stake are job creation, economic 
development, and revitalization of communities across the 
    Thank you for holding this hearing and for giving me the 
opportunity to testify. I welcome all of your questions.
    [The prepared statement of Mr. Ifshin follows:]
  Prepared Statement of Adam Ifshin, President, DLC Management Corp., 
                          Tarrytown, New York
    Thank you, Chairman Rangel and Ranking Member McCrery for 
conducting today's hearing on potential changes to the tax treatment of 
partnership ``carried interest.''
    My name is Adam Ifshin and I am the incoming chairman of the 
International Council of Shopping Centers' economic policy committee 
and the co-founder and president of DLC Management Corporation, an 
owner, developer, and re-developer of shopping centers, headquartered 
in Tarrytown, NY. DLC specializes in revitalizing older properties in 
in-fill first tier suburbs, cities and some small towns.
    I am appearing today on behalf of the ICSC, the Real Estate 
Roundtable, and other real estate organizations listed whose members 
will be significantly impacted by proposals to tax all carried interest 
as ordinary income.
    We understand and appreciate that H.R. 2834 is intended to improve 
tax fairness and the income disparity gap. These are issues that 
warrant serious attention. However, we believe that H.R 2834 is not the 
proper tax policy for real estate and would not accomplish these goals. 
We believe the legislation would hinder real estate entrepreneurs at 
all levels and particularly those in the earlier phases of building 
their businesses.
    Therefore, we urge Committee Members to proceed very cautiously, as 
the real estate industry and the communities it serves across the 
country have much at stake. While current law is far from perfect, we 
believe H.R. 2834 would result in the most sweeping and potentially 
most significant tax increase on real estate owners since the enactment 
of the passive loss rules of the 1986 Tax Reform Act. The application 
of those rules, particularly to existing real estate investments, 
triggered unintended consequences, namely the savings and loan 
collapse, a credit crunch that caused a major downturn in the real 
estate industry and cost taxpayers billions of dollars. H.R. 2834's 
effect on entrepreneurial risk taking--especially of those whose 
efforts most directly impact Main Street--would cause unintended 
consequences that would ripple through the economy.
History of DLC Management
    I started DLC Management when I was twenty-six years old. The 
commercial real estate industry was struggling to overcome the damage 
caused by the savings and loan crisis and the 1986 Tax Reform Act. 
Since starting from the ground floor, my company has grown to become 
one of the nation's preeminent owners and medium-size operators of 
retail shopping centers with 72 centers located across 25 states. Over 
the past 16 years, DLC has created value in underserved markets by 
investing hundreds of millions of dollars in commercial real estate. 
DLC focuses on the redevelopment of older distressed properties in 
challenging environments, which often include older in-fill suburbs and 
cities such as Peekskill, NY, environmentally challenged brownfield 
properties like Levittown Mall in Tullytown, PA, and underserved rural 
or multi-ethnic city neighborhoods like Carbondale, IL, and inner city 
Baltimore, MD.
    We reinvest most of our capital gains into new projects in order to 
continue to make long-term investments in communities that might not 
otherwise see revitalization. And I can unequivocally state that my 
company as it exists today could not have been built if the taxation on 
gains was at the ordinary income rates proposed by H.R. 2834. The 
returns simply would not have justified the risk in many cases.
Discussion of the Carried Interest Structure
    A carried interest is the return on the entrepreneurial risk that 
makes the deal or project happen. Embedded in the DLC business plan, 
and virtually every real estate partnership of the last several 
decades, is the concept that a material component of the compensation 
to the general partner is capital gain. Of course, that assumes there 
is a capital gain in the end. Many real estate developments never get 
off the ground. Still others fail or fall short of their goals. In all 
these cases, the general partner gets nothing other than fees.
    For years, many real estate transactions have been structured as 
limited partnerships. In a typical limited partnership, there will be 
one or more financial investors as the limited partners and an operator 
or developer, serving as the general partner. The general partner 
brings a combination of intangible assets, assumption of significant 
risk, and intellectual capital as part of arranging and operating the 
venture. In exchange, the general partner receives a share of future 
partnership profits, typically after the limited partners receive a 
minimum compounded preferred return generally in the range of 8-12 
percent per annum and their initial equity back. The general partner's 
profits are a pre-determined percentage of the residual profits that is 
arrived at after the limited partners have attained their required 
minimum return on the investment.
    In addition to this subordinated carried interest, the general 
partner typically has two other economic interests in the partnership. 
The general partner or a related entity receives a non-profit based 
management fee for performing day-to-day property management services. 
This is taxed as ordinary income. The general partner typically also 
invests capital, side by side with the investor, commonly 1-10 percent 
of the total capital in the partnership. This is structured as a 
limited partner interest.
What the Carried Interest Represents to the General Partner and 
    The industry has long favored this carried interest format because 
it pairs the experience and early stage risk-taking of the real estate 
developer/businessperson with the capital of the financial partner in a 
flexible structure that best matches risks and rewards for both 
parties. Moreover, it has survived five decades of tax legislation 
including numerous overhauls of the Federal tax law relating to both 
partnerships and real estate.
    In the context of real estate, H.R. 2834 is based on a flawed 
premise--the notion that a carried interest is a proxy for a fee--
specifically a fee for investor money management services. The real 
estate general partner is a manager of an asset. Buildings require an 
intensive amount of owner attention. You cannot just buy them and do 
nothing until you sell years later. They require substantial amounts of 
capital and management from development or acquisition through 
disposition to be productive assets.
    Why do the limited partners grant the general partner a carried 
interest? A carried interest is granted not for routine services like 
leasing and property management, but for the value it will add to the 
venture beyond routine services. It is granted for the general partner 
bringing the investors the ``deal.'' It's for committing to a venture 
alongside the investors that will be highly illiquid. It is granted 
because the general partner is subordinating his return to that of the 
limited partners. It is for the general partner's business acumen, 
experience and relationships. Knowing when to buy, how much to pay, 
whether to expand or renovate, when to sell and to whom. This is the 
``capital'' the general partner invests in the partnership.
    The carried interest is also granted in recognition of the risk 
exposure the general partner has in the venture. This exposure is often 
far greater than the money it contributed. Typically, a general partner 
is responsible for all partnership liabilities such as environmental 
contamination and lawsuits, and often explicitly guarantees matters 
such as construction completion, operating deficits and debt. In the 
case of development, a carried interest recognizes development risks 
and opportunity costs borne by the real estate entrepreneur, both 
before and after admission of the financial partner.
    Primary among these risks is the risk that governmental approvals 
will not be obtained or, even if obtained, will not be timely or 
achieved within budget. Besides zoning and development plan approvals, 
such approvals include specialized permits such as those for wetlands, 
sewer, and roadway-related matters. Approvals typically take years and 
can cost hundreds of thousands, even millions of dollars, for a single 
project. They represent a unique risk of the developer because 
financial partners normally will not commit until all or most of such 
approvals are obtained.
    After the financial partner is admitted, the developer bears risks 
disproportionate to its capital contributions because at a minimum it 
alone guarantees that the building will be completed on time and within 
budget. It takes considerable business acumen, experience and skill to 
manage major building construction. Design changes, tenant change 
orders, labor or material cost increases and schedule delays must be 
managed against pre-determined budget and reserve amounts, or the 
general partner will be left responsible for cost overruns.
    Acquisition of existing properties also presents some of these same 
development risks although on a lesser scale. Most acquisitions of 
existing buildings are made with the plan to put additional capital 
into building improvements. This is because many buildings are sold 
with deferred maintenance obligations or at a time in the ownership 
cycle when new capital infusion is needed to keep the building updated 
and optimally marketable. These improvements may be in the form of 
expansion or renovation of varying scale. The amount of capital added 
will depend on the age and condition of the building, market demand and 
what amount and type of investment the owners believe will maximize the 
return on investment. Again, the general partner must manage this 
capital investment wisely or bear the risk of cost overages.
    Development and property management services are explicitly 
compensated through fees negotiated at arm's length between the real 
estate entrepreneur and the financial partner. As in other markets, 
such negotiations are driven by industry practice and the size of the 
project. Beyond the discipline of market forces in setting such fees, 
the ``disguised fee'' rules of Section 707 of the Internal Revenue Code 
have since 1984 precluded using partnership distributions as a proxy 
for fees to the developer (or any other partner). Thus a developer's 
carried interest represents not compensation for services but 
recognition of the considerable development risk taken, the substantial 
opportunity cost involved in pursuing a particular project and putting 
one's balance sheet at risk to it, and the value added to the venture 
from directly aligning the interests of the developer and the financial 
partner. The general partner also can be at risk for recourse loans and 
environmental indemnities for all loans.
H.R. 2834 Discriminates Against Partnership Form--Founders Stock 
    H.R. 2834 discriminates against the partnership form. Under the 
bill, if an entrepreneur managed a partnership venture and received a 
carried interest, the return paid on the carried interest would be 
ordinary income. However, if instead of taking in a capital partner, he 
is able to borrow the capital from a bank and operates as a sole 
proprietor, capital gain treatment would be allowed on the carried 
interest return. The entrepreneur is conducting the same activity in 
both scenarios yet the bill would result in different tax treatment.
    The corollary in the corporate world is seen in companies such as 
Google and Microsoft where the founders took the earliest (and 
greatest) risk in launching the enterprise and were later joined by 
financial partners who purchase preferred stock for a much larger 
capital contribution per share than that made by the founders. Neither 
Congress nor Treasury questions the wisdom or fairness of affording 
capital gains treatment to such founders when they ultimately sell 
their stock. The same logic should apply to a partnership between the 
``founder'' of a real estate project and its subsequent financial 
H.R. 2834 Would Encourage Use of Debt over Equity
    H.R. 2834 would have the effect of favoring debt over equity. 
Partnerships with equity contributions would be subject to the bill's 
tax increase while loan arrangements would not. So, taxpayers would be 
encouraged to structure a transaction as a loan from the investor to 
the entrepreneur instead of forming a partnership with the investors 
making an equity contribution. Encouraging debt over equity is not good 
policy generally and certainly is not good policy in the current credit 
and liquidity climate. The world financial markets have been roiled by 
their exposure to an abundance (perhaps overabundance) of lending from 
subprime mortgages to commercial conduit financing. Mortgage backed 
securities are suffering steep declines in values. We will soon see how 
strong or fragile these markets are. Nevertheless, this does not appear 
the time to impose a tax that would affect the value of the real estate 
collateralizing a significant portion of the debt market.
DLC Achievements Using the Carried Interest
    Following are some illustrations of DLC's achievements of bringing 
national retailers and new life into towns and properties time long 
forgot--these deals were all done in a partnership format with carried 
interest taxed at the capital gains rate. If current law is changed to 
tax carried interest at the ordinary income rate, then the investment 
viability of projects like these could be brought into question--and 
eventually a disruption in the real estate marketplace could take 

      Spring Valley, NY--DLC brought Target, Bed, Bath and 
Beyond, Michaels Arts and Crafts, T.J. Maxx, 9 West and other 
recognized retailers to a 70 percent vacant center in a market that is 
50 percent African-American and 30 percent Latino. Most of the retail 
had moved out to an upscale mall three miles away, yet through our 
efforts, the center is now 100 percent occupied. During this project, 
550 construction jobs were created; 650 retail jobs added. DLC paid 
over $30 million for the center and has spent $12 million in 
investments, the largest private sector investment in Spring Valley in 
the past 20 years.
      Peekskill, NY--DLC totally re-developed a 1950's shopping 
center where the supermarket anchor and the junior anchor had both gone 
bankrupt. We brought the first new full service grocery store, a Stop & 
Shop, to this predominantly minority community in 20 years. Other 
national tenants include a CVS, Dunkin' Donuts, Dollar Tree and Tuesday 
Morning. The project produced 600 new construction jobs and 400-450 
permanent retail jobs. Our development was 100 percent privately funded 
and over four years in the making. DLC paid $14 million for the site 
and invested $19 million thereafter to redevelop it.
      Oxon Hill, MD--DLC acquired two underperforming grocery 
anchored shopping centers in an African-American community. We fully 
expanded and renovated one center and brought to 100 percent occupancy, 
featuring retailers such as Shoppers Food Warehouse, A.J. Wright and 
Advanced Auto. The rejuvenation of the second center is now underway 
with new facades, new national tenants and the Giant grocer is 
renovating and expanding.
      Levittown, PA--DLC tore down an obsolete 1950's open air 
mall. This project required major environmental brownfields remediation 
to address more than one million square feet of asbestos-containing 
material and 67 underground fuel tanks. Now there is a new center being 
built featuring a Home Depot, Wal-Mart Supercenter, Ross Dress for 
Less, Starbucks, Wachovia, Famous Footwear, Dress Barn, Day Care Center 
and others. Over 1,000 construction jobs have been created and 1,000 
retail jobs. DLC bought the property for $9.5 million and will invest 
$60 million total, without any public subsidy. This center will be the 
largest commercial taxpayer in the borough.
Impact of H.R. 2834 on Real Estate
    Most real estate projects are not short term in nature. Projects 
frequently take 5-10 years to fully mature from concept to 
entitlements, to construction, to lease up, and stabilization. If H.R. 
2834 were to pass the Congress some development would still occur, but 
the material shift in the risk/reward trade-off for the developer would 
mean that fewer projects would be built. Those that would be built 
would tend to be higher-end, fancier developments in wealthy 
communities and central business districts where there is less risk.
    What H.R. 2834 proposes makes underserved and given-up-for-dead 
locations, like those described above, far less appealing to developers 
because those deals are harder to put together and have greater risk 
associated with doing them. The net result will be to cause the 
greatest harm to those communities that need development and 
revitalization the most--communities like Newburgh, NY, Spring Valley, 
NY, and the West Side of Baltimore, where there is a fundamental lack 
of shopping alternatives for predominantly minority consumers. A lack 
of retail options leads to higher prices for basic commodities like 
milk and bread for those people who can least afford to pay.
    Community leaders where we do business fully understand and 
appreciate the benefits our development brings to their citizens--more 
consumer choices at less cost, job opportunities, both at the 
construction phase and thereafter, an increased tax base and improved 
quality of life.
    I should add at this point that while my business is in the retail 
shopping sector, the use and importance of the carried interest is the 
same for all types of real estate--apartments, office and industrial. 
Examples of retail projects I've cited in this testimony could just as 
easily be affordable apartment complexes or mixed-use projects that 
combine residential, retail and office elements. The same 
entrepreneurial risk is involved, similar investment duration and 
similar subordination of the general partner's return to the investors' 

    Effect on Tax Fairness and Income Disparity

    Finally, it is often mentioned that H.R. 2834 is a matter of tax 
fairness. The question is rhetorically asked, ``Why should a wealthy 
Wall Street investment manager be allowed to pay at tax at a rate less 
than his or her assistant?'' I acknowledge that there are significant 
issues of tax fairness in the Tax Code and income disparity in the 
country and the industry applauds Congress for addressing these issues. 
However, I don't think the analogy is as simple or as accurate as it 
first sounds. First, an executive assistant's effective tax rate is not 
likely to be 35 percent. Because of the progressivity in our tax system 
and the variety of exemptions or deductions that exist, it's likely the 
assistant's effective tax rate is substantially less than 35 percent. 
Nevertheless, and more importantly, we don't believe H.R. 2834 would be 
an effective tool in addressing these issues and, in fact, would have a 
counterproductive effect.
    The most successful real estate managers, whether they are in real 
estate or other industries, would be able to pass the increased tax 
cost onto investors. These investors would have to accept this cost 
shifting (at least most of it) if they want their capital invested by 
the most successful real estate owner/operators. Alternatively, these 
real estate managers will be able to use their resources to re-
structure their transactions to avoid the tax altogether.
    Those entrepreneurs that are trying to develop their business and 
are scraping and competing for capital, will not have the negotiating 
leverage to pass on the increased tax to their investors. Neither would 
many have the resources to re-structure transactions from the long 
accepted partnership/carried interest structure. As a result, it is the 
entrepreneurs at this end of the entrepreneurial spectrum that most 
likely will bear the brunt of H.R. 2834's proposed tax increase. That 
outcome will not promote tax fairness or mitigate income disparity.
    H.R. 2834 would result in tax favored capital gain treatment being 
limited to those taxpayers that have the money to invest in real 
estate. Those that don't have the money to invest, but are willing to 
take risk and invest sweat equity, would not be allowed favored tax 
treatment. Current law allows a more balanced result and I encourage 
Members of the Committee to consider this carefully as they move ahead.
Effective Date
    H.R. 2834 does not have an effective date. As the passive loss 
rules demonstrated 20 years ago, applying tax increases to existing 
investment partnerships is effectively retroactive application. The 
resulting disruption could be as dramatic as we saw in 1986. The 
passive loss rules helped trigger the savings and loan crises and 
billions of dollars in lost real estate value. Therefore, any 
modification to the carried interest rules as they apply to real estate 
should apply only to partnerships entered into on a going forward basis 
and not existing partnerships.
    According to IRS statistics, in 2005, 46 percent of partnership tax 
returns came from the real estate industry. Over $1 trillion in equity 
is invested in real estate through partnerships leveraged on average 
another $300-$400 billion in loans. Therefore, a major change in 
partnership tax rules, such as that proposed by H.R. 2834, would have a 
tremendous impact to the real estate industry--a significant economic 
driver in our nation's economy. At the end of the day, this is not a 
Wall Street issue--it's a Main Street issue. At stake are job creation, 
economic development, and revitalization of communities across the 
    Chairman Rangel and Ranking Member McCrery, thank you for holding 
this hearing and for giving me the opportunity to testify. We look 
forward to working with you as you continue to examine this matter.

    Real Estate Trade Association Members of The Real Estate 
    National Association of Real Estate Investment Trusts
    National Association of Realtors
    National Association of Homebuilders
    National Association of Real Estate Investment Managers
    National Multi-Housing Council
    National Association of Industrial and Office Properties
    Pension Real Estate Association
    Mortgage Bankers Association of America
    International Council of Shopping Centers
    Commercial Mortgage Securities Association
    Building Owners and Managers Association International American 
Hotel & Lodging Association
    American Resort Development Association
    Association of Foreign Investors in Real Estate
    Urban Land Institute
    The following facts illustrate the overall contribution real estate 
makes to communities and the economy:
      Real estate is a vital part of our national economy 
contributing, over $2.9 trillion or one third of the Gross Domestic 
Product. Real estate asset values, residential and commercial, total 
nearly $20 trillion. Real estate creates jobs for over 9 million 
Americans--and these are not ``off-shored.''
      America's real estate is the source for nearly 70 percent 
of local tax revenues, which pay for schools, roads, police and other 
essential public services.
      U.S. commercial real estate is worth approximately $5 
      Private investments in commercial real estate done 
largely through partnerships have a total equity of over $1 trillion.
      America's 50,000 shopping centers account for over $2.25 
trillion in sales and generate over $120 billion in state sales taxes.
      Multifamily construction starts in 2006 totaled 338,000 
housing units for a total of $50 billion of housing investment. Housing 
services for rental apartments totaled $263 billion in 2005.
      Housing accounts for 32 percent of household wealth. 
Total single-family (owner occupied) housing is worth approximately $15 
trillion, with homeowners' equity valued at around $8 trillion.
      Publicly traded real estate investment trusts (REITs) 
have a total equity market capitalization of $355 billion.
      Real estate partnerships make up the second largest share 
of partnerships, measured in total assets, but represent the largest 
share of both partnerships (1.2 million) and partners (6.6 million 
      Real estate partnerships are responsible for investing 
$2.6 trillion in assets. 59.9 percent of their income comes from long-
term capital gains; 40.1 percent is taxed at ordinary income tax rates.


    Chairman RANGEL. The Chair recognizes the testimony of 
Bruce Rosenblum, Managing Director of the well known Carlyle 
Group and Chairman of the Board of Private Equity Council.


    Mr. ROSENBLUM. Thank you, Chairman Rangel, Ranking Member 
McCrery, and Members of the Committee.
    I am pleased to appear before you today on behalf of the 
Private Equity Council to present our views on the taxation of 
carried interest for partnerships.
    First, a few points about the private equity industry. It 
is not just large firms like Carlyle. It includes hundreds of 
firms, large and small, located in all parts of the United 
States. Even the largest firms today were small businesses as 
recently as 15 or 20 years ago, and they are still owned in 
significant part by their founders.
    Over the years, numerous companies, including household 
names such as Auto Zone, J-Crew and Dunkin Donuts, have been 
turned around or improved by the focused strategies that 
characterize private equity investment, and private equity has 
been extremely profitable for its limited partner investors, 
comprised in significant part of pension funds, universities 
and foundations.
    Private equity activity is driven by firms known as 
sponsors that establish private equity partnerships or funds. 
The sponsor serves as the general partner of the fund, sets the 
fund's strategy and makes the initial capital commitment to the 
    The sponsor raises additional capital from third party 
limited partners, and the respective ownership rights of the 
sponsor and these limited partners are established at the 
inception of the fund.
    Typically, the sponsor's ownership rights include a so-
called carried interest. Partnership structures using carried 
interest are pervasive across many business sectors, not only 
in private equity and venture capital partnerships, but also in 
real estate, timber, oil and gas, small business, and family 
partnerships. They have been used for many years and their tax 
treatment is well settled.
    Equally well settled are the principles defining capital 
gains, and it could not be more clear that private equity 
activity is at the core of the capital gains definition: owning 
and growing the value of businesses.
    While private equity firms also receive many types of 
income that are not capital gains, such as fees, rents and 
interest, it can hardly be disputed that the profits from the 
sale of a business that is owned and improved over many years 
is a capital gain.
    What are the arguments in favor of changing this well 
settled tax treatment? The ones I have heard rest on 
fundamental misunderstandings about private equity ownership 
and the nature of capital gains.
    For example, the premise of H.R. 2834 seems to be that 
capital gains allocated to private equity sponsors should not 
be respected as such because these sponsors provide services to 
the funds they establish, or because they receive profits 
disproportionate to their invested capital.
    But capital gains treatment has never depended on the 
amount or proportionality of capital provided by one investor 
as compared to another, nor is it denied to an investor whose 
efforts, as well as capital, drive an investment's 
    The proprietors of a small business may invest very little 
capital and may generate most of their ownership value through 
personal efforts, but when they sell their business, their 
profit is a capital gain.
    The founder of the technology company receives capital 
gains from the sale of a stock interest even if he or she 
contributed only a tiny fraction of the company's capital.
    We also hear that owners of carried interest bear no risk. 
In truth, private equity sponsors bear many types of risks. For 
starters, private equity partners contribute substantial 
capital to their funds. While this capital may represent only 5 
or 6 percent of a fund's total capital, it usually represents a 
very high percentage of these partners' net worth.
    Private equity general partners also have residual 
liability for obligations of the partnership, and like other 
entrepreneurs, private equity sponsors bear the risk that years 
of effort and foregone opportunities will not result in any 
significant value for their ownership interest.
    Finally, some allege that the current law is inconsistent 
with tax fairness. But the taxation of carried interest 
ownership is fair when understood as part of a tax system which 
for many good reasons taxes long term capital gains at a lower 
rate than the highest marginal ordinary income rates.
    As long as one believes that a lower long term capital 
gains rate is sound policy, there is no inequity in the current 
taxation regime. Indeed, what fairness requires is that the Tax 
Code not single out certain investors or certain types of 
partnerships for less favorable treatment.
    The changes that have been proposed will have economic 
consequences. I do not suggest that private equity investment 
will disappear, but it is reasonable to assume that a dramatic 
tax increase will have a negative impact on private equity and 
other forms of investment, particularly in a fragile market 
    In addition, the proposed tax increase could lead to lower 
returns for pension funds and other investors. It could make 
U.S. private equity firms less competitive with foreign firms 
and foreign governments, and it could drive the center of 
gravity of private equity investing overseas.
    I do not believe these economic risks are justified by 
whatever modest revenue would be raised by the proposals.
    Thank you again for the opportunity to present our views, 
and I would be happy to answer any questions.
    [The prepared statement of Mr. Rosenblum follows:]
 Prepared Statement of Bruce Rosenblum, Managing Director, The Carlyle 
        Group, and Chairman of the Board, Private Equity Council
    Mr. Chairman and Members of the Committee, I am pleased to appear 
before you today on behalf of the Private Equity Council to present our 
views on the taxation of carried interest for partnerships. I am a 
partner and managing director of The Carlyle Group, one of the world's 
largest private equity investment firms, which originates and manages 
funds focused across four major investment areas: buyout; venture and 
growth capital; real estate; and leveraged finance. I also serve as the 
Chairman of the Board of the Private Equity Council, a relatively new 
organization comprising 11 of the leading private equity investment 
firms doing business in the United States.\1\ The PEC was formed to 
foster a better understanding about the positive contributions private 
equity investment firms make to the U.S. economy.
    \1\ The members of the Private Equity Council are Apax Partners, 
Apollo Management LP, Bain Capital, The Blackstone Group, The Carlyle 
Group, Kohlberg Kravis & Roberts & Co., Hellman & Friedman LLC, THL 
Partners, Providence Equity Partners, Silver Lake Partners, and TPG.
The Face Of Private Equity
    Before addressing the carried interest tax issue, I think it is 
important to describe private equity investment. Some have a perception 
that private equity investment is an esoteric form of ``black box'' 
finance practiced by a small cadre of sophisticated investors. The 
truth is that private equity investment is about numerous 
entrepreneurial firms, large and small, located in all parts of the 
United States, that are integral to capital formation and liquidity in 
this country. Some, like Carlyle, do multi-billion dollar transactions; 
others may do transactions of $5 million or less, locally or 
regionally; and, in recent years, spurred by programs like the new 
markets tax credit and empowerment zones, a new cadre of entrepreneurs 
have turned to private equity finance to make capital investments in 
underserved urban and rural communities. Private equity investment is 
also about benefits provided to tens of millions of Americans through 
enhanced investment returns delivered to pensions, endowments, 
foundations and other private equity investors. And private equity 
investment is about thousands of thriving companies contributing to the 
U.S. economy in many positive ways. When you buy coffee in the morning 
at Dunkin' Donuts, see a movie produced by MGM Studios, or shop at Toys 
R Us, J. Crew, Petco, or Auto Zone, to name just a few, you are 
interacting with private equity companies.
Private Equity Investors
    Private equity (PE) investment is driven by private equity firms--
known as general partners (GPs) or ``sponsors''--which establish a 
venture in partnership form (typically referred to as a ``fund''). The 
sponsor invests its own capital in the fund, and raises capital from 
third-party investors who become limited partners (LPs) in the fund. 
The sponsor uses the partnership's capital, along with funds borrowed 
from banks and other lenders, to buy or invest in companies that it 
believes could be significantly more successful with the right infusion 
of capital, talent and strategy.
    Private equity has been extremely profitable for the LP investors 
who receive most of the profits generated by PE funds. Over the 25 
years from 1980 to 2005, the top-quartile private equity investment 
firms generated per annum returns to LP investors of 39.1 percent (net 
of all fees and expenses). By contrast, the S&P 500 returned 12.3 
percent per annum over the same period. This suggests that $1,000 
continuously invested in the top-quartile PE firms during this period 
would have created $3.8 million in value by 2005. The same amount 
invested in the public markets would have increased to $18,200. Private 
Equity Intelligence reports that between 1991-2006, private equity 
funds distributed $430 billion in profits to their LPs. Clearly, top PE 
funds have been exceptional investments over the past quarter century, 
a major reason we are able to continue to attract capital from LPs.
    The largest category of investors benefiting from these exceptional 
returns have been public and private pension funds, leading public and 
private universities, and major foundations that underwrite worthy 
causes in communities across the country. The 20 largest public pension 
funds for which data is available \2\ currently have some $111 billion 
invested in private equity on behalf of 10.5 million beneficiaries.
    \2\ California Public Employees Retirement System, the California 
State Teachers Retirement System, New York State Common Retirement 
Fund, Florida State Board of Administration, New York City Retirement 
System, Teacher Retirement System of Texas, New York City Teachers 
Retirement System, New York State Teachers Retirement System, State of 
Wisconsin Investment Board, New Jersey State Investment Council, 
Washington State Investment Board, Regents of the University of 
California, Ohio Public Employees Retirement System, Oregon State 
Treasury, State Teachers Retirement System of Ohio, Oregon Public 
Employees Retirement Fund, Pennsylvania Public School Employees 
Retirement System, Michigan Department of Treasury, Virginia Retirement 
System, Minnesota State Board of Investment.
    Let me give you a concrete example of what these numbers mean to 
real people. The Washington State Investment Board, which is 
responsible for more than $75 billion in assets in 16 separate 
retirement funds that benefit more than 440,000 public employees, 
teachers, school employees, law enforcement officers, firefighters and 
judges, has been a major private equity investor for 25 years. In that 
time, the WSIB has realized profits on its private equity investments 
of $9.71 billion. Annual returns on private equity investments made by 
the board since 1981 have averaged 15 percent, compared to 10.1 percent 
for the S&P 500. Put another way, the excess returns generated by 
private equity investments have fully funded retirement plans for 
10,000 WSIB retirees.
    Other clear benefits of private equity investment include 
strengthened university endowments better able to extend financial aid 
and create greater educational opportunities for students in virtually 
every state in the country, and strengthened foundations better able to 
carry out their social and scientific missions.
Private Equity In Practice
    The best way to understand private equity ownership is to see it in 
practice. The PEC has been developing a series of case studies 
documenting the ways private equity firms grow companies and make them 
more competitive. I want to share three concrete examples from 
Carlyle's experience.
    In 2005, we acquired a company called AxleTech International 
Holdings, Inc., which designs and manufactures drivetrain components 
for growing end markets in the military, construction, material 
handling, agriculture and other commercial sectors. AxleTech was a 
solid business, but it was focused on the low margin, low growth 
commercial segment of the market. Under Carlyle's strategic direction, 
AxleTech developed a concerted business development initiative to offer 
its axle and suspension solutions to military vehicle manufacturers in 
need of heavier drivetrain equipment to support the heavy armored 
vehicles required to protect American soldiers in Iraq and Afghanistan. 
At the same time, AxleTech expanded its product and service offerings 
in its high margin replacement parts business while continuing to grow 
its traditional commercial business. The result is that since Carlyle's 
acquisition, AxleTech sales have increased 16 percent annually and 
employment has increased by 34 percent from 425 to 568, with new jobs 
created in AxleTech's facilities in Troy, MI, Oshkosh, WI, and 
overseas. Indeed, it is one of the very few U.S. automotive-related 
companies that are growing in this challenging environment for the 
industry. And AxleTech's job growth does not take into account the 
ripple effects on AxleTech's suppliers which are experiencing new 
hiring and increased capital investments.
    In 2002, we acquired Rexnord Corporation, a Milwaukee-based 
provider of power transmission, bearing, aerospace, and specialty 
components. While healthy, it was a neglected division of a large 
British conglomerate. After being acquired by Carlyle and its partners, 
the company refocused its business on lines with the strongest growth 
prospects, took steps to improve product quality, inventory management, 
procurement and customer delivery, made key strategic acquisitions, and 
developed a plan to expand business in the growing China market. Under 
Carlyle's ownership, total revenues rose from $722 million in 2003 to 
$1.08 billion in 2006 and enterprise value doubled from $913 million to 
$1.8 billion.
    Finally, Bain Capital, THL Partners and Carlyle bought Dunkin' 
Brands (Dunkin' Donuts and Baskin-Robbins ice cream shops) in 2006 from 
a European beverage conglomerate which gave the business low priority 
and minimal attention. Under private equity ownership, investing in 
long-term growth is a key business strategy. Jon Luther, CEO of Dunkin' 
Brands, recently told the U.S. House of Representatives Financial 
Services Committee, ``The benefits of our new ownership to our company 
have been enormous. Their financial expertise led to a ground-breaking 
securitization deal that resulted in very favorable financing at 
favorable interest rates. This has enabled us to make significant 
investments in our infrastructure and our growth initiatives. . . . 
They have opened the door to opportunities that were previously beyond 
our reach.'' Today, Dunkin' Brands is expanding west of the 
Mississippi, and is on track to establish franchises that will create 
250,000 new jobs--with the further benefit of creating a new class of 
small business entrepreneurs for whom owning multiple Dunkin' Donuts 
franchises is a way to achieve personal financial security and success.
Understanding Private Equity Partnerships
    In order to understand the issues relating to the taxation of 
``carried interest,'' it is helpful to review the structure of private 
equity partnerships, how they are formed and owned, and how they 
    As noted above, private equity investment is typically conducted 
through a private equity partnership, or ``fund.'' The fund is formed 
by a private equity firm, or ``sponsor,'' which is itself typically a 
partnership comprised of the founders and other individual owners of 
the private equity firm. Typically, the sponsor (or one of its 
affiliates) serves as the GP of the fund and charges an annual 
management fee to the fund that ranges from one to two percent of the 
assets under management. In addition, the sponsor (often through 
contributions by its individual owners) invests its own capital in the 
fund, which generally constitutes between 3-10 percent of the 
partnership's overall investment capital.
    A fund's partnership agreement establishes the parties' respective 
ownership rights and responsibilities from the inception of the fund. 
Most PE funds are designed to ensure the investors' right to receive a 
return of their capital and a minimum level of profit before the 
sponsor receives any so-called ``carried interest.'' Thus, under a 
typical arrangement, when a PE fund sells assets at a profit, the 
investors are entitled first to their capital back, plus an additional 
eight to nine percent per annum return on their capital (a so-called 
``hurdle'' rate), as well as reimbursement for any fees paid to the 
sponsor or its affiliates. Any proceeds remaining after the hurdle is 
cleared and fees are reimbursed are distributed in accordance with the 
partnership agreement, typically 80 percent to the investors and 20 
percent to the sponsor. This allocation of profits to the sponsor is 
commonly referred to as a ``carried interest.''
    The carried interest is also typically subject to a ``clawback'' 
provision that requires the PE firm (and, thus, the individual partners 
of that firm) to return distributions to the extent of any subsequent 
losses in other investments of the fund, so that the sponsor never ends 
up with more than its designated portion (e.g., 20 percent) of profits. 
If the fund generates losses on some investments, the sponsor shares in 
the downside because any profits from its carry on successful 
investments are offset by the deals gone sour. If enough deals in a 
fund do poorly, the sponsor could be left with no carry at all. Thus, 
the sponsor's retention of a carried interest in its funds effectively 
acts as both a risk-sharing mechanism and as an incentive to find the 
right companies in which to invest, to use its entrepreneurial skills 
to improve those companies, and ultimately to deliver outstanding 
returns for LP investors.
    Despite the impression you might have, not all profits realized by 
a private equity sponsor from a fund are taxed at long-term capital 
gains rates. Those profits may include many elements taxed at higher 
rates, including rent taxed as ordinary income, interest taxed as 
ordinary income, and, on occasion, short-term capital gains. The 
sponsor (like any other partner of a partnership) is taxed on its 
allocated share of profits based on the underlying character of the 
income produced at the partnership level. It is only the allocation of 
what is indisputably long-term capital gains income--the profits from 
the appreciation in value of long-lived capital assets, such as the 
stock of a corporation--that is taxed at ``differential'' capital gains 
rates. However, since the core objective of a private equity firm is to 
acquire businesses, improve their value over the course of many years, 
and ultimately sell them for a profit, it is typically the case that a 
large portion of the profits generated by a private equity fund are, in 
fact, long-term capital gains.
Private Equity Tax Issues
    The debate over carried interest taxation has many elements, some 
of which are technical. I would like to focus my testimony on 
correcting a series of fundamental mischaracterizations that have 
emerged as this debate has unfolded. But I have also attached to my 
testimony a paper prepared for PEC by one of the country's leading tax 
professors, David Weisbach of the University of Chicago Law School, 
which addresses many of the relevant policy and technical tax issues 
associated with this debate.
A Carried Interest Is Not ``the Equivalent'' of a Stock Option.
    Some have argued that a carried interest is the equivalent of a 
stock option given to a private equity sponsor in exchange for its 
``services,'' and thus should be taxed as ordinary income. I understand 
the surface appeal of this argument. But upon analysis, it comes up 
hollow. While carried interests and stock options are similar in the 
general sense that they increase in value based on increases in the 
value of underlying businesses, they differ in many fundamental 
    First, options arise out of an employer-employee relationship. A 
stock option is a right granted by a corporation as compensation to an 
employee.  By contrast, a private equity sponsor with a carried 
interest is not an ``employee'' of the limited partners, but rather is 
an owner of the venture from the outset, who maintains control over the 
management and affairs of the venture. In most cases, the venture would 
not even exist without the sponsor's ideas, driving force, and skill.
    Thus, a ``carried interest'' profits interest is an ownership 
interest in a business enterprise (a fund), created by the founders of 
that business enterprise in connection with their formation of the 
venture. In contrast to an option, the general partner need not 
exercise anything to be considered an owner of the venture and receives 
allocations and distributions in accordance with the partnership terms 
from the outset. In these respects, a carried interest has much more in 
common with ``founders stock'' in a corporation than a corporate stock 
    Partnership interests with carried interest allocations are also 
typically subject to terms and restrictions (e.g., minimum return 
hurdles, clawback provisions) not associated with stock options. 
Moreover, while stock options are used in private companies (including 
portfolio companies owned by private equity firms), they are most 
prevalent in public companies, where (once exercisable) they entitle 
the holder, at any time of his or her choosing, to acquire a liquid 
security that can almost immediately be converted into cash. If, 
subsequently, the value of the corporation decreases and its 
stockholders suffer losses, there are no consequences for the option 
holder who has exercised and taken this cash. In contrast, the holder 
of a carried interest typically remains at risk for the investment 
returns delivered to limited partners over the entire life of the 
business enterprise (the fund), has residual risk if the venture fails 
(as discussed further below), and receives cash with respect to the 
carried interest only concurrent with the limited partners' receipt of 
cash profits. Thus, the ``alignment of interests'' between limited 
partners and holders of carried interests is much more complete than 
that of stockholders and holders of stock options.
Holders of Carried Interests Bear Significant Economic Risks
    Proponents of a tax change have also claimed that owners of carried 
interests bear no risk, and thus should not be entitled to capital 
gains treatment on their profits. In truth, private equity sponsors 
bear many types of entrepreneurial risk.
    First, sponsors (and their individual partners) contribute 
substantial capital to their private equity funds. At Carlyle, this can 
represent hundreds of millions of dollars invested in a single fund. 
Whatever percentage of total partnership capital this investment 
represents, it typically represents a very high percentage of the 
private equity partners' capital available for investment. This capital 
is subject to risk of loss, in whole or in part.
    Moreover, like other entrepreneurs, private equity sponsors (and 
their individual partners) contribute ideas, expertise, and years of 
effort to the private equity partnerships they form and own. Like other 
entrepreneurs, these sponsors (and their individual partners) bear the 
risk that this investment will not result in any significant value in 
their ownership interests. Private equity partners forgo other 
opportunities that provide greater security and guaranteed returns in 
exchange for the greater upside potential provided by ownership of 
their interests in private equity partnerships. But it is worth noting 
that, according to Private Equity Intelligence, 30 percent of the 578 
private equity, venture, and similar funds formed between 1991-97 did 
not deliver any carried interest proceeds to their GPs. The risk of 
``coming up empty'' is real.
    Private equity general partners also have liability for the 
obligations of the partnership to the extent the partnership is not 
able to meet such obligations, and they may be asserted to have 
liability to third parties for certain actions of the partnership. In 
addition, private equity general partners contribute their goodwill, 
business relationships and reputations to their funds, and these assets 
are subject to impairment.
    Finally, private equity general partners may be obligated as a 
business matter (even if not legally obligated) to suffer out of pocket 
losses on the operations of a sponsored partnership. For example, 
Carlyle formed a fund in early 2000 to pursue a specified subcategory 
of private equity investments, and at the time the fund had a high 
level of demand from limited partners. About two years later, however, 
there had been a major shift in the prospects for these types of 
investments, and many of the early investments in the fund were in fact 
performing badly. At the low point, we valued the capital in these 
initial investments at less than 40 cents on the dollar. As a gesture 
of goodwill to limited partners, Carlyle reduced the level of 
management fees; refocused the investment objectives of the fund; gave 
limited partners a one-time option to reduce their unfunded commitments 
(some actually chose to increase commitments based on the refocused 
strategy); and, at additional cost to the firm, brought on additional 
investment professionals to help execute the strategy for prospective 
fund investments. Carlyle continued to devote considerable attention 
and expense to this fund, with the objective of at least returning 
limited partner capital, even though it was highly unlikely that there 
would ever be sufficient profits in the fund to support any allocation 
of carried interest profits. In fact, after several years of effort, it 
is now clear that the limited partners will receive all of their 
capital back with a modest profit; there will be no profits allocated 
to ``carried interest'' in this fund (since the minimum profitability 
hurdles will not be cleared); and the fund will be an out-of-pocket 
loss to Carlyle (i.e., expenses will exceed fees).
Private Equity Funds and Their Partners Own Capital Assets
    A third line of argument holds that private equity sponsors are not 
owners of a capital asset and thus cannot be eligible for a capital 
    However, it is clear that the underlying economic activity pursued 
by private equity firms is at its core about the creation of capital 
gain--i.e., ownership and growth in the value of businesses. There can 
be no question that capital gains are created when these businesses 
(typically corporations, which pay their own level of corporate taxes) 
are acquired by a private equity fund, held for the long-term, and sold 
at a profit.
    As discussed above, the carried interest is simply a feature of the 
sponsor's ownership interest in the business enterprise (i.e., the 
fund) that acquires these capital assets. Indeed, it is the sponsor 
that establishes the private equity fund, sets the investment strategy 
for the fund and makes the strategic decisions on which businesses to 
acquire, how to finance the acquisitions and how to run the businesses. 
It is the sponsor that makes the initial commitment of capital to the 
private equity fund. And it is the sponsor that raises capital from the 
limited partners, who are offered in return a form of ``financing 
partnership interest''--an ownership interest that typically entitles 
them to a return of their capital, the first allocation of profits from 
that capital until they have received a minimum return or ``hurdle,'' 
and 80 percent of the profits from that capital once the ``hurdle'' has 
been satisfied. The sponsor retains an ownership interest that entitles 
it to a return of its invested capital, the profits attributable to 
that capital, and 20 percent of all other profits once the ``hurdle'' 
has been satisfied. In sum, a private equity sponsor clearly has 
``ownership'' in the capital assets held by a private equity 
partnership and, like any other owner, should be taxed at capital gains 
rates on the profits from the sale of those assets.
Private Equity Sponsors Do Not Benefit From ``Loopholes''
    A recurring mantra of tax change proponents is that they are simply 
attempting to ``close a loophole'' that has been ``exploited'' by 
private equity sponsors. Nothing could be further from the truth.
    Partnership structures using carried interests, or profits 
allocations ``disproportionate'' to invested capital, are pervasive 
across a broad swath of business sectors. These ownership structures 
have been used for many years in many contexts, and are commonplace in 
all forms of partnerships, including real estate, oil and gas, venture 
capital, small business, and family business partnerships. The flexible 
partnership structure, in which capital, ideas and strategic management 
can be provided by different partners, who split profits according to 
agreement, has been critical to the legacy of entrepreneurship that 
characterizes the success of American business. And the tax treatment 
of this ownership structure is well settled. It can hardly be called a 
    Likewise, the principles underlying what is and what is not a 
capital gain are well settled. Capital gains treatment is not tied to 
subjective evaluations of the level of ``risk'' taken by an investor or 
the ``worthiness'' of an investment; nor is it dependent on the amount 
or ``proportionality'' of capital provided by one investor as compared 
to another investor; nor is it denied to an investor whose efforts, as 
well as capital, drive an investment's profitability. Instead, the 
rules governing capital gains are simple and straightforward: if you 
own a capital asset, hold it for more than a year, and sell it for more 
than you paid for it, you are taxed at long-term capital gains rates.
    Thus, the proprietors of a small business may invest very little 
capital in the business, and may generate most of their ownership value 
through their personal efforts over many years; when they sell the 
business, their profit is nonetheless treated as capital gain. An 
entrepreneur receives capital gain treatment when he or she buys a run-
down apartment building at a ``fire sale'' price, invests years of 
labor rehabilitating and leasing the building, and sells it at a 
profit. The founder of a technology company may put very little capital 
into a business formed to develop his or her ideas. Over the years, as 
he or she raises equity financing from third parties, his or her 
ownership share may significantly exceed his or her share of overall 
capital invested in the business. Nonetheless, the founder will receive 
capital gains treatment on the sale of his or her stock ownership, even 
though he or she has provided only a small percentage of the overall 
capital invested in the business.
``Tax Fairness'' Does Not Require Treating Carried Interest Proceeds As 
        Ordinary Income
    Perhaps the signature argument advanced by proponents of a tax 
change is that such a change is needed to restore ``fairness'' to the 
tax system.
    Tax fairness is an important value. All of us should pay our fair 
share of taxes. And I believe that the taxation of carried interest 
ownership interests is fair when understood as part of a tax system 
which, for many good policy reasons--encouraging long-term investment 
and risk-taking, avoiding ``lock-in'' (i.e., significant disincentives 
to selling a capital asset), mitigating the double taxation of 
corporate-produced returns, and minimizing the tax on ``inflationary'' 
returns--taxes long-term capital gains at a lower rate than the highest 
marginal rates applicable to ordinary income. In each case, the 
justifications for a differential long-term capital gains rate apply 
equally well to capital gains derived from carried interests as they do 
to capital gains derived from other forms of ownership interests. Thus, 
as long as one believes that taxing long-term capital gains at a lower 
rate is sound tax policy, something Congress has affirmed repeatedly, 
there is no ``inequity'' in the current taxation of capital gains 
attributable to carried interests. Indeed, I believe that fairness 
requires that the Tax Code not single out certain investors for less 
favorable treatment.
    Moreover, it is worth noting that private equity partners do not 
exclusively receive long-term capital gains, nor do they pay taxes at 
an ``effective tax rate'' of 15 percent. As noted above, profits 
allocated to carried interests often include elements taxed as ordinary 
income, and private equity firms receive fees taxable as ordinary 
income. In addition, many private equity partners receive salary and 
bonus income that is taxed as such. It is only to the extent that they 
receive their allocable share of long-term capital gains attributable 
to their ownership interests that private equity partners are taxed, 
fairly, at long-term capital gains rates.
    In fact, many of the commentators who have raised ``fairness'' 
issues about carried interest taxation have also expressed the view 
that the ``bigger problem'' is the differential long-term capital gains 
rate itself, which such commentators say should be abolished 
altogether. Regardless of whether one agrees with this position (I do 
not), I believe it is at least more ``conceptually coherent'' than 
carving out for ``special treatment'' the capital gains received by 
private equity and venture capital firms, as HR 2834 seeks to do. There 
is no justification for treating capital gains allocated to private 
equity sponsors less favorably than other capital gains--including 
those earned by other successful investors and businessmen, whether 
they be Warren Buffett, Bill Gates, or persons of more modest means who 
have successfully invested in the stock market or a small family 
    Nor is it accurate to describe carried interest taxation, as some 
have, as a ``tax break'' that helps the ``rich get richer.'' If 
anything, the history of the carried interest is that of the ``not 
particularly rich''--and the ``not rich at all''--getting richer. There 
are numerous examples of private equity, real estate and oil and gas 
entrepreneurs from modest backgrounds building wealth through value-
creating enterprises that included carried interests as part of their 
ownership structure. The relentless media and political focus on a 
handful of highly successful founders of large private equity firms 
ignores the fact that these individuals (like many other successful 
business founders) were not necessarily ``rich'' when they started 
their businesses.
    Also ignored are the many thousands of business founders who employ 
carried interest ownership structures in small to medium size 
enterprises, or in ``start up'' businesses that are still struggling to 
get themselves off the ground.
    Ironically, H.R. 2834 and similar proposals would create more of a 
``rich get richer'' environment, by providing that capital gains 
generated in certain types of partnerships will be respected as such 
only to the extent allocated to partners ``in proportion'' to invested 
capital. Thus, only those who are in a position to provide significant 
risk capital--and not those who build these businesses through their 
ideas, vision and effort--will be in a position to derive significant 
benefit from differential long-term capital gains rates.
    This is one reason why the newly formed Access To Capital 
Coalition, which represents many African-American and women 
entrepreneurs and investment firms, has said that ``Carried interest 
has played a vital role in attracting highly talented and committed 
risk-taking minority and women entrepreneurs to the investment capital 
industries. It also has served, and has the capacity to serve to even 
greater degrees, as a mechanism for increasing minority and women 
entrepreneurs' access to investment capital and capital investments in 
underserved urban and rural communities.
    ``We believe that because of its direct impact on minority- and 
women-owned firms, and its broader impact on the investment capital 
industries as a whole, the legislation could impose a significant 
financial burden on minority- and women-owned investment capital firms, 
both with respect to their profitability and maintaining and improving 
their access to investment capital, vertically and horizontally. These 
developments could threaten the viability and stifle the growth of many 
minority- and women-owned firms and managers in the industries. Also, 
because of its larger effect, the legislation has the potential to 
significantly curtail access to investment capital for minority and 
women entrepreneurs and many of the communities that they serve.''
The Law Of Unintended Consequences
    Finally, proponents of the proposed legislation claim there is no 
risk that it will create adverse consequences for long-term investment 
or the economy. I wonder how they can be so sure. I have been careful 
not to declare that the sky will fall or that private equity investment 
will disappear if these changes are enacted. Quite the contrary, 
private equity firms--at least those, like Carlyle, that have become 
large and well established--will survive. But predicting how markets 
will respond to such a huge change in the economic structure of private 
equity investment--or assuming that such activity will go on as if 
nothing happened--is naive, especially during a time of considerable 
market sensitivity to external events.
    I cannot predict what actions Carlyle or any other PE firm will 
take in response to a tax change. And no one can predict the 
consequences of a tax change with absolute certainty. Tax costs are but 
one of many variables affecting private equity investment activity. 
Other factors, including interest rates, access to capital, market 
liquidity, and sector and macro economic trends are all relevant. But a 
change in carried interest taxation is clearly a relevant variable in 
the extent to which such activity will be pursued. And it is worth 
noting that since capital gains rates were lowered, the pace of private 
equity investment activity has increased significantly. I think it is 
reasonable to believe that a dramatic tax increase will indeed have a 
negative impact on private equity investment.
    Of course private equity sponsors will continue to meet their 
responsibilities to their limited partners, even if the ``rules of 
play'' are changed in the middle of the game. And, of course, we will 
pay taxes on whatever basis is determined by Congress. But over time, 
investment structures will change; incentives for new fund formation 
(or formation of new PE firms) will be diminished; and there will 
inevitably be less activity in the sector, at least by U.S. firms with 
U.S. owners. I believe Congress ought to proceed very carefully before 
risking an adverse impact on a form of investment that has been a major 
and positive force in strengthening U.S. competitiveness, giving 
struggling or failing businesses a new lease on life, and pumping 
critically needed capital into the economy.
    In addition to the general economic harm that could occur from 
diminished private equity investment activity, let me cite three 
specific potential consequences which should cause concern.
    Lower Returns For Investors: It may be that sponsors can develop 
new financing models that ensure the same level of return to PE firm 
partners and our LP investors--although, if we do, it is likely that 
these new structures would significantly reduce any anticipated tax 
revenue expected from this change. But alternatively, PE sponsors may 
look at ways to offset the higher tax burden through changes in 
economic terms that will adversely impact their LPs. A likely result 
would be the eventual reduction in the returns of pension funds, 
endowments, foundations, and other investors who rely on these returns 
to carry out important social missions. This is exactly why Pensions 
and Investments Magazine, the leading trade journal for many such 
investors, recently said in an editorial that ``pension funds, 
endowments, and foundations, even though they are tax-exempt 
institutions, might end up paying the increased taxes Congress is 
considering imposing on the general partners of hedge funds and private 
equity firms. . . . The result: lower returns for the pension funds, 
endowments, and foundations.''
    Loss of Competitiveness: Another possible consequence is that U.S. 
firms will become less competitive with foreign PE firms, and even 
foreign governments with huge investment war chests. The Wall Street 
Journal noted in a recent article that the world's capital is going 
global, reporting that many sovereign governments are actively seeking 
investment opportunities worldwide. They, and the major foreign PE 
firms with whom we compete, will not be as constrained by taxes, and 
will be in a more competitive position to acquire companies than U.S. 
PE firms with a higher ``cost of capital.''
    The U.S. is the dominant capital market in the world, and this 
Committee has been very supportive of protecting that status. But it is 
odd that, as governments the world over are striving to make their tax 
systems more competitive to attract foreign capital and challenge U.S. 
dominance, this Congress is considering a proposal that would go in the 
opposite direction.
    Migration Of Capital Activity: A third possible consequence is that 
private equity activity will increasingly move overseas. There has been 
considerable misunderstanding about this risk, with some dismissing the 
prospect of major U.S. PE firms relocating. However, the concern is not 
that PEC members or other well-established U.S. private equity firms 
will relocate their U.S. operations--indeed, I think this is not highly 
likely. Rather, the question is whether the U.S. will be the home for 
the next generation of PE entrepreneurs, who will have discretion to 
start their businesses wherever the climate is most favorable. Will the 
``center of gravity'' migrate to Europe, Asia, the Middle East, or 
Eastern Europe, where firms will tend to seek first investment 
opportunities in their own regions? Will the U.S. see growth capital 
now invested to strengthen American companies shifting to help foreign 
firms better compete against U.S. businesses? And are the perceived 
benefits of this change in tax policy worth taking that risk?
Tax Treatment of Publicly-Traded Partnerships
    I do want to address an issue that has received considerable 
attention recently. Although the focus of this hearing is not on the 
tax treatment of publicly traded partnerships, I would like to provide 
the committee with a few observations regarding legislation which would 
deny partnership treatment to certain publicly-traded partnerships that 
derive income (directly or indirectly) from services provided as an 
investment advisor or from asset management services provided by an 
investment advisor.
    We oppose the bill on several grounds. It inappropriately singles 
out our industry for exclusion from the general rules for qualification 
as a PTP. In doing so, it will discourage private equity firms from 
going public in the U.S., impeding potential benefits both to such 
firms and the U.S. capital markets. Those PE firms which do go public 
will be subject to a ``triple taxation'' regime, with the same income 
potentially taxed at the portfolio company level, at the public entity 
level, and at the investor level. And, despite all of this dislocation, 
the incremental tax revenue produced by the change is unlikely to be 
    Virtually all private equity firms are organized as partnerships or 
other ``flow through'' entities today. Thus, going public as a PTP 
simply preserves the status quo for tax purposes. There is no abuse or 
tax evasion involved. In fact, public PE firms would generally conduct 
a portion of their operations through a corporation, thus subjecting to 
corporate taxation income which is not subject to such tax under 
private ownership.
    Under the current law, there is a general standard for PTP 
qualification: 90 percent of income must be qualified income, such as 
dividends, interest and capital gains. The private equity industry is 
not seeking ``special treatment'' but simply the ability to use a 
structure that is made available to, and used by, other sectors, such 
as oil and gas. There is no justification for singling out PE firms for 
adverse treatment.
    Indeed, exclusion of PE firms is particularly inappropriate given 
that their activities center around investments in corporations that 
are themselves taxable entities.
    Thus, income earned by these firms would be subjected to three 
levels of taxation: (i) the first level of corporate tax would be paid 
by the investment funds' portfolio companies on their operating income; 
(ii) the second level of corporate tax would be paid by the PE sponsor 
on its share of the gain from the sale of the portfolio companies or on 
distributions received from such companies; and (iii) the third level 
of tax would be paid by the public owners of the PE sponsor when they 
sell their shares.
    Because of the overall structure, the dividends-received-deductions 
would generally not be available to ameliorate the three levels of tax. 
Thus, the PTP bill appears to impose a penalty on publicly-traded PE 
firms that corporate enterprises in foreign jurisdictions do not bear, 
and which most other corporate enterprises in the U.S. do not bear (by 
virtue of consolidation or the dividends-received-deduction).
    This penalty will constrain the ability of mature private equity 
firms to raise capital in the U.S. public markets that may be required 
to compete in an intense and increasingly global business. In turn, 
U.S. public market investors may be deprived of an opportunity to 
participate in the next phase of growth of this sector, and the 
competitiveness of the U.S. capital markets will suffer.
    We understand that the bill was driven at least in part by a 
concern over erosion of the corporate tax base. However, as noted 
above, conversion by private equity firms to PTPs would simply preserve 
the status quo. Other financial firms organized as C corporations have 
not shown an inclination to organize as PTPs despite the opportunity to 
do so. Financial corporations contemplating a change to PTP status 
generally would face significant corporate taxes upon conversion, which 
will often be prohibitive.
    Finally, the transition to public ownership may be important in 
succession planning and allowing a mature PE firm to survive beyond its 
founders. By discouraging and possibly precluding such steps, the bill 
imposes unfair limits on the ability of these firms to fully realize 
their potential.
    I would like to thank Chairman Rangel and Ranking Member McCrery 
again for the opportunity to present our views on these important 
issues. We look forward to working with you and the other Members of 
the Committee in the weeks ahead. I would be happy to answer any 
questions you might have regarding these issues.


    Chairman RANGEL. Thank you, Mr. Rosenblum. Members are 
waiting to ask questions. I just want to confine mine to Mr. 
    Mr. Silver, are there people in the corporate world that 
manage funds and do the same thing as equity partners do in the 
private sector, and you might say they put in sweat equity 
because they are working hard in order to protect and expand 
the profitability of the funds.
    I want to make it clear to this panel, no matter what the 
testimony is, if at the end of the day we can reach the 
conclusion that the system as it exists is equitable because 
one group formed a partnership, the other group formed a 
corporation, we have to find some reason, and I am not 
convinced by your testimony, Mr. Silver, that what you are 
doing is that much different from what somebody in the 
corporate investment banking business is doing, especially if 
we are talking about no direct money investment being made.
    Could you share with me why there should be this difference 
in how the fee that is received by the person that is doing the 
work, the good work for venture capital, should be different 
from your competitor whose fee is treated as ordinary income 
and your group's fee would be considered as an investment and 
return on capital?
    Mr. SILVER. Yes, Mr. Chairman. I would be happy to try to 
address that. I assume by your question that you are actually 
referring to in the case of venture capital, corporate 
venturing as opposed to investment banking, per se.
    Chairman RANGEL. Those that you normally consider a 
competitor, that you are doing such extraordinary work that 
your clients would believe that is so different, and one would 
assume that you are entitled to a different type of 
    It has been difficult for a lot of Members of this 
Committee, without targeting you or anyone else, to see how you 
feel comfortable in distinguishing your work from the corporate 
work and deal with the same type of thing.
    Mr. SILVER. I think there are a number of important 
distinctions. I will simply in the interest of time identify a 
    One was mentioned here among the panelists' remarks, and 
that is the general partners of individual venture funds are 
significant investors in their own funds. A substantial portion 
of the net worth of the individual general partners is 
generally also in the pool of capital that is being invested.
    Chairman RANGEL. Do you have to make any investment at all 
as a partner in order for your fee to be treated as capital 
gains? Do you have to put any money at all in the venture?
    Mr. SILVER. Every general partner at Core Capital and every 
general partner in every venture fund I am aware of has made a 
significant personal financial investment.
    Chairman RANGEL. I thought you spoke a lot about sweat 
equity in terms of the value of the investment.
    Mr. SILVER. I did. I was trying to originally answer the 
question you asked about the distinction between independent 
venture funds and corporate venture funds.
    The first and most obvious distinction is that----
    Chairman RANGEL. I do not think there is much difference in 
how those who invest their funds are treated as capital gains 
or the return on investment. That is not a problem. You 
understand that? It is not a problem that the partner is 
investing capital, how the return on the capital they invested 
is treated, that is not a problem.
    What I want you to address is those services that are 
provided that are not direct financial investments, how that, 
too, is treated as capital gains. That would help me.
    Mr. SILVER. In the day to day practical world of venture 
capital, it is almost always the case that independent venture 
funds are in fact the lead investors in starting new companies, 
and the corporate venture funds, to the extent they 
participate, tend to be follow on providers of capital.
    The actual work, the sweat you are referring to, the sweat 
equity you referred to----
    Chairman RANGEL. You referred to.
    Mr. SILVER. That I referred to that you were making 
reference to, is largely undertaken by firms like mine. We work 
side by side along with the entrepreneurs to build these 
companies from scratch. We are involved from the outset in 
doing everything that an individual does who puts a company 
    We hire management teams. We build strategic plans.
    Chairman RANGEL. People who come from the corporate world, 
they do not do these things that you do?
    Mr. SILVER. Corporations do. The venture arms of 
corporations, which is what I think you are referring to, are 
generally providers of capital to invest in ideas and emerging 
companies which generally have some potential strategic 
importance to the corporation.
    Chairman RANGEL. I am only talking about services rendered 
that are not direct investments. I want to make it clear. You 
invest, whether you are a partnership, a corporation. To 
someone like me, it makes sense they should get the same return 
on their investment.
    I just want you to try to help me to distinguish between 
people who make no direct capital investment, they are just 
concerned about going into minority communities and taking 
projects on that no one else would take, bringing people 
together, reforming the system, putting in sweat equity, at the 
end of the day, somebody gets an ordinary income and somebody 
else gets capital gains.
    The person that gets the capital gains, for purposes of our 
discussion, did not put up any equity other than sweat equity.
    That is the problem as to whether or not there is some 
other reason----
    Mr. SILVER. I do not know of any venture fund in which the 
partners do not as part of the pool of equity being invested 
participate themselves directly--who do not participate 
themselves directly, and I do not know of any venture fund 
where it is not true that the investment is going into the 
creation of a capital asset.
    The creation of the company is the creation of the capital 
    Chairman RANGEL. Mr. McCrery.
    Mr. MCCRERY. Thank you, Mr. Chairman.
    I want to ask about two things, because we have talked 
about this some already today. Number one is risk. Several of 
you talked a good bit about risk and how general partners have 
inordinate risk compared to say somebody working for UBS or 
CitiBank or whatever.
    Number two, if the Levin bill were to pass, are there not 
ways that businesses, Mr. Stanfill, like yours, or Mr. 
Rosenblum, like yours, could reorganize and get around this, to 
get the same capital gains treatment?
    Mr. ROSENBLUM. I think the most fundamental point here is 
not that we are harder working or smarter or more deserving in 
some general sense than anybody else. We are owners. We form 
businesses. We take risks, both with our capital and with our 
time, and with being a manager with residual liability for the 
business, and with worrying on occasion of going out of pocket 
to swage the limited partners that we have raised money from.
    We are not asking to be treated better or worse than other 
businessowners, but we are asking to be treated like 
businessowners. I think risk is certainly part of that.
    In terms of alternate ways of approaching it, I think one 
of the striking things about the bill that has been proposed 
here is that it changes taxation only on a particular type of 
structure and a particular type of financing.
    It does not change the taxation on the underlying activity 
that we are performing, which is going out, buying a business, 
improving it, and selling it.
    You have to ask yourself is there a different way to 
conduct that business? Is there a different way to raise that 
financing? Of course, there is.
    We have not studied all the alternatives that may be 
    Mr. MCCRERY. But you probably would, would you not, if this 
bill were to pass?
    Mr. ROSENBLUM. I am sure we would have many accountants and 
lawyers on our door step if a bill is passed to talk to us 
about it. There are very simple things that have already been 
mentioned by some of the other panels, taking debt financing 
and pursuing it that way.
    What we are getting from limited partners is a form of 
financing. It has been very beneficial for them because they 
get to participate in the vast majority of the profits that are 
created by this business, but there are other ways to obtain 
    Mr. IFSHIN. Representative McCrery.
    Mr. MCCRERY. Quickly, because I want to give Mr. Stanfill a 
    Mr. IFSHIN. I will be very brief. As it relates to risk, in 
a real estate setting, the general partner frequently takes on 
risk that if a project runs into difficulty or fails, can cause 
them to incur actual dollar losses.
    I think it is important to understand that because in many 
fund settings, that may or may not be potentially possible. I 
do not know. If a real estate developer sets out to develop a 
project, gets his entitlements, gets his limited partners lined 
up and gets a construction loan, he probably is going to have 
to personally guarantee that construction loan. If that deal 
goes bad, that developer could very well lose millions of 
dollars against a potential profit that may have been a 
fraction of what he actually loses.
    Mr. MCCRERY. Mr. Stanfill, do you have any thoughts on 
    Mr. STANFILL. Just a quick comment, sir. It strikes me that 
the biggest risk that my partners and I take is making poor 
judgments in our investments and not earning a good return for 
our investors, and therefore, not earning a carried interest 
for ourselves.
    We are well compensated whether--I have been well served by 
capital gains, clearly. I do not think--it is a fairness issue 
with me. I do not think I pay a particularly heavy price by 
paying the same rate on my compensation that other people pay.
    Mr. MCCRERY. Mr. Stanfill, if you take this conclusion to 
its logical extension, the conclusion that Mr. Rosenblum 
reached, that of course, we will organize in some different 
business set up to get the same treatment, because the 
underlying--the treatment of the underlying asset and sale of 
the asset is not changed by this bill, so the logical extension 
of that is we will chase that next form of business 
organization, and then the next form, until we do not have any 
preferential treatment for capital gains any more.
    Is that your desire? Would that solve your fairness problem 
if we just did not have preferential treatment for capital 
    Mr. STANFILL. Not capital gains that apply to compensation, 
    Mr. MCCRERY. No, I am talking about capital gains for the 
sale of a capital asset. Do you want to keep that preferential 
treatment in the Tax Code or not?
    Mr. STANFILL. I have no trouble treating all income, be it 
dividends, capital gains, ordinary income, at the same rate. We 
are talking in that case about a total revision of the Tax 
Code, and I think that is unlikely.
    Mr. MCCRERY. Right. That is a totally different question. 
We have had a couple of witnesses today who have suggested that 
there should not be preferential treatment for capital gains, 
and that discussion we have not really explored very well in 
this Committee. I am hopeful that is not the intent of the 
authors of the legislation that we are discussing.
    Chairman RANGEL. Mr. Crowley from New York.
    Mr. CROWLEY. Thank you, Mr. Chairman. Let me thank the 
panel for their steadfastness and remaining and contributing to 
the discussion today.
    I have been following this issue, as many of you know, for 
some time now, and listening to all sides, and have had an 
opportunity to meet with some of you privately.
    Mr. Rosenblum, you stated previously that private equity 
investments, and I quote, ``Will not wither up and die,'' if 
the Tax Code is changed, but that ``Rather, there will be deals 
that won't get done. There will be entrepreneurs that won't get 
funded, and there will be turnarounds that won't be 
    Additionally, Mr. Ifshin, you have stated ``If current law 
is changed to tax carried interest at the ordinary income rate, 
then the investment viability of real estate projects will 
surely be brought into question.''
    Both of these comments appear to indicate that investors 
make economic decisions based on tax law as opposed to a profit 
    Would you agree with that statement that I just made and 
the observation I just made, and would altering the tax rate on 
investment fund managers alter the tax treatment of investors?
    Mr. ROSENBLUM. What I would say is that entrepreneurs and 
people who fund enterprises like a private equity firm, like a 
private equity fund, make decisions based on a risk/reward 
basis. Certainly, the tax cost of doing business is part of 
that risk/reward equation.
    I think it is just simple economics that there will be some 
contraction of the pool of activities that will be attractive 
to both the general partners trying to run these funds and the 
limited partners who are being asked to invest in them or other 
sources of capital, that will in the end result in fewer types 
of deals getting done.
    I agree with Mr. Ifshin that probably the place that 
happens first is at the margins with the deals that are viewed 
as a bigger risk, a bigger stretch, a longer time commitment, 
in some way more speculative and further out on the risk/reward 
    Mr. CROWLEY. Mr. Ifshin.
    Mr. IFSHIN. Certainly. Since Congress first adopted 
partnership tax treatment some 50 plus years ago, private real 
estate investment has utilized that format with a flow through 
of capital gains treatment from the appreciation of a capital 
asset. That has led to substantially the overwhelming majority 
of all development, redevelopment, from New York City to San 
    I do not know of any sophisticated real estate owner or 
developer who looks at project profitability solely on a pre-
tax basis. Tax considerations have been embedded in real estate 
investment and developer go forward or not go forward or take 
risk or not take risk decisions as long as I have been in the 
business and certainly for two generations before me.
    The use of the partnership as a vehicle, and embedded in 
that capital gains treatment for the general partner, has been 
embedded in real estate transactions since the law was enacted, 
and in fact, the partnership form had been used by two 
generations of real estate developers before anybody ever 
created the concept of a hedge fund or a private equity fund.
    Mr. CROWLEY. It is safe to say that profit is still a 
mighty incentive?
    Mr. IFSHIN. Profits are always important, but the net 
profit after tax is what at the end of the day as an 
entrepreneur you can take and re-invest in another project and 
create more jobs, or take home and feed your children with the 
    Mr. CROWLEY. I thank you both. Mr. Stanfill, you previously 
stated that a lower tax rate for carried interest is neither 
fair nor equitable and that venture capitalists get ample 
compensation, ``financial and psychic'' for the work they do.
    As venture capitalists are the ones providing their own 
capital for innovations, the more they are taxed, the less 
funds they have to re-invest back into innovations.
    Could that lead to what Mr. Rosenblum has stated 
previously, that some deals simply will not get done?
    Mr. STANFILL. I think it is possible that some deals will 
not get done, but it strikes me as marginal. I may be missing 
something. I just do not see this as a serious----
    Mr. CROWLEY. I am asking in light of the results of a study 
that show that in approximately 62 percent of all venture 
capital deals, people either lose money or just break even. 
There is apparently tremendous risk in terms of that.
    Mr. Silver, you might want to make a comment on that.
    Mr. SILVER. Yes, Congressman. I think you are exactly 
correct. The most important idea to take away from venture 
capital is that you must have winners to offset your losers, 
and you do not know which investments are going to be the 
winners when they start. You hope they all will be. They are 
    The study statistics that you cite are common knowledge. I 
think they are right. The vast majority of investments that 
venture capitalists make fail or fail to return significant 
enough sums to cover and return capital to the general partners 
and to their investors.
    Consequently, I believe what will happen as you move 
capital gains tax rates up is you will force the general 
partners in venture funds to make decisions about kinds of 
investments which alter those investments. We will move to 
later stage, less risky, shorter term kinds of investments, and 
consequently will not make investments in earlier stage, 
riskier kinds of companies, which are themselves the companies 
that have been the greatest engines of economic growth in the 
United States.
    Mr. CROWLEY. Thank you. Thank you, Mr. Chairman.
    Chairman RANGEL. Thank you. Mr. Becerra.
    Mr. BECERRA. Thank you, Mr. Chairman. Again, thank you all 
for your patience. It has been a great hearing.
    Let me ask a quick question of all of you. It is obvious 
that everyone here indicated that you do participate in 
investment activities and therefore carried interest would 
    If by chance we were to enact legislation similar to the 
House bill before us and it would affect the issue of carried 
interest and its treatment as ordinary income as opposed to 
capital gains, would any of you leave your business?
    I just want to hear from those who would leave.
    [No response.]
    Mr. Ifshin, you talked about real estate and how you deal 
with a physical asset, real estate or a structure that you 
develop on that real estate. You talk about some of the risks 
    I will ask you two questions. First, can you continue to 
provide this Committee with as much information as you can 
about that risk, where you distinguish between that hard asset 
versus money or security which is the asset in other private 
equity investments?
    Secondly, a more direct question and a quick answer, and 
then you can follow up with written testimony if you want to 
elaborate, should we treat real estate investments where 
carried interest is a form of--you do not want to call it 
compensation--there is a reward in carried interest, should we 
treat real estate differently than we do other types of 
investments, private equity investments?
    Mr. IFSHIN. We will follow up with written testimony. The 
short answer is--I am certainly not a tax lawyer and do not 
purport to be one--the way it has been explained to me, if we 
are using the same form of partnership, then there is not a way 
to distinguish between the two.
    Mr. BECERRA. If there were a way to distinguish, should we?
    Mr. IFSHIN. I am not intimately familiar with their 
business. I do not know intimately whether or not I can make a 
qualified judgment for you.
    Mr. BECERRA. That is fair. I appreciate your trying to 
respond. Mr. Rosenblum, you mentioned something about pension 
funds might receive or see a lower return on investment if we 
were to pass this House bill.
    I believe there was testimony today by Mr. Russell Reed, 
the Chief Investment Officer of the California Public Employees 
Retirement System, indicating that he had no great concern if 
we were to make moves to tax the carried interest or at least 
propose a different tax treatment for the general partners in 
some of these arrangements.
    If you could follow up with us and provide any information 
that led you to make the statement that the pension funds might 
suffer lower returns, which obviously would be a concern to a 
number of us because many pension funds obviously are based on 
what employees/workers, who do by the way pay ordinary income 
rates, what their returns would be for their retirement 
    If you could provide anything in writing subsequently, that 
would be very helpful.
    Mr. ROSENBLUM. Certainly.
    Mr. BECERRA. Mr. Hindery, you heard the testimony from some 
of the individuals who do raise concerns about changing the 
treatment of carried interest. If you could comment, and again, 
if you could try to be specific and brief, for example, I am 
interested in any comments you have with regard to the issue of 
the real estate industry and where currently some general 
partners in the real estate industry actually have to carry 
paper if the investment falls down and they are stuck with the 
paper, which the banks ultimately want payment, if they run 
into an issue of environmental clean up, comment.
    Mr. HINDERY. Congressman, I will try to be brief. Some on 
this panel would have you believe there is somehow a direct 
correlation between their personal taxation as a hedge fund or 
private equity manager and the vitality of these underlying 
    We hear about Google and FedEx, and I am thoroughly 
impressed. There is no correlation. If there was a correlation, 
when Mr. Bush had his tax cut and reduced capital gains rates, 
we should have cut our management fees. There have been six 
distinct rate changes in the last 20 years in capital gains.
    These rates have not adjusted. If you take Mr. Rosenblum, 
an extremist, in a perfect world, we should pay no taxes 
because then we would be extremely vital. It is apples and 
oranges, Congressman.
    On the real estate side, to Mr. Ifshin, if Mr. Ifshin in 
fact does put capital into his project, he has become a capital 
investor in it, and is entitled to capital gains treatment, 
capital gains loss and gain.
    We are talking simply about the management fee of those of 
us who have the privilege of running other people's moneys. On 
that one point, none of us came up here and offered to debate 
with you and talk with you about cutting our fees when the 
capital gains rate went down.
    Now you are trying to simply move us to a level of taxation 
that every other regular American pays on his or her management 
fees, and to tie the vitality of these three industries, now 
four, in Mr. Ifshin's case, to this issue is one of the great 
obfuscations I have ever confronted.
    Mr. BECERRA. Mr. Chairman, I know my time has expired. Can 
I just make one clarification? I think, Mr. Chairman, when you 
had a colloquy with Mr. Silver, Mr. Silver mentioned the fact 
that most general fund managers that he is aware of made an 
investment, their personal investment, in these investments.
    I think we have to be clear. I think the legislation that 
Mr. Levin is carrying would treat any personal investment that 
a fund manager makes as a capital gain on the sale of that 
particular asset, so we have to make sure we are clear.
    If you yourself as a general partner or fund manager make 
an investment of your own resources into this fund, you will 
receive capital gain treatment upon the sale of that particular 
asset, not ordinary income treatment.
    Thank you.
    Chairman RANGEL. Mr. Levin, the author of the bill.
    Mr. LEVIN OF MICHIGAN. I will be brief. Mr. Chairman and 
Mr. McCrery, this has been, I think, a very long but useful 
    We are determined under the leadership of our Chairman to 
have these kinds of hearings, to open up these kinds of issues, 
to not simply look the other way, because our constituents are 
insistent that a Tax Code works when there is fairness, when 
there is equity, and when there are distinctions made that are 
rational, that are justifiable.
    They want distinctions that we can explain to them and that 
we can tell them they make good sense in terms of equity and in 
terms of growth.
    Let others carry on. I just wanted to say to you, Mr. 
Silver, and we have had a chance to talk before, and our door 
is always open, as everybody's door is here.
    When you say we invest our time and lots of it, we work 
with the management team often on a daily basis developing 
strategy, introducing the company to customers and suppliers, 
identifying and hiring key managers, and leveraging our past 
experience to address competitive and operating issues, that 
strikes a lot of people as the kind of work they do. In the 
real estate business, they may well be doing some of this when 
they are selling a house.
    You talk about risk, I do not think you can base a tax 
policy basically on risk because there is so much risk in what 
everybody does.
    You mentioned the person who takes the stock option. There 
is immense risk and you can try to distinguish it if you want, 
or others, and there has been reference here to people who work 
on commissions or who work on bonuses. There are lots of 
people, and this relates to your question, Mr. Chairman, who 
are in the stock industry, who make more from the bonuses than 
they do from their other pay. They have immense risk as to what 
they are going to earn. Immense risk.
    We have to be able to tell our constituents who risk a lot, 
who work hard, who do lots of things more or less as you have 
described here, why there should be a differentiation, a 
    The gist of this effort is to try to have a Code that has 
fairness, equity, and draws distinctions that are sustainable 
to our constituents. As Mr. Rangel has said, our Tax Code in 
terms of compliance is based more on the people's feeling of 
equity, of balance, of legitimate distinctions than anything 
else. If it is not there, it collapses.
    I will yield the rest of my time so others can carry on. I 
am going to have to leave to talk about this issue with a 
colleague of mine in another setting.
    This has been a vitally useful effort. I just want to echo 
what Mr. Rangel has said. This is not an effort to soak 
anybody. This is a search for a Tax Code that really makes 
sense and makes distinctions that we can defend.
    Mr. SILVER. Congressman, I appreciate your comments. You 
and I did have a chance to have a very productive conversation 
privately at an earlier date. You have spoken eloquently about 
the issue of fairness, and it is clearly a very important 
    I would like to leave you and Members of the Committee with 
a better understanding than perhaps I have of the unique role 
that the venture capital community plays in here and with 
respect to fairness, we play the same role in building 
companies that the founders and entrepreneurs do.
    The question about fairness, we invest our time and our 
money like an entrepreneur does. The entrepreneur receives 
capital gains for that work. The question of fairness that you 
are addressing is a broader macro level question, which is much 
warranted and ought to be examined, I think, in a much more 
holistic fashion.
    The fairness issue here is really a question of the tax 
treatment of the kind of work done between the venture 
capitalist as investor/co-founder and the entrepreneur, not a 
question at the more macro level of tax fairness within the 
    Mr. LEVIN OF MICHIGAN. You can shape it that way.
    Mr. Stanfill, you do not seem to agree with that.
    Mr. STANFILL. I respectfully disagree. I have bright, 
young, well educated partners, sometimes we lead deals. 
Sometimes we follow on deals and others lead, and our tax 
treatment is the same. It simply does not strike me as fair or 
    Mr. LEVIN OF MICHIGAN. The red light is on. Thank you.
    Chairman RANGEL. Thank you, Mr. Levin. Mr. Tiberi.
    Mr. TIBERI. Thank you, Mr. Chairman. That is a tough act to 
follow. I just want to thank you and Chairman Levin for your 
sincerity, not only in this legislation, but in this hearing.
    I want to thank Mr. Ifshin for putting a different face on 
this. Let me tell you about a different face that I saw on this 
issue in August in my district.
    Mr. Rangel and Mr. Levin's legislation gets a lot of 
attention in the media about how it affects Wall Street. My 
district is far from Wall Street. Let me tell you a little bit 
about some of the interaction that I had.
    In Ohio, we have five public employee pension systems. My 
mother-in-law, a single mom, a grandma, was a school secretary. 
She is on one of those systems. She has great returns compared 
to Social Security. In fact, all of our five pension systems do 
much better than Social Security does, and they all love their 
systems. Teachers, firefighters, police officers, local and 
state employees.
    In talking not to the political people but a few of the 
folks that run a couple of these pension systems, the comment 
to me was do not think that returns are not going to be 
impacted by tax treatments.
    That is something my mother-in-law has concerns about. This 
is not from any Republican or Democrat or Union official or 
state official. People who are involved in the funds 
    More important than that, I talked to a guy who is an 
Italian immigrant. He is a stone maker, along with the brick 
layer, and Mr. Pascrell is not here, but my Italian friend, Mr. 
Crowley, is, and a carpenter, three guys who came from Italy, 
who have formed a real estate partnership. Now they do real 
estate development, home building.
    They believe that this will have an impact on their 
business. A very Main Street issue, not a Wall Street issue, 
but a Main Street issue that Mr. Ifshin, you put a face on.
    I was at the James Cancer Hospital in Columbus, one of the 
ten cancer hospitals in America accredited by the Federal 
Government, and met with an inventor that now uses a cancer 
device that it took years to get on the market, and if it was 
not for venture capitalists, it may not be on the market today.
    He said to me be careful what you guys do because this was 
hard enough to get, and if you make it tougher to get, what is 
the next invention that is not going to be on the market.
    What I am saying, Mr. Chairman, is I understand that you 
are sincere in trying to close loopholes, but what we do here 
does have impact on real people outside of Wall Street, whether 
it is a real estate developer who was a stone maker, whether it 
was my mother-in-law who was a school secretary, or whether it 
was an inventor who could not get something to market without 
venture capitalists, and all believe there is concern there.
    What I want to ask all of you, just to make a comment, as I 
look at this legislation, and I have talked to a tax lawyer who 
said to me you guys are trying to make this more equitable, but 
in this legislation, it appears to me you are picking winners 
and losers.
    My question to all of you is how do we draw the line here 
in Congress? How does the Chairman pass a piece of legislation 
with my support and Mr. McCrery's support and bipartisan 
support when we are essentially saying if you are in real 
estate, your capital gain is going to be treated as ordinary 
income but if you are in another industry, your partnership is 
not, and are we heading down a road of making the Tax Code even 
more inequitable than it already is?
    Mr. Hindery.
    Mr. HINDERY. Congressman, two quick comments. I think the 
only way to approach this is across the spectrum of investment 
partnerships. I think when you cut to the nub, we are all the 
    There are six of us that have the privilege of being up 
here right now. Only Mr. Kramer speaks for the investor crowd. 
The rest of us are managers. I defer to his comments which 
makes the point strongly that the investor community is 
indifferent, the concerns that your mother-in-law has, I do not 
believe deep in my soul, are concerns that she needs to have.
    It is not an issue for the investor community. It is simply 
a personal taxation issue for those of us who are managers.
    I think the answer for this Committee and this Congress is 
to treat all of these investor partnerships exactly the same, 
that which is by its nature ordinary income, tax as such. That, 
to Mr. Ifshin's comment, the concern about real estate, 
legitimate. That which is capital, treat as capital.
    I think there is very bright lines, Congressman, that can 
be drawn to let you and your colleagues make that distinction 
for us as we go forward as practitioners.
    Mr. TIBERI. Thank you.
    Mr. STANFILL. I essentially would agree with that comment. 
I think capital should be the key.
    Mr. KRAMER. Actually, I respectfully find it scary that I 
do believe there probably are people in the public pension 
world that you can talk to who actually do think that their 
fees are going to go up because tax rates are going to go up 
for their managers.
    I do find that scary. The irony is if you have 
conversations with leading people in the private equity world 
and in the hedge fund world, you will find very few people 
privately who would possibly agree with that argument. It is 
only the people they make it to publicly. Privately, they do 
not buy into that argument.
    On the broader issue, one of the problems with one way the 
Committee might go in this area is obviously there are equity 
issues and there is a question, why am I supposed to treat 
private equity and hedge funds differently than I treat other 
    On the other hand, if you basically said it looks and 
smells to me like compensation income, make it real simple, if 
I am a money manager at Fidelity, I pay ordinary income. If I 
am a money manager and I own the same stocks at Goldman Sachs, 
I pay ordinary income.
    I actually own stocks. As a hedge fund manager, you know, 
then I get this capital gains benefit. There is an inequity and 
the obvious argument would be if you can extend it to other 
industries and get the votes together to do that, that would 
actually be more intellectually coherent.
    Mr. TIBERI. Thank you.
    Chairman RANGEL. You can make one Member of this Committee 
very happy if you share those views with his mother-in-law.
    Mr. SILVER. Congressman, I think you made several important 
points. The first is it is not just a Wall Street issue. It is 
a Main Street issue. As you may know, we actually have an 
investment in a company in Columbus, Ohio. We also have 
investments in companies in Seattle, Golden, Colorado, RTP, 
Austin, Texas, and smaller communities scattered throughout the 
country, which do not typically see venture capital and which 
do not have any venture capital firms.
    I think it would be fair to say that a number of those 
companies would not have been able to launch without venture 
    The second observation that you made which I certainly 
concur with is that there is an artificial and intellectually 
incoherent inconsistency in selecting or identifying out a 
particular not just asset class but sector within the asset 
    We are looking at a snapshot today. If we were having this 
conversation in the late nineties, we might have been talking 
about venture capital. If we were talking about it in 2000, 
2001, 2002, we might have been talking about hedge funds. If we 
are talking about it today, we are talking about mega buy out 
    That is because there is a natural evolution and a natural 
ebb and flow within the financial industry and every industry. 
I do not know real estate as well, but I am certain there are 
ebbs and flows in the real estate industry, which also are a 
function of time and timing.
    My strong concurrence with you is that we ought not to be 
in the business of trying to identify a subset of a subset of 
an asset class for particular tax identification issues.
    Mr. IFSHIN. Congressman, to me, it comes across as you have 
to be careful of what unintended consequences emerge from 
something like H.R. 2834.
    In 1986, when the Tax Reconciliation Act was passed, it 
ended up costing the Federal Government over $200 billion in 
the form of RTC and FDIC bail outs of S&Ls that went broke 
because they lent money to developers who had relied on the tax 
treatment that was removed.
    Unintended consequences as it relates to this piece of 
legislation that I think are most important to consider are 
ones that would occur on the local level, as opposed to Federal 
tax receipts.
    We bought an asset several years ago in your district. We 
are working to re-do that asset. If we succeed, one would 
assume that (a) we will create construction period jobs and we 
will ultimately lease that space to retailers who will create 
permanent jobs in what is the second largest Somali community 
in the world outside of Somalia.
    It is a very, very challenged neighborhood and it is a 
challenging project. If we succeed, one logically assumes that 
the assessment on that property will go up, and the tax base in 
a neighborhood that you well know has a shrinking tax base, 
will go up. Therefore, the homeowners in that community will 
face less of a relative increase in their property tax burdens 
than they would in the absence of our project.
    We do this all over the country, not just in your district, 
Congressman. That is the impact that we have all over the 
    If you want to look at the average household income in that 
particular portion of your district----
    Mr. TIBERI. I know it.
    Mr. IFSHIN. I will tell you that the thing that is coming 
at your constituents is that their property tax bills are not 
going up one or 2 percent, they are going up 8 and 10 percent a 
year. Why? Because the tax base is shrinking. Their property 
taxes are becoming an ever growing percentage of their 
disposable income.
    Chairman RANGEL. Mr. Doggett.
    Mr. DOGGETT. Thank you very much for staying this late 
hour. We have been told really in this Committee for 12 years 
that our concerns about fairness and equity in the Tax Code and 
fiscal responsibility in the budget were inconsistent with 
competitiveness and with economic opportunity.
    I think particularly your testimony, Mr. Hindery, just as 
with Mr. Shay earlier on international tax, suggests that is 
not true and there will be members of the business community 
who will come forward and say we have to have both, and that 
when a gross inequity exists, we need to correct it.
    I do have some concern on the venture capital issue because 
I represent an area in which venture capital has been very 
important to the growth particularly of our small technology 
businesses. I gather Mr. Silver and Mr. Stanfill have worked in 
this area.
    Are there not some distinctions, first of all, in the 
length of venture capital funds versus the length of time 
involved in the typical private equity fund?
    Mr. STANFILL. You are talking about the timeframe?
    Mr. DOGGETT. Is it usually 10 year funds?
    Mr. STANFILL. There are 10 year funds. As a matter of fact, 
we will exit from an investment we made in 1995. There is no 
question that we spend a lot of time, sometimes decades or 
more, in bringing a company----
    Mr. DOGGETT. I guess my first question to you, you feel 
there should be no distinction for venture capital from other 
types of equity funds, even though you are in the venture 
capital business?
    Mr. STANFILL. That is correct.
    Mr. DOGGETT. If that is the position that prevails 
ultimately, will there be a need for reasonable transition 
rules for funds that have already been formed, that have been 
going on for seven/eight/nine years and are now down to near 
the conclusion of the fund, where people relied on the old 
rules before you apply a new approach?
    Mr. STANFILL. I think a grandfather provision might make 
sense in that case, Congressman.
    Mr. DOGGETT. With reference to the role that venture 
capital funds play, Mr. Silver, versus other types of private 
equity funds, you commented on this to Mr. Rangel earlier, but 
do you find venture capital funds much more involved with the 
management of what are often start up or fairly new 
    Mr. SILVER. Yes, Congressman. There are some substantial 
distinctions between various kinds of private equity funds. I 
leave it to my colleagues in the hedge fund and the private 
equity fund business, the buy out business, to describe their 
own activities.
    The point I have been trying to make repeatedly this 
afternoon is that the role that the venture capital community 
plays is a co-founding/finance role. You are absolutely right 
in identifying longevity as one of the keys to that.
    As Mr. Stanfill pointed out in his own experience, we are 
involved on a daily basis, for years and years, in growing 
these funds. Our first fund at Core Capital was launched in 
1999. We made 23 investments in that fund. We have exited 14, 
or I should say only 14, in that time, and it will probably 
take us another 4 years to get out of all of the other 
transactions that we are in.
    I should also say because I know Mr. Stanfill and I have 
different points of view on this, that I appreciate Mr. 
Stanfill's desire to address wealth and equality in this 
country, but I do think that the approach he is advocating is 
the wrong tool to address those concerns.
    I actually think it endangers the structure that has 
supported innovation. The point I tried to make to an earlier 
question was that if the result of this tax disincentive is to 
incentivize venture capitalists to make investments in later 
stage companies, then almost by definition we will make fewer 
investments in early stage companies, create fewer jobs, and 
reap the penalty of that in economic growth.
    Mr. DOGGETT. If the Committee does include venture capital 
with other types of equity funds on this whole matter, how do 
you believe that venture capital funds might reorganize to 
avoid that new law?
    Mr. SILVER. I cannot answer the question as to how 
specifically they will reorganize, but I can assure you that 
every venture capital firm and every general partner in every 
venture capital firm will examine that issue closely.
    Mr. DOGGETT. Mr. Stanfill.
    Mr. STANFILL. I would only add if we do not start with our 
own house in terms of fairness, where do we start.
    Mr. DOGGETT. Thank you very much.
    Chairman RANGEL. From Texas asking the witnesses to 
identify the next loophole.
    Mr. DOGGETT. I know there will be one.
    Chairman RANGEL. Mr. Blumenauer. Thank you for your 
    Mr. BLUMENAUER. Mr. Chairman, I must say that it is worth 
sitting through 10 hours of hearing today. I do not know that 
since I have been in Congress that I have sat through each of 
the panels and enjoyed them as much.
    Particularly this panel, I have airplane reading for 
tomorrow going home. I will re-read each of the statements. I 
found them fascinating.
    I personally do distinguish as it relates to real estate. I 
have been having these conversations at home with a variety of 
people who are in--we do not have a huge hedge fund. We have a 
little bit of activity. We have financial advisors. We have 
people involved with venture finance. We have lots of people 
who want venture investments.
    I think this hearing, Mr. Chairman, might look a little 
different next year, given some of the froth that is going on 
in other aspects of financial markets. I wonder in terms of 
when we sort of squeeze out some of the problems we have seen 
with some investments and we look into some of the financial 
markets, if we might be having a slightly different take about 
priorities and what we want to do.
    Putting that aside, I have noticed a tiny bit of difference 
from left to right here on the panel. I am just speaking as I 
am looking. I am very interested in getting reactions, I guess, 
in two areas from each of the panelists. I will try to be 
    It was my impression that primarily this money followed the 
performance of investments, that if hedge funds or venture 
capital starts blowing up, people are going to go elsewhere. If 
people have goofy fee structures or there is more economic 
opportunity somewhere else, regardless of the tax structure, 
people are going to follow where there are good investments, 
and if there are not good investments, they are not going to be 
doing it, and pension funds and university endowments are not 
going to be throwing money at the people in question.
    I was intrigued, Mr. Hindery, with your point that we did 
not see fee structures altered when there have been adjustments 
downward. It has been about 40 minutes since you said that. I 
would like to start to give you an opportunity to clarify, if 
you have changed your mind.
    I would like to go down the line with folks in terms of is 
that a valid point, and second, I was concerned, Mr. Silver, 
you mentioned there are not enough qualified, talented 
professionals, that firms are declining, and it is hard to get 
good people. I am wondering is that because we are not paying 
them enough, there are not people in venture capital or in 
hedge funds that you cannot attract the best and the brightest?
    If we could just go from left to right briefly, I would be 
interested in your observations or amendments.
    Mr. HINDERY. Congressman, this is an awful good gig if you 
can get it. I just think all of this unintended consequence 
plow that has tried to be overhung on this industry today, it 
is an obfuscation. This is a good deal, Congressman. It really 
    I would simply ask my colleague, Mr. Rosenblum, why he did 
not adjust his rate down, if he is so anxious about the 
consequences to this entire industry, when there is the 
prospect of the rates on his personal level going up.
    That inconsistency, I think, belies the strength of every 
one of the arguments that has been made at the far end of the 
table. There has been no rate adjustment in the six times----
    Mr. BLUMENAUER. I am sorry. My time is fast going. I really 
do want to have people react to this. I think it is important.
    Do you have trouble getting qualified people to work for 
you in the industry?
    Mr. HINDERY. I have no problems at all; none. In fact, it 
is quite the opposite. There is no industry that is a richer 
environment than ours right now to attract people.
    Mr. BLUMENAUER. Mr. Stanfill.
    Mr. STANFILL. We have no problem filling slots. We are a 
very small firm. We are small potatoes, to tell you the truth. 
People seek us out. We do not have room for the people who come 
to see us.
    Mr. BLUMENAUER. Do you see an issue here in terms of the 
relationship between capital gains going down and fee 
adjustments? Did you adjust your fees when capital gains went 
    Mr. STANFILL. We did not adjust our fees. However, the 
terms, the partnership terms, after the decline that the 
industry went through after the meltdown in 2000, all of a 
sudden it became a buyer's market instead of a seller's market. 
The terms that were negotiated were more in the investor's 
favor than they had been.
    Mr. BLUMENAUER. Mr. Kramer.
    Mr. KRAMER. Three decades ago when I did work in this town, 
actually, I did not know anyone who was talented who wanted to 
go into the asset management business. It just was not the 
thing. Now, the top people coming out of the top schools, they 
want to be in private equity. They want to be in hedge funds. 
Nobody thought that way then. There is not any question about 
where the talent is going.
    In terms of tax rates and fees, that is not a subjective 
thing. That is empirically the case, historically. There is no 
relationship between what the tax rates were and what the fees 
had been. There is not some counter argument that somebody 
could make.
    More broadly, today, the financial services industry is a 
record part of GDP. By the way, to throw more tax subsidies 
into it, you will get more of anything.
    If at the margin some of the mathematically inclined did 
not go to hedge funds, in other words, if there was some 
diversion of talent away from what all of us do professionally, 
it is not clear to me that as a social matter, America would 
suffer if in fact our whole general area of enterprise was 
deemed less attractive.
    I would also say just a general thing, and I think all of 
us think this way, if you have a pool of money, you have $1 
million, you have $100 million, you are always thinking the 
same way, which is what is the most attractive risk-adjusted 
set of places that I can use to do with this money.
    Actually, whether you tax me at a lower rate or you tax me 
at a higher rate, I am still going to be looking at the best 
risk-adjusted after-tax return that I can get, because I do not 
know how else to think about the $1 million.
    Mr. SILVER. Congressman, I think it is very important that 
we not think of the financial services sector that we are 
discussing as monolithic. We have been very fortunate to 
attract very talented people to our firm, but it is not in fact 
easy to do that.
    We have several hundred million under management, but we do 
not have billions and billions. If you do the math on a 2 
percent management fee on several hundred million dollars and 
you subtract out rent escalators and legal fees and accounting 
fees and everything else, there is not there what you might 
think there is.
    I would answer your question slightly differently and say 
yes, we are in a constant search for good talent because there 
are other places for prospective young venture capitalists to 
go, including within this sector, but the sector is not 
monolithic, and that is what causes that movement to occur.
    You do not want to lose those people because what makes 
venture capitalists, successful venture capitalists unique, is 
an unusual combination of technology background and business 
building skills. That is hard to come by.
    Mr. IFSHIN. Congressman, we have a terrible time attracting 
talent such to the point that we have actually started a 
training program for recent college graduates. The reason is 
that there is a huge draw of those people to Wall Street and 
what they pay.
    As it relates to fees, we do not charge investment 
management fees. It is not applicable.
    Mr. ROSENBLUM. Let me just say on this fee issue, I am not 
sure where Mr. Hindery gets his data, but I think it is 
important to have some data when you talk about this.
    There has been a trend over the last 10 years in the 
private equity industry, certainly at our firm, to have lower 
fees as a percentage of capital under management. I do not 
think that you can fairly attribute that to any one particular 
factor, but I think taxes are part of the mix there.
    Mr. BLUMENAUER. I will stop. I would like to request that 
be submitted in writing. I think it is a little different than 
what I heard. I do not want to debate it, but I would like it 
clarified in terms of percentage of assets under management, 
the fees, as opposed to the fees that are charged related to 
the tax. I just need help clarifying that. I heard two 
different things.
    Thank you. Thank you for your patience.
    Chairman RANGEL. Ms. Schwartz.
    Ms. SCHWARTZ. Thank you, Mr. Chairman. Thank you for your 
patience and for the panel as well. As is sometimes said, if I 
am standing between you and dinner, I suppose I should be 
brief. I hope we are standing between you and dinner anyway. It 
is getting about that time.
    I also think that today's hearing, and your panel in 
particular, really expresses a lot about what is great about 
America, the willingness to invest and take risks and support 
bright ideas and entrepreneurs and make money off that. That is 
part of what we do in this country. It is a good thing.
    We are also looking at here, of course, how we can be fair 
about how we tax those winners, and I guess sometimes those 
    Thank you for what you have done. I know some of you I have 
met with individually, and I appreciate that, and hopefully we 
will sort this out in a way that allows a continuation of 
investment in the brightest ideas.
    One of the questions I asked the previous panel, I wanted 
to give you the opportunity to respond to as well, and it has 
to do with the concern about our public pensions. If you were 
here before, I mentioned that previously when I was a state 
senator in Pennsylvania, I authored the law that moved our 
retirement systems in Pennsylvania, both for the teachers and 
for public employees, to a prudent person standard from a legal 
    That created an enormous opportunity to invest in different 
ways and to get much better returns on those investments. 
Certainly those investment managers have made good profits off 
that, and I think much of that is fair.
    There has been a scare put out. I think it was a good idea. 
It has worked out well, I think, for the pensions and for 
taxpayers in Pennsylvania and other states where we have done 
    The concern is if we make a change in the way we handle the 
taxation for the managers in terms of carried interest, that we 
will see a real change in not getting those kind of returns, 
that we will not see investment managers willing to do this, 
they will have to charge much higher fees, that it will disrupt 
what is working.
    Mr. Kramer, I think I will start with you because you were 
very clear about the fact that would not happen, I think is 
what you said. The previous panel agreed with you, by the way. 
They said that would not happen. Most of the pension funds have 
said they did not believe that would happen.
    I just want to give you the opportunity, Mr. Kramer, to re-
affirm that, and then anyone else who wants to really disagree, 
that this change could really be damaging to the retired, the 
pensioner, in any of our districts, who are really worried 
about that, or our taxpayers who have also been very pleased 
not to see taxes go up for school districts in particular 
because it has worked.
    We do not want to disrupt what works. Mr. Kramer, would you 
start, and then if anyone wants to disagree with you.
    Do you think we will see a negative consequence?
    Mr. KRAMER. Yesterday I agreed to join with your State 
Treasurer. She is putting together a group of seven people to 
initiate reforms on the investment side in Pennsylvania, and I 
will be part of that, helping your state.
    Ms. SCHWARTZ. Thank you.
    Mr. KRAMER. Two things. Number one, one of my erstwhile 
private equity friends called yesterday, why am I in this 
position. That is the world, alternative managers, that I come 
from socially. He wanted me to at least make the point that 
hedge funds and private equity are appropriate investments for 
pension systems, and actually, I have in fact strongly 
supported that view.
    I went and took this particular assignment in New Jersey, 
because New Jersey had never done any of this stuff. They never 
used any outside managers. They never had a private equity 
investment. They never had real estate. They never had venture 
capital and they never had hedge funds.
    I went there in order to change it. I do believe in the 
activity. I would simply say that what Congressman Tiberi 
expressed undoubtedly is true of the sentiment of some of the 
people on the pension side. I would not want to accuse anyone 
of public hypocrisy, but I have a lot of friends in the 
alternative management business, and it is difficult for me to 
find people in the alternative management business who actually 
believe that fees are automatically going to go up because the 
tax rates go up.
    If basically the returns are great over the next 5 years, 
then people are going to be able to charge even more for what 
sort of everybody collectively does.
    Ms. SCHWARTZ. Anyone else want to disagree with that? Mr. 
    Mr. ROSENBLUM. I would say this is not a black and white 
issue and it is not consequences that are going to happen 
overnight or be uniform across different managers.
    There clearly are investors who are concerned about it. 
Obviously, there are some who are not. I think the concerns are 
genuine and I think the economic likelihood is that pressured 
by additional costs, the firms that can extract something more 
are going to try to extract it. It will not be everybody. They 
will not be able to pass all the costs through.
    I think you will see a shift over time, and I am very 
surprised that folks think they have the crystal ball that 
tells them that will not happen.
    Ms. SCHWARTZ. Thank you.
    Mr. HINDERY. Congresswoman, in the prior panel, if there is 
an absolute one to one correlation, I believe there is none, as 
seemingly does Mr. Kramer, I believe there is none, but in the 
prior panel, it was proffered to this Committee that if in fact 
it passed through, it would have a two basis point impact on 
the returns of the public investor community. That is if it is 
a 100 percent correlation, two basis points. That is my point.
    Ms. SCHWARTZ. Let me thank you very much. I guess I would 
say my assumptions, one of the reasons we are spending the time 
that we are is because there will be consequences. There will 
be changes. There will be effects.
    We want to make sure, as we often do, we have to make sure 
that the risks, as you do in the work you do, that the benefits 
outweigh the risks that we are taking in terms of the 
consequences, and that all of those really very smart people 
who work for you, and actually, we have a lot of smart people 
working for us as well, will figure it out so that we get the 
greatest benefit to Americans, both the taxpayers and the 
    Thank you.
    Chairman RANGEL. Let me thank this panel for its patience. 
I think Mr. Blumenauer said it. It certainly was illuminating 
listening to your testimony. I know no matter how many times I 
say it, it would appear as though we are targeting public/
private investors, equity investors, or hedge fund operators.
    I would just like to conclude by saying this Committee 
started these hearings with the sole purpose of seeing how we 
could eliminate the alternative minimum tax. We made it 
abundantly clear that where we saw in the Tax Code unfairness, 
something that did not encourage economic growth, that would be 
used as one source of revenues in order to compensate for the 
dramatic loss we would have in alternative taxes.
    Orin Kramer knows I live in Harlem. I have not had an 
overwhelming number of constituents come to me because I said 
fairness and equity and they said you are taking something away 
from me.
    There is no one here that can find anything that the Chair 
has said that would indicate that we are looking at these 
issues for the purpose of raising revenue.
    I am amazed that fairness and equity as a guideline for 
this Committee has caused so much concern. Having said that, I 
would assume that you will have time to tell your constituents 
that there is a valid case made for the difference in the way 
people are taxed.
    This Committee would like to hear it. This has been a great 
Committee. I want to give a special thanks for Orin Kramer 
because I know some of the people he associates with, and they 
are not going to be very nice to you tomorrow or the next day 
or the next day.
    This has been illuminating. As we have said before, we hope 
that you may have time to come back and to clear up some 
things. If you read things in the paper that you believe that 
you wish you had time to talk about while you had this time 
with us, please feel free to share that with us. We want to 
make certain at the end of the day, we can have a bill that the 
people believe in.
    You have been an extraordinary panel. I want to thank you 
so much for your patience and being with us at this very, very 
late hour.
    Thank you. Before I adjourn the Committee, I ask unanimous 
consent that the statement submitted from Mayor Blumberg's 
office on the question of the expansion of the ITC be submitted 
in the record.
    The Chair hears no objection.
    [The document referred to follows:]
    Chairman RANGEL. I want to thank Mr. McCrery for his 
patience and being with us. The Committee will stand adjourned 
subject to the call of the Chair.
    [Whereupon, at 7:30 p.m., the Committee was adjourned, 
subject to the call of the Chair.]
    [Submissions for the record follow:]

         Statement of American Prepaid Legal Services Institute
    I am John R. Wachsmann, President of the American Prepaid Legal 
Services Institute. The American Prepaid Legal Services Institute (API) 
is a professional trade organization representing the legal services 
plan industry. Headquartered in Chicago, API is affiliated with the 
American Bar Association. Our membership includes the administrators, 
sponsors and provider attorneys for the largest and most developed 
legal services plans in the nation. The API is looked upon nationally 
as the primary voice for the legal services plan industry.
    I offer this written testimony in support of employer-paid group 
legal services for working families. Employer-paid group legal services 
provide a vital safety net for middle-income families.
    The hearing today deals with the economic challenges and inequities 
in the Tax Code facing America's working families. Committee Chairman 
Rangel noted in calling the hearing that ``One of the fundamental 
duties of the Committee on Ways and Means is to conduct oversight of 
the Tax Code and ensure that our tax laws promote fairness and equity 
for America's working families.''
    One effective and inexpensive part of tax relief for working 
families should be the restoration of the tax exempt status of 
Employer-Paid Group Legal Services. This is targeted tax relief that 
works two ways:

      It reduces the tax burden on working families and 
      It seeks to prevent or amerliorate the consequences of 
calamitous events that without legal assistance can quickly snowball 
into disaster
    For example, one of the economic challenges facing working families 
is surviving in an increasingly complex financial environment. 
Currently working families are in an extremely precarious economic 
position. A perfect storm of adjustable rate mortgage increases, credit 
card interest rate increases, layoffs and cutbacks have put many 
families on the edge of economic collapse. Many working families are 
living paycheck to paycheck with very little cushion in the event of 
illness or injury.
    A single event, such as a divorce, job lay-off or illness that 
interrupts cash flow is enough to trigger defaults on mortgages, 
evictions or collection lawsuits. Now is the time when working families 
need access to the legal system, through employer-provided legal plans, 
to save their homes, deal with debt and keep their families intact.
    Group legal plans help working Americans in financial distress. 
Plans provide preventative assistance with mortgage and refinancing 
document review, as well as advice on sub-prime loans and exotic 
financing instruments. Group legal plans help American families 
understand the economics of their mortgages to avoid entering into 
transactions likely to result in future defaults.
    If a default has occurred, plans will review the documents for 
compliance with existing laws and advise on workouts that allow 
reinstatement of the mortgages. The result is not only saving the 
family's place to live, but safeguarding the family's primary 
    Group legal plans also provide employees with low cost basic legal 
services, including assistance with the preparation of a will, probate, 
and domestic relations issues, such as child support collection. Other 
issues plans address are:
      Protecting spouses and children in the event of death
      Anticipating the need for long term care, as well as 
Medicare and Medicaid issues
      Informing medical professionals on how they want to be 
treated in the event of a serious illness or a life threatening 
      Instructing family members on how they want their 
property handled in the event of incapacitating illness or accident
      Addressing financial management and investment issues in 
the face of a decreased income
      Educating clients on how to avoid identity theft and what 
steps to take if a client is a victim of this crime
    Legal plans provide the advice and legal documents to accomplish 
these tasks through wills and trusts, powers of attorney, living wills/
medical directives, guardianship and conservatorships, nursing home 
contract review, Medicare and Medicaid appeals and home refinancing 
document review.
    Yet now, when the need is at its greatest, fewer Americans have 
access to inexpensive, preventative legal assistance. Since the loss of 
the benefit's tax-preferred status in 1992, existing plans have been 
forced to cut back and few new plans have been added.
     As employers seek to limit expenses by reducing or eliminating 
benefits in general, targeting benefits that are not tax-preferred is 
high on employers' lists. Recently this trend toward reducing benefits 
has taken a toll on existing group legal plans. Large employers such as 
Rouge Steel, Delphi and Visteon have either dropped the benefit 
entirely or created a two-tier benefit system that eliminates group 
legal for their newest employees. The lack of a tax preference for 
group legal plans makes the benefit vulnerable for reduction or 
elimination by employers, effectively barring access to justice for 
millions of working Americans.
    Section 120 was originally enacted in 1976 and extended on seven 
separate occasions between 1981 and 1991. This Congress has the 
opportunity to reinstate Section 120 of the Internal Revenue Code of 
1986 and restore the exclusion from gross income for amounts received 
under qualified group legal services plans. This will provide an 
incentive for existing plans and tax relief for working families and 
    Bills have been offered in the past several Congresses, including 
this year's bill, H.R. 1840, introduced by Congressmen Stark and Camp 
and co-sponsored by 31 Members of Congress, 15 of whom are on the Ways 
and Means Committee. The identical Senate version of the bill, S. 1130, 
has similar bi-partisan support on the Finance Committee.
    Reinstatement of the benefit's tax preference will provide direct 
and immediate tax relief to employees. When this exclusion expired, it 
triggered a tax increase for millions of working Americans whose 
employers contribute to such plans. Currently more than 2 million 
working families with legal plans offered by such national companies as 
Caterpillar, J.I. Case, Mack Truck, John Deere, Ford Motor Company, 
General Motors, and thousands of small businesses are taxed on the 
employer's contribution, whether or not they use the benefit.
    Businesses will also gain direct and immediate tax relief. 
Employers must pay an additional 7.65 percent of every dollar devoted 
to a legal plan as part of its payroll tax. Employees pay the payroll 
tax plus income tax on the cost of the benefit whether they use it or 
not in any given year.
    Encouraging this benefit is also an efficient and low cost way of 
offering economic protection and education to middle class working 
families. Employers can provide a substantial legal service benefit to 
participants at a fraction of what medical and other benefit plans 
cost. For an average employer contribution of less than $100 annually, 
employees and retirees are able to take advantage of a wide range of 
legal services often worth hundreds and even thousands of dollars, 
which otherwise would be well beyond their means.
    In conclusion, reinstating Section 120 would repeal a tax increase 
on middle class Americans and businesses and restore equity to the tax 
treatment of this benefit. Reinstatement will also insure access to the 
legal system for millions of middle-class families who might otherwise 
be priced out of our justice system. Restoring the tax-preferred status 
will demonstrate to millions of hard-working low and middle-income 
workers, not only that this Congress supports them, but that the Tax 
Code can be fair and equitable.

                    Statement of Chamber of Commerce
    The U.S. Chamber of Commerce, the world's largest business 
federation representing more than three million businesses and 
organizations of every size, sector, and region, is pleased to have the 
opportunity to express its views on the proposal to increase the tax 
rate on the general partner's share of a limited partnership's profits, 
known as carried interest, from the long-term capital gains rate of 15 
percent to ordinary income tax rates of up to 35 percent.
    The Chamber opposes this change. Advocates of this tax increase 
have sold the increase as targeting a few wealthy hedge fund managers; 
however, it stands to impact over 15.6 million individuals that are 
invested in 2.5 million partnerships. Carried interest is a core 
element of partnership finance in every sector of the U.S. economy 
engaged in capital formation, including real estate, private equity, 
hedge funds, healthcare, and retail. Raising the cost of doing business 
with these entities would make the capital markets less efficient at a 
time when the U.S. is facing fierce international tax competition.
    This changes would undo decades of established tax law and lead to 
wholesale alterations in the structure of partnership agreements 
including loan-purchase arrangements and shifting general partner costs 
to investors and portfolio companies.
    The incidence of a tax increase on carried interest would be spread 
across all the players in the partnership--general partners through 
lower after-tax gains, limited partners and their beneficiaries through 
higher partnership costs and lower returns, and owners and employees of 
portfolio companies as lower business valuations.
    Selectively raising tax rates on the long-term capital gains of 
limited partnerships will drive capital offshore and reduce the 
productivity of American workers and the ability of U.S. companies to 
compete in global markets. In the long term, it will cost American jobs 
and reduce American incomes. In today's global economy, countries have 
to compete for the capital they need to grow. Reducing partnership 
returns by raising tax rates would encourage investors to put their 
money elsewhere.
    The Chamber recently commissioned a study by economist Dr. John 
Rutledge on the use of partnerships and carried interest throughout the 
entire economy. Key findings of the study are summarized below. The 
full report can be found on the U.S. Chamber's website, 
    A half-century ago, in order to encourage entrepreneurship and 
capital formation, Congress created a flexible investment vehicle that 
these parties could use to work together. That vehicle is the 
Partnership, in which each partner contributes their unique assets, the 
partners have great flexibility to divide up the gains from their 
investment in any way they deem appropriate, and all income to the 
partnership flows through the partnership to be taxed to the individual 
partners, based solely on the character of the income--ordinary income, 
short-term capital gains or long-term capital gains--that the 
partnership receives.
    Since its inception, the partnership structure has been a 
resounding success, giving American investors and entrepreneurs the 
tools to create and grow businesses, build shopping centers, build 
hospitals, explore for oil and gas, found new technology companies, and 
finance mergers and acquisitions. In 2004, more than 15.6 million 
Americans were partners in 2.5 million partnerships investing $11.6 
trillion through the partnership structure.\1\ The assets held by 
partnerships grew from over $2 trillion in 1993 to $11.6 trillion in 
2004, providing capital for the growth of the U.S. economy during that 
period. The partnership structure is, in no small measure, responsible 
for the innovation, entrepreneurial activity and growth that have made 
the U.S. capital market and economy the envy of every country in the 
    \1\ Internal Revenue Service, 2007, Data Book 2006, (United States 
Department of the Treasury, Washington, D.C.).
    When creating and structuring partnerships that have a life of 5-10 
years, investors work hard to make sure that the interests of the 
various partners are aligned to avoid potential conflicts later. 
Limited Partners may put up 90-99 percent of the financial capital but 
lack the intangible entrepreneurial assets to carry out a successful 
project, typically agree to carve out a portion--usually 20 percent--of 
the ultimate gains of a project for the general partner, who may 
contribute only 1-10 percent of the financial capital, in recognition 
of the fact that the reputation, network, know-how and other intangible 
assets of the general partner are extremely valuable. To further align 
their interests, the partners often agree that the general partner must 
wait until the end of the partnership, after all of the limited 
partner's capital, partnership expenses and fees, and usually a 
preferred return have been paid, before the general partner receives 
their portion of the gain. These delayed payments--carried on the 
partnerships capital accounts until the end of the partnership--are 
referred to as the general partner's ``carried interest.''
    In addition to carried interest, the general partner collects an 
annual management fee from the partnership--usually 2 percent of total 
committed capital per year--as compensation for the work of managing 
the partnership's activities. Such management fees are treated as 
ordinary income and taxed at ordinary income tax rates. According to a 
recent study by Andrew Metrick and Ayako Yasuda of the Wharton School, 
management fees for a typical private equity fund make up 60-67 percent 
of the total value received by general partners, with the remaining 33-
40 percent comprised of carried interest.\2\
    \2\ Metrick, Andrew, and Ayako Yasuda, 2007, The Economics of 
Private Equity Funds.
     Under well-established tax principles, all partnership income is 
passed through to the individuals making up the partnerships based on 
the character of the income received. To the degree the partnership 
receives fees or interest payments, all partners--general partners and 
Limited Partners--will be taxed at ordinary income rates. To the degree 
the partnership receives long-term capital gains or short-term capital 
gains, the partners will pay taxes on that income in the appropriate 
    According to the Internal Revenue Service, fees and short-term 
capital gains income, which are taxed at ordinary income rates (up to 
35 percent), accounted for 49.8 percent of total partnership income. 
The remaining 50.2 percent of partnership income consisted of long-term 
capital gains tax at 15 percent. A weighted average of the two tells us 
that the blended average tax rate paid by partners in 2004 was 25 
    \3\ Internal Revenue Service, 2007. The weighted average calculated 
as [(49.8)(.35)+(50.2)(.15)]/100=24.96 percent.
Review of Academic Literature
    Over the past 30 years there has grown a vast academic literature 
on partnerships in general and private equity partnerships in 
particular. Although there are many different opinions on various 
aspects of the private equity markets, the vast majority of research 
agrees on several key points:
    First, private equity is a large and extremely important part of 
the U.S. economy that has played an irreplaceable role in the 
restructuring of American companies over the last 25 years into today's 
strong global competitors.
    Second, private equity arises partly in response to a market 
failure in the public markets, known as the ``Jensen hypothesis,'' \4\ 
in which some entrenched managers of public companies fail to look 
after the interests of their shareholders. The stronger governance and 
tighter control exercised by private equity investors combined with the 
closely aligned interests of the private equity investors and the 
managers of their portfolio companies through partnership agreements 
work to correct this problem.
    \4\ Jensen, M.C., 1993, The modern industrial revolution, exit, and 
the failure of internal control systems,
    Third, private equity is a major and growing source of expansion 
capital for family-owned ``middle market'' companies that are too small 
or otherwise unsuited for the public markets. These small companies are 
the backbone of the American economy, accounting for more than half of 
GDP and virtually all employment growth.
    Fourth, private equity sponsors and the network of operating 
resources they bring to portfolio companies significantly improve the 
productivity, profitability, asset management, and growth of the 
companies manage. According to Steven Kaplan, Professor at the 
University of Chicago School of Business and one of the leading experts 
in the area, ``the academic evidence for the positive productivity 
effects of private equity is unequivocal.'' \5\
    \5\ The Wall Street Journal, 2007, Trading Shots: Taxing Private 
Equity, (The Wall Street Journal).
    Fifth, private equity in the form of venture capital invested in 
computers, industrial, energy, retail, distribution, software, 
healthcare and consumer products has had an extraordinary record in 
creating new businesses, new technologies, new business models, and new 
jobs. According to Venture Impact, a study prepared by Global Insight 
(2007), venture-backed companies like Intel, Microsoft, Medtronic, 
Apple, Google, Home Depot, Starbucks, and eBay accounted for $2.3 
trillion of revenue, 17.6 percent of GDP, and 10.4 million private 
sector jobs in 2006. Venture-backed companies grow faster, are more 
profitable, and hire more people than the overall economy.
    Sixth, and finally, private equity in the form of real estate 
partnerships has dramatically increased the availability and lowered 
the cost of capital to build homes, shopping centers, office buildings, 
and hospitals for American families and businesses. In Emerging Trends 
in Real Estate (Urban Land Institute (2007)), the study reports that in 
2006, investors provided $4.3 trillion in capital to the U.S. real 
estate sector, including $3.2 trillion in debt capital and $1.1 
trillion in equity capital. Of the equity capital, the bulk was 
provided through partnerships by private investors ($451 billion), 
pension funds ($162 billion), foreign investors ($55 billion), life 
insurance companies ($30 billion), private financial institutions ($5.1 
billion), REITs ($315 billion), and public untraded funds ($37.4 
    \6\ Miller, Jonathan D., 2006. Emerging Trends in Real Estate (ULI-
the Urban Land Institute, Washington, D.C.). p. 21.
    Below is a detailed review of several key articles written on this 
    1. Cumming, Siegel, and Wright (2007) \7\
    \7\ Cumming, Douglas, Donald S. Siegel, and Mike Wright, 2007, 
Private equity, leveraged buyouts and governance, Journal of Corporate 
Finance 13, 439-460.
    In an extraordinarily thorough review article in the September 2007 
issue of the Journal of Corporate Finance, Cumming et al. conclude that 
``there is a general consensus that across different methodologies, 
measures, and time periods, regarding a key stylized fact: [leveraged 
buyouts] (LBOs) and especially, [management buyouts] (MBOs), enhance 
performance and have a salient effect on work practices. More 
generally, the findings of the productivity studies are consistent with 
recent theoretical and empirical evidence, Jovanovic and Rousseau 
(2002) suggesting that corporate takeovers result in the reallocation 
of a firm's resources to more efficient uses and to better managers.''
    2. Kaplan (1989) \8\
    \8\ Kaplan, S.N., 1989a, The effects of management buyouts on 
operating performance and value, Journal of Financial Economics 24, 
    In a classic article, Kaplan examines a sample group of 76 large 
management buyouts of public companies from 1980 to 1986, presenting 
evidence for long-term changes in operating results for these 
companies. Kaplan found that in the three years following the buyout, 
the sample companies experienced increases in operating income, 
decreases in capital expenditures, and increases in net cash flow. 
Consistent with these documented operating changes, the mean and median 
increases in market value (adjusted for market returns) were 96 percent 
and 77 percent over the period from two months before the buyout 
announcement to the post-buyout sale. Kaplan provides evidence that the 
operating changes and value increases are due to improved incentives as 
opposed to layoffs, managerial exploitation of shareholders via inside 
information or wealth transfer from employees to investors.
    3. Wright, Wilson and Robbie (1996) \9\
    \9\ Wright, M., N. Wilson, and K. Robbie, 1996, The longer term 
effects of management-led buyouts, Journal of Entrepreneurial and Small 
Business Finance 5, 213-234.
    The authors examine the longevity and longer-term effects of 
smaller buyouts. The evidence presented shows that the majority of 
these companies remain as independent buy-outs for at least eight years 
after the transaction, and that entrepreneurial actions concerning both 
restructuring and product innovation are important parts of 
entrepreneurs' strategies over a ten year period or more. Wright, 
Wilson and Robbie also provide an analysis of the financial performance 
and productivity of these companies using a large sample of buyouts and 
non-buyouts. Their analysis shows that buy-outs significantly 
outperformed a matched sample of non-buyouts, especially from year 3 
onwards. Regression analysis showed a productivity differential of 9 
percent on average from the second year after the buyout onwards. 
Companies which remained buyouts for ten or more years experienced 
substantial changes in their senior management team, and were also 
found to undertake significant product development and market-based 
strategic actions.
    4. Nikoskelainen and Wright (2007) \10\
    \10\ Nikoskelainen, Erkki, and Mike Wright, 2007, The impact of 
corporate governance mechanisms on value increase in leveraged buyouts, 
Journal of Corporate Finance 13, 511-537.
    The authors use a data set comprising 321 exited buyouts in the 
United Kingdom from 1995 to 2004 to investigate the realized value 
increase in exited leveraged buyouts (LBO). Nikoskelainen and Wright 
test Michael C. Jensen's (1993) free cash flow theory, showing that 
value increase and return characteristics of LBOs are related to the 
associated corporate governance mechanisms, most notably managerial 
equity holdings. They also show that return characteristics and the 
likelihood of a positive return are related to the size of the target 
company and to any acquisitions executed during the holding period.
    5. Renneboog, Simon, and Wright (2007) \11\
    \11\ Renneboog, Luc, Tomas Simons, and Mike Wright, ibid. Why do 
public firms go private in the UK? The impact of private equity 
investors, incentive realignment and undervaluation, 591-628.
    This paper examines the magnitude and sources of the expected 
shareholder gains in United Kingdom Public-to-Private (PTP) 
transactions from 1997 to 2003. They show that pre-transaction public 
shareholders receive a premium of 40 percent. They test the sources of 
value creation from the delisting and find that the main sources of 
value are undervaluation of the target firm in the public market, 
increased interest deduction and tax savings and better alignment of 
owner-manager incentives.
    6. Jensen (1989) \12\
    \12\ Jensen, M., 1989, The eclipse of the public corporation, 
Harvard Business Review 67, 61-74.
    Jensen argues against the 1980's protest and backlash from business 
leaders and government officials calling for regulatory and legislative 
restrictions against privatization (takeovers, corporate breakups, 
divisional spin-offs, leveraged buyouts and going-private 
transactions). He believes that this trend from public to private 
ownership represents organizational innovation and should be encouraged 
by policy. Jensen explains that there is a conflict in public 
corporations between owners and managers of assets known as the 
``agency problem,'' particularly in distribution of free cash flow. He 
argues that weak public company management in the mid 1960s and 1970s 
triggered the privatizations of the 1980s. He sees LBO firms as 
bringing a new model of general management that increases productivity 
because private companies are managed to maximize long-term value 
rather than quarterly earnings. He argues that private equity 
revitalizes the corporate sector by creating more nimble enterprises. 
Jensen further asserts that it is important that the general partners 
of LBO partnerships take their compensation on back-end profits rather 
than front-end fees because it provides strong incentives to do good 
deals, not just to do deals.
    7. Jensen (1993) \13\
    \13\ Jensen, M.C., 1993, The modern industrial revolution, exit, 
and the failure of internal control systems, Journal of Finance 48, 
    Jensen describes the problems that accompany the ``modern 
Industrial Revolution'' of the past 20 years, citing that ``finance has 
failed to provide firms with an effective mechanism to achieve 
efficient corporate investment.'' He explains that large corporations 
today do not follow the rules of modern capital-budgeting procedures, 
most specifically succumbing to agency problems that misalign 
managerial and firm interests--damaging managers' incentives to 
maximize firm value instead of personal gain. The classic structure of 
private equity buyouts helps to realign incentives through increased 
managerial equity holding, increased monitoring via commitment to 
service debt, and the active involvement of investors whose ultimate 
returns depend on the firm's value upon exit. Jensen provides a 
framework for analyzing expected longevity and improved performance in 
the long-run, arguing that financial sponsor involvement in companies 
that have previously been wasting free cash flow and under-performing 
can permanently improve the company's performance through improved 
organization and practices.
    8. Knoll (2007) \14\
    \14\ Knoll, Michael S., 2007, The taxation of private equity 
carried interests: Estimating the revenue effects of taxing profit 
Interests as ordinary income, Social Science Research Electronic Paper 
Collection (Philadelphia, PA).
    Knoll presents the first academic analysis to quantify the tax 
benefit to private equity managers of the current treatment of carried 
interests and the additional tax that the Treasury would collect if 
current tax treatment were changed in accord with recent proposed 
legislation. He points out that it is misleading to look at one party 
in isolation because private equity investments involve several parties 
including general partner, limited partner, and portfolio company 
owners and managers who are joined by negotiated business agreements. 
Knoll uses a method for estimating tax impacts that was developed 25 
years ago by Merton Miller and Myron Scholes (1982). Using the Miller-
Scholes methodology, he estimates the tax implications of raising tax 
rates on carried interest for all parties in the private equity 
    The fund's investment capital comes from its limited partners--
wealthy individuals, charitable foundations with large endowments, 
pension funds, and corporations, and insurance companies. Each limited 
partners has a different tax status. Using estimates of the composition 
of limited partners, Knoll calculates estimates of net tax revenue gain 
from the proposed tax increase.
    Knoll estimates, based on assumed $200 billion of annual limited 
partner investments and with no change in the composition of the 
partnerships or structure of the fund agreements, that the change in 
tax treatment as a combination of ordinary income tax rates and 
accelerating taxation of corporate entities would generate an 
additional $2 to $3 billion per year. He notes, however, that it is 
highly likely that the structure of private equity funds will change in 
response to the tax treatment revisions, shifting some portion of the 
burden of increased taxes to limited partners and to the portfolio 
companies. Assuming that companies are generating taxable profits, and 
can use the additional expense deduction, shifting carried interest to 
portfolio companies would virtually cancel out any additional taxes 
paid by the general partners, with the result that increasing carried 
interest tax rates would generate little or no net increase in tax 
    9. Fleischer (2006) \15\
    \15\ Fleischer, Victor, 2006, Two and Twenty: Partnership Profits 
in Hedge Funds, Venture Capital Funds and Private Equity Funds, 
Colloquium on Tax Policy and Public Finance (NYU School of Law).
    Fleischer proposes a ``cost-of-capital'' approach under which the 
general partners of investment partnerships with more than $25 million 
in capital under management would be allocated an annual cost-of-
capital charge (e.g. 6 percent of the 20 percent profits interest times 
the total capital under management) as ordinary income. The limited 
partners would then be able to deduct the corresponding amount (or 
would capitalize the expense, as appropriate). Fleischer argues that 
this tax treatment more closely reflects the economics of the 
arrangement, explaining ``in the typical fund, the general partner 
effectively receives a non-recourse, interest-free compensatory loan of 
20 percent of the capital in the fund, but the foregone interest is not 
taxed currently as ordinary income.''
    Fleischer claims that his cost-of-capital approach also provides a 
reasonable compromise on the character of income issue: ``as when an 
entrepreneur takes a below market salary and pours her efforts back 
into the business as `sweat equity,' the appreciation in the value of a 
private equity fund reflects a mix of labor income and investment 
income. A cost-of-capital approach disaggregates these two elements, 
allowing service partners to receive the same capital gains preference 
that they would receive on other investments, but no more.''
    10. Weisbach (2007) \16\
    \16\ Weisbach, David A., 2007, The Taxation of Carried Interests in 
Private Equity Partnerships.
    Weisbach argues that the arguments behind the Levin bill (H.R. 2834 
in the 110th Congress) are misplaced for two reasons: 1) the labor 
involved in private equity investment is no different than the labor 
that is intrinsically involved in any investment activity, and should 
be treated no differently; and 2) even if there were good reasons for 
taxing carried interest as ordinary income, the tax changes would be 
``complex and avoidable, imposing costs on all involved without raising 
any significant revenue.''
    To support his first point, he compares private equity investment 
to purchasing stock through a margin account. In both situations, 
investors combine their capital with that of third parties, and labor 
effort is requires to make the investment. The only difference between 
the two scenarios is that private equity funds issue limited 
partnership interests as a means of financing their investment instead 
of margin debt. Weisbach argues that there are no valid reasons to 
change the way that these sponsors are taxed simply because they have 
chosen a different method of financing their activities or because they 
use a partnership.
    The problem of complexity and avoidance that Weisbach describes is 
independent of the issue of what is appropriate according to tax law, 
and is concerned mostly with practicality. In order to change the tax 
treatment of carried interest as proposed, one would first have to 
define carried interests. In addition, if that were accomplished 
satisfactorily, fund managers would have little problem avoiding the 
bulk of these new taxes by acquiring non-recourse loans from limited 
    Weisbach concludes that the decision of private equity fund 
managers to use limited partnerships instead of debt to finance their 
investments does not warrant such a significant change in tax law; and 
that even if it did, the small increases in tax revenues (after 
investors have avoided the bulk of the impact of the tax rate increase 
with simple changes in financing structure) would not outweigh the 
difficulties and costs that the new laws would present.
    11. Abrams (2007) \17\
    \17\ Abrams, Howard E., 2007, Taxation of Carried Interests, Tax 
    Abrams discusses current issues surrounding carried interest tax 
changes, concluding that while current tax law was drafted largely out 
of administrative convenience, it is in fact a fairly good compromise 
between the many conceptual and practical difficulties of fashioning a 
proper tax treatment for investment activities. He argues that while 
surely some portion of the returns could be considered compensation for 
services, it is not valid to classify all of the carried interest 
received by the general partner as compensation since a large part of 
carried interest is in fact the risky return on a capital investment 
and should qualify for capital gain treatment.
    Abrams considers Fleischer's (2006) proposed cost-of-capital 
approach as a compromise, arguing that though much of the logic is 
sound, the proposal has very little effect on tax revenues since with 
every cost-of-capital charge the general partner pays, the limited 
partners are allowed a corresponding deduction, except for non-profit 
tax-exempt entities for whom the deduction holds no value. Because of 
the small impact this system would have on tax revenues, Abrams 
suggests that even if Fleischer's approach were the correct one, the 
transaction cost of changing current tax law is greater than the 
ultimate benefits of such a change, due largely to undesirable 
complexity and avoidance issues.
    12. Fenn and Liang (1995) \18\
    \18\ Fenn, George W., Nellie Liang, and Stephen Prowse, 1995, The 
Economics of the Private Equity Market, Staff Series (Board of 
Governors of the Federal Reserve System, Washington D.C.).
    This thorough review of the history and structure of private equity 
and venture capital was published as a staff study of the Federal 
Reserve Board. The report traces the historical positive role 
regulatory and tax changes have played in fueling investment activity 
through the widespread adoption of limited partnerships as the dominant 
form of organizing private equity ventures.
    Fenn and Liang describe the rise of the partnership as the most 
effective structure for dealing with issues of information and 
incentive structure between the general partner, institutional 
investors, and portfolio companies. Fenn and Liang emphasize that the 
expansion of the private equity market has increased access to outside 
equity capital for both classic start-up companies and established 
private companies.
    Relevant to the current proposed regulatory and tax changes, Fenn 
and Liang describe the abrupt slowing of venture capital investment in 
the late 1960s and early 1970s due to a shortage of qualified 
entrepreneurs, a sharp increase in the capital gains tax rate, and a 
change in tax treatment of employee stock options. These changes not 
only discouraged investments in start-ups but drove fund managers to 
shift to other strategies for private equity investing. The result, 
they note, was an increase in leveraged buy-outs of larger, more 
established companies and very little investment in new ventures.
    Public concern about the scarcity of capital for new ventures 
prompted another round of regulatory changes in the late 1970s, 
changing the guidelines for public pension fund investing to include 
private equity and venture capital investments. The initial impact of 
these changes was to reinvigorate the new-issues market; its long-run 
impact has been to encourage pension fund investments in private equity 
partnerships. The evolution of the limited partnership in combination 
with favorable regulatory and tax changes led to early notable start-up 
successes such as Apple Computer, Intel, and Federal Express.
    Since its inception, the partnership structure has been a 
resounding success, giving American investors and entrepreneurs the 
tools to create and grow businesses, build shopping centers, build 
hospitals, explore for oil and gas, found new technology companies, and 
finance mergers and acquisitions. In 2004, more than 15.6 million 
Americans were partners in 2.5 million partnerships investing $11.6 
trillion using the partnership structure.
    Increasing tax rates on long-term capital gains income designated 
as a general partner's carried interest would alter the long-accepted 
tax principle that partnership income flows through to the partners who 
pay tax based on the character of the income received by the 
partnership. If a group of financial investors came together to form a 
partnership with no general partner to engage in exactly the same 
investment activities, 100 percent of the profits from the partnership 
would be taxed at long-term capital gains rates. The partnership 
structure simply assigns a slice of those capital gains to the general 
partner to induce them to contribute their intangible assets--brand, 
reputation, deal flow network, and experience--to the venture. The fact 
that limited partners do so willingly, through arms-length negotiations 
with general partners, serves as a measure of the value that a good 
general partner brings to the table.
    The incidence of a tax increase on carried interest would not hit 
just the fund managers but would be spread across all the players in 
the partnership--general partners through lower after-tax gains, 
limited partners and their beneficiaries through higher partnership 
costs and lower returns, and owners and employees of operating 
companies as lower business valuations.
    U.S.-based companies are facing fierce international tax 
competition. In today's global economy, countries have to compete for 
the capital they need to grow. Increasing carried interest taxes would 
disrupt long-standing business practices in U.S. capital markets and 
risk undermining America's preeminent position in the world as a leader 
in invention, innovation, entrepreneurial activities, and growth. 
Higher tax rates would reduce the amount of long-term capital available 
to the U.S. economy and undermine investment, innovation, 
entrepreneurial activity, and productivity.

   Statement of National Association of Publicly Traded Partnerships
    The National Association of Publicly Traded Partnerships (NAPTP) is 
pleased to have this opportunity to submit a statement for the record 
with respect to the ``Hearing on Fairness and Equity for America's 
Working Families'' held by the Committee on Ways and Means on September 
6, 2007. NAPTP, formerly the Coalition of Publicly Traded Partnerships, 
is a trade association representing publicly traded partnerships \1\ 
(PTPs) and those who work with them. Our current membership includes 
sixty PTPs and thirty-five other companies.
    \1\ Publicly traded partnerships are also referred to as ``master 
limited partnerships'' or MLPs.
    PTPs are provided for under section 7704 of the Internal Revenue 
Code. This section generally provides that a very limited universe of 
companies--those engaged in active natural resource or real estate 
business as well as those generating passive investment income--can be 
publicly traded partnerships.
I. Publicly Traded Partnerships and Carried Interest
    A primary focus of this hearing is the fact that certain private 
equity and hedge fund managers, among others, are compensated for their 
services via a ``carried interest''--a partnership profits interest--
and that this compensation is received and taxed as capital gains. 
Awareness of and concern about this practice escalated early this year 
when a few such funds went public as PTPs or expressed the intention of 
doing so. It is important to remember, however, that the ability of 
these managers to receive carried interest in the form of capital gains 
arises not because their companies are publicly traded partnerships--
the vast majority are not--but because they are partnerships whose 
investments produce capital gain. The tax treatment of carried interest 
is based on long established rules of Subchapter K regarding the tax 
treatment of partnership interests received in return for services 
provided to the partnership, and not on the publicly traded partnership 
rules of section 7704.
    Moreover, it is important to recognize that not all carried 
interests, nor all partnership profits interests, pass through capital 
gains to the holder of the interest. The rate at which the income from 
``carried interest'' is taxed is dependent on (i) the organizational 
nature of the company receiving the carried interest (C corporation, 
partnership, etc.) and (ii) the character or nature of the underlying 
income. If the recipient is a C corporation, the income will be taxed 
at ordinary income tax rates. If it is a partnership, then it is not 
taxed at the entity level and the rate at which it is taxed is 
dependent on the nature of the income. The nature of the income 
received by the partner will depend upon the nature of the income 
generated by the business. Typically, the private equity funds receive 
the bulk of their income when they sell the companies in which they 
invest, and the proceeds from a sale are usually characterized as long-
term capital gains. In contrast, the business of ``traditional'' PTPs, 
i.e., those PTPs clearly and purposefully treated as partnerships in 
1987, generates ordinary income.
    The general partners of many PTPs (ten of which are themselves 
PTPs) have profits interests known as an incentive distribution rights 
(IDRs), under which the general partner receives a 2 percent interest 
in the PTP's income. This percentage share increases in steps as 
distributions to the limited partners reach target levels. This profits 
interest, however, gives rise to ordinary business income and is taxed 
as such in the hands of the general partner.
    While private equity firms are not part of NAPTP, we take no 
position on whether the carried interest rules for investment 
partnerships should be changed. However, as an association that was 
organized in the 1980s when the tax treatment of PTPs was a subject of 
debate, and which played a role in the enactment of the current law 
that preserves partnership treatment for certain PTPs, NAPTP is happy 
to provide its perspective on the history and intent of section 7704 
and to provide information on the PTPs that we represent.
    As we do so, we strongly urge that Congress avoid changing the law 
that for two decades has governed the ``traditional'' PTPs. Those PTPs 
operating in the energy industry in particular are a long-established 
segment of that industry and play an important role in the development 
of the national energy infrastructure needed to insure our continued 
economic growth and security. This role is widely recognized by 
observers ranging from FERC to energy analysts on Wall Street. There is 
no policy reason to overturn twenty years of settled and successful tax 
law by changing the tax treatment of these traditional PTPs.
II. Early History of PTPs
    The first publicly traded partnership was Apache Petroleum Company, 
which was created in 1981 by Apache Oil through the roll-up of several 
smaller partnerships. It was soon followed by a number of oil and gas 
exploration and production PTPs as well as by real estate PTPs. Some, 
like Apache, were formed by partnership roll-ups; some by spin-offs of 
corporate assets; some (until the Tax Reform Act of 1986 repealed the 
General Utilities doctrine) through corporate liquidations; and a few 
through IPOs for new business operations.
    The energy and real estate industries had traditionally used 
limited partnerships as a means of raising capital and conducting 
operations. The pass-through structure of partnerships allowed 
investors to share directly in both the profits and the tax attributes 
of these industries. Traditional limited partnerships, however, could 
attract only a limited pool of investors. They required investors to 
commit large amounts of money and were very illiquid. Thus, only very 
affluent investors could afford to participate.
    By dividing partnership interests into thousands or tens of 
thousands of units which were affordably priced and could be traded on 
public exchanges, PTPs were able attract a far broader range of 
investors than private limited partnerships, providing a new flow of 
equity capital to the energy and real estate industries. Unlike many of 
the limited partnerships that were formed during the 1980s as tax 
shelters aimed at providing investors with a tax loss, PTPs were 
created to be income-generating investments. Companies with energy, 
real estate, or other assets providing positive income streams over a 
number of years were able to attract investors seeking steady cash 
    As the 1980s progressed, PTPs began to emerge in other industries, 
e.g., the Boston Celtics and the Cedar Fair amusement park company. 
This became a source of concern to tax policymakers.
A. Development of the 1987 Legislation
    Until 1987 there were no provisions in the Internal Revenue Code 
specifically addressing publicly traded partnerships. However, the 
growth of PTPs led to fears on the part of the Treasury Department and 
some Congressional policymakers that the expansion of PTPs would cause 
a substantial loss of corporate tax revenue. In addition, the 1980s 
were the decade of tax reform, and some felt as a policy matter that 
the fact that public trading of securities was an inherently corporate 
characteristic--an idea with which we have always disagreed.\2\
    \2\ The vast majority of corporations are never publicly traded.
    After several years of debate over the issue of whether large and/
or publicly traded partnerships should continue to receive pass-through 
tax treatment, the Treasury Department and Congressional tax writers 
determined to address the issue in 1987. It was clear from the 
beginning that while there were varying views on the degree to which 
PTPs should be restricted, there was considerable support for the idea 
that the natural resources industry, which had always raised capital 
through partnerships, should continue to be able to do so through PTPs.
    Hearings on publicly traded partnerships were held by this 
Committee on June 30 and July 1, 1987, and by the Senate Finance 
Subcommittee on Taxation and Debt Management on July 21, 1987. At both 
the House and Senate hearings, Assistant Treasury Secretary for Tax 
Policy J. Roger Mentz, one of the primary advocates of restricting the 
use of PTPs, testified that partnership tax treatment should be 
retained for PTPs engaged in natural resources development:
    If Congress changes the classification of MLPs for tax purposes, we 
suggest that it consider extending the current statutory pass-through 
models to include activities such as natural resource development. 
Thus, as with REITs, RICs, and REMICs, entities engaged principally in 
developing timber, coal, oil, and gas, and other natural resources 
serve a relatively passive function, generating income from wasting 
assets and distributing it to investors. Given the importance of 
natural resource development in the nation's security, Congress should 
consider carefully whether such traditionally noncorporate activities 
should be subjected to corporate level tax. . . . [Emphasis added]
B. Final Legislation
    The provisions that we now know as section 7704 of the Code, which 
were enacted as part of the Revenue Act of 1987, originated in this 
Committee. This Committee retained partnership tax treatment for PTPs 
generating the type of income, such as interest and dividends, that one 
would receive as a passive investor, explaining in its report,
    If the publicly traded partnership's income is from sources that 
are commonly considered to be passive investments, then there is less 
reason to treat the publicly traded partnership as a corporation, 
either because investors could earn such income directly (e.g., 
interest income), or because it is already subject to corporate-level 
tax (in the case of dividends). Therefore, under the bill, an exception 
is provided . . . in the case of partnerships whose income is 
principally from passive-type investments.
    This Committee did not allow interest to be treated as qualifying 
income if it was earned in conducting a financial or insurance 
business, ``as deriving interest is an integral part of the active 
conduct of the business.'' Dividends, unlike interest, were not 
specifically restricted in the statutory language, but this Committee's 
report states, ``Similarly, it is not intended that dividend income 
derived in the ordinary conduct of a business in which dividend income 
is an integral part (e.g., a securities broker/dealer) be treated as 
passive-type income.''
    Importantly, this Committee also retained partnership tax treatment 
for PTPs engaged in two types of active businesses: real estate and 
natural resource activities, noting in its report that these activities 
``have commonly or typically been conducted in partnership form'' and 
that it ``considers it inappropriate to subject net income from such 
activities to the two-level corporate tax regime to the extent the 
activities are conducted in forms that permit a single level of tax 
under present law.'' Natural resources activities were purposely 
defined very broadly to include ``income and gains from exploration, 
development, mining or production, refining, transportation (including 
through pipelines transporting gas, oil or products thereof), or 
marketing of, any mineral or natural resource, including geothermal 
energy and timber.'' \3\ This is essentially the rule that Congress 
adopted in the final bill.
    \3\ ``In the case of natural resources activities, special 
considerations apply. Thus passive-type income from such activities is 
considerably broader. . . .''
    In summary, Congress' intent in 1987 was to allow partnership tax 
treatment for PTPs generating investment-type income, i.e., income such 
as interest and dividends which a passive investor might earn without 
directly participating in a business. Partnership tax treatment for 
active business operations was also allowed to continue for two 
industries which had traditionally used the partnership structure, real 
estate and natural resources. Importantly, however, the evidence is 
that Congress also intended that qualifying income should include 
dividends received by PTPs from taxpaying corporate subsidiaries.
C. Non-Qualifying Income and Corporate Subsidiaries
    As noted above, while the legislative history of section 7704 
clearly indicated that interest and dividends earned as part of a 
financial business should not be considered to be qualifying income, it 
did not state or imply that dividends from corporate subsidiaries of 
PTPs would not be qualifying income to the PTP. To the contrary, it is 
apparent that Congress condoned the use of corporate subsidiaries.
    The 1987 Treasury testimony noted above, which suggested that 
partnership tax treatment be retained for entities engaged principally 
in developing natural resources, also acknowledged that if this 
exception was enacted into law, many ``downstream'' operations such as 
milling, processing, refining, or marketing activities would remain in 
corporate form. Thus Congress was aware of the potential use of 
corporate subsidiaries for this purpose and did not exclude or restrict 
dividends from such subsidiaries as qualifying income in enacting 
section 7704.
    In addition, as the legislative history makes clear, section 7704 
was resulted from the concern that the widespread use of PTPs would 
lead to a loss of corporate income tax revenue. Thus, there could be no 
objection to a PTP receiving dividend income from a subsidiary earning 
non-qualifying income that had been subject to corporate tax. Finally, 
the transition rules provided by Congress for existing PTPs with non-
qualifying income allowed them to remain in existence after the 
transition period ended if they were able to change their income stream 
to meet the qualifying income test of 7704, and placed no restrictions 
on PTPs' ability to place operations in corporate subsidiaries for this 
    Some NAPTP members form corporate subsidiaries for related 
activities that generate non-qualifying income.\4\ This is done to 
ensure that the qualifying income test is met. Although the amounts 
involved are usually quite small, it is important to remember that the 
penalty for exceeding the 10 percent limit on non-qualifying income is 
extremely severe--the conversion of the PTP into a corporation, with 
resulting adverse tax consequences to the company and its investors. We 
therefore feel it is entirely appropriate to use a corporate 
subsidiary, which is not afforded flow-through treatment, to act as a 
``safety valve'' for the qualifying income test.
    \4\ Some members also have corporate subsidiaries which generate 
qualifying income, as part of an acquisition or joint venture, or for 
other reasons.
    Since 1987 no additional restrictions have been placed on the 
activities of publicly traded partnerships and there have been some 
small liberalizations in their tax treatment. For example, in 1993 the 
rule enacted in 1987 which treated all income from a PTP as unrelated 
business income for tax-exempt investors, regardless of the nature of 
the income, was repealed; and in 2004, with bipartisan support, 
Congress added PTPs to the list of qualifying income sources for mutual 
III. PTPs Today
A. PTP Businesses
    The PTP universe today looks very different from the one in 1987. 
Most of the PTPs doing business in 1987 are gone, eliminated not by 
Congress, but by the marketplace. Changes in economic conditions for 
the energy and real estate industries in the latter part of the 1980s 
led to a wholesale change in the composition of the PTP universe.
    Gradually over the course of the 1990s and early 2000s, the 
exploration and production PTPs were replaced by companies in the 
``midstream'' sector of the energy business: pipeline and marine 
transportation, processing, refining, gathering, marketing, etc. This 
sector is much less affected by oil and gas prices, receiving a 
contracted fee for services regardless of the price of the commodity, 
and thus is better able to maintain steady distributions through the 
ups and downs of the markets. Companies with these types of assets, 
particularly regulated pipelines, found that they were able to attract 
more capital in PTP form than in corporate form.
    Today, by the Association's count, there are some 80 publicly 
traded partnerships trading on the major exchanges, including the 
Fortress and Blackstone entities. The great majority of these are 
energy-related partnerships, as demonstrated in Table 1. The total 
market capital of these 80 PTPs is about $163 billion as of August 31, 
of which about $134 billion or 82 percent comes from the energy-related 

     Table 1 Publicly Traded
 Partnerships on Major Exchanges
                                             Percent    Market   Percent
                                  Number*    of Total   ($B)     of
Oil and Gas Midstream Operations  39         48.8%      $91.7    56.2%
Marine Transportation             6          7.5%       $3.8     2.3%
Propane & Heating Oil             9          11.3%      $23.6    14.4%
Oil & Gas E&P                     7          8.8%       $7.6     4.6%
Coal                              5          6.3%       $7.4     4.5%
All Energy                        65         82.3%      $134.0   82.2%
Other Minerals, Timber            2          2.5%       $2.2     1.4%
Real Estate--Income Properties    3          3.8%       $8.5     5.2%
Real Estate--Mortgage Securities  3          3.8%       $1.8     1.1%
Miscellaneous                     6          7.5%       $16.5    10.1%
All PTPs                          80         100%       $163.0   100.0%
 ANumbers include 10 PTPs which are publicly traded general partners of
  other PTPs. This includes 6 in Midstream Operations, 2 in Propane &
  Heating Oil, and 2 in Coal.

B. PTPs in the Energy Industry
    Of the various sectors of the energy industry in which PTPs 
operate, the largest by far, representing over half of the PTP market 
capital, is the midstream sector: PTPs which gather oil and natural gas 
in gathering pipelines; compress natural gas for transportation; refine 
or process crude oil and natural gas into natural gas liquids; fuels, 
and other products; transport oil, gas, and refined products in intra- 
and interstate transmission pipeline systems; and store them in 
terminals. Another group of PTPs, currently six in number, transports 
petroleum products by water to areas not reached by pipelines.
    In other energy niches, several PTPs are engaged in the 
distribution of heating oil and propane. In addition, seven to date 
have returned to the place where PTPs originally started--exploration 
and production of oil and gas. For various reasons, these PTPs are 
considered by analysts to be more conservative and less risky than 
their 1980s counterparts. Finally, three PTPs and two PTP general 
partners are in the coal industry; one engaged in active production; 
the others as lessors of coal reserves.
    As midstream energy operations have become an increasingly 
important part of the businesses conducted by PTPs, PTPs have 
conversely become an increasingly important part of the midstream 
energy industry, and particularly the ownership and operation of oil 
and gas pipelines. As shown below in Figures 1 and 2, the midstream 
energy PTPs dominate the PTP world in both numbers and market capital.
    Why has so much midstream energy capital moved into PTPs? Over the 
past decade, many corporate energy companies have realized that they 
had a good deal of capital tied up in pipeline assets which, although 
dependable generators of cash, produce only a modest return, 
particularly for those pipelines subject to rate regulation. By selling 
these assets to PTPs, they could monetize them and reinvest the capital 
in areas closer to their core business and with higher returns. PTP 
unitholders, meanwhile, would receive the benefit of the steady cash 
distributions generated by pipeline fees.
    PTPs, for their part, have proven to be a highly efficient means of 
raising and investing capital in pipeline systems. Their structure 
affords such PTPs a lower cost of capital, allowing them to spend more 
on building or acquiring pipelines. PTPs need to pay out most of their 
earnings as cash distributions due to their pass-through tax status, 
which requires the unitholders to pay tax on their shares of 
partnership income regardless of whether they receive a corresponding 
amount in cash; therefore, PTPs cannot retain earnings for building or 
acquiring pipelines and other assets. The need to go to the equity or 
credit markets to raise capital lends discipline to their capital 
expenditures, helping to ensure the most efficient use of capital.
    For these reasons, the proportion of oil and gas pipelines owned by 
MLPs has steadily increased over the years. We estimate that PTPs today 
own over 200,000 miles of pipelines--gathering and transmission, 
onshore and offshore, carrying natural gas, natural gas liquids, crude 
oil, and refined products, as shown in Table 2. Of the $163 million of 
PTP market capital, $102 million is in pipeline PTPs. To an increasing 
extent, PTPs are building and maintaining the pipeline infrastructure 
on which we depend for energy security.

 Table 2 PTP-Owned Pipeline Mileage as of August
                                                  Mileage (1)
Crude Oil                                         29,496
Refined Petroleum Products                        37,527
Natural Gas                                       123,942
Natural Gas Liquids \(3)\                         20,641
TOTAL                                             211,606
(1) Sources: PTP 10-Ks and websites. When a PTP owns a partial interest
  in a pipeline, the mileage included is equal to (pipeline miles) x
  (percentage interest).

    This fact has been increasingly recognized by, among others, the 
Federal Energy Regulatory Commission (FERC), which oversees a number of 
pipelines owned and operated by PTPs. Most recently, on July 19, 2007, 
FERC Chairman Kelliher issued a policy statement stating that PTPs will 
henceforth be included in the proxy group for calculation of returns 
under the discounted cash flow model for natural gas pipelines. 
Kelliher noted that PTPs have been included in oil pipeline proxy 
groups for a number of years due to the lack of corporate owners and 
    The reality is that both sectors have increasingly adopted the MLP 
structure as the framework for the pipeline business. This raises a 
policy question: have we reached a tipping point, have we reached the 
point where the natural gas pipeline sector has adopted the MLP to such 
an extent that it is perverse to exclude MLPs from the proxy group? In 
my view we have reached that point. It seems clear we reached that 
point with respect to oil pipelines some time ago.
    It was in recognition of this fact that the Senate Finance 
Committee this year included in its energy tax provisions a measure 
that would include transportation and storage of blended ethanol, 
biodiesel, and other renewable fuels in the definition of ``natural 
resource activities'' under section 7704. If the Federal policy of 
dramatically increased use of these fuels is to be achieved, pipelines 
will have to be built or converted to carry them. The past decade has 
shown that if large amounts of capital are to be put into pipelines, it 
will be PTPs that will do it.
    The energy PTPs are doing exactly what Congress intended them to do 
in 1987, including building and maintaining the pipeline infrastructure 
on which we depend for energy security. Accordingly, the PTP provisions 
are working well and should be allowed to continue doing so.
IV. Conclusion
    Twenty years ago Congress and the Treasury Department undertook a 
lengthy and careful consideration of the issue of publicly traded 
partnerships and who should have access to this particular business 
structure. The result was the enactment of section 7704 of the Tax 
Code. It is clear from the legislative history that those in Congress 
and the Executive Branch who participated in the development of section 
7704 intended that--

      Activities generating passive investment income such as 
interest and dividends should be able to use publicly traded 
partnerships. However, companies for whom interest and dividends were 
their business income, such as those in the financial services 
industry, should not qualify as PTPs.
      Two types of active businesses, natural resources and 
real estate, which had traditionally raised capital through 
partnerships and whose existence was important to the national economy, 
should continue to be able to access the capital markets in partnership 
      As long it is not ``business'' income to a PTP, dividend 
income, including income received from a corporate subsidiary, is 
qualifying income.
    Over the ensuing years, the economics of the midstream energy 
transportation and storage industry and the interest of many integrated 
energy companies in finding more lucrative investments for their 
capital, have led to an increasingly important role for PTPs in this 
sector. The PTP rules have worked well in allowing capital to be 
channeled into the infrastructure needed to move traditional energy 
sources out of the ground, process them into useable products, and 
transport them from production areas to the areas where they are 
consumed. As the country moves to alternative forms of energy, PTPs 
will continue to play a central role. The ongoing debate on the pros 
and cons of carried interest should not be allowed to change this fact.

            Statement of National Center for Policy Analysis
    Mr. Chairman and Members of the Committee, thank you for this 
opportunity to submit testimony on methods to achieve a fair and 
equitable tax system. My testimony draws heavily from research 
conducted by scholars at the National Center for Policy Analysis 
(NCPA), particularly from NCPA Brief Analysis numbers 537, 571, and 
588--all of which can be found at the ncpa.org website.
    The Alternative Minimum Tax (AMT) enacted in 1978 was intended to 
tax the small number of wealthy individuals who, in any given year, 
legally owe no personal income tax due to the many exemptions allowed 
by the U.S. Tax Code. The AMT has its own set of rules, which limit 
deductions. Individuals with incomes above a certain level calculate 
their taxes under both sets of rules and pay whichever amount is 
    However, the exemption levels are not indexed for inflation. Thus, 
as incomes have risen, more and more middle-class Americans have been 
forced to pay the AMT. Congress has addressed this problem by passing a 
series of temporary increases in the exempt amount, but when these 
temporary fixes expire, millions of middle-income citizens will be 
forced to pay a tax intended only for the super-rich. Rather than 
creating another temporary fix, Congress should use this opportunity to 
permanently restructure the tax system.
Problems with the AMT
    In addition to the burden that awaits middle-class families when 
the AMT extensions expire, there are other problems.
    Uncertainty for Taxpayers. By continuously setting back the date 
when the 2000 exemption levels return, legislators create uncertainty 
in the economy. In any given year, if Congress cannot agree on 
legislation to temporarily extend higher exemption levels, the middle 
class will be hit by the AMT. Furthermore, should Congress allow a 
return to 2000 exemption levels, the complexity of the AMT creates 
uncertainty for individual tax filers as to how they will be affected. 
Thus, even in the years when Congress is successful in extending higher 
exemptions, middle-class taxpayers may reduce their investments in 
order to protect themselves against a possible future rollback.
    Future Dependence. Because of the growing number of taxpayers 
filing the AMT every year, the Federal budget will increasingly depend 
on it for tax revenue. Though repealing the AMT will cost an average of 
$74.5 billion annually over the next decade, if it remains in place, 
the costs increase over time. Every year, over two million more 
taxpayers will file AMT. By 2008, the AMT will be more expensive to 
repeal than the income tax--$100 billion versus $72 billion--according 
to the Tax Policy Center.
    Unfairness. Currently, the AMT taxes individuals a flat 26 percent 
of gross income minus deductions for mortgage interest and charitable 
contributions. Therefore, the brunt of the AMT falls on taxpayers 
earning between $200,000 and $500,000. This is because they are most 
likely to fall under the AMT, but have lower mortgage interest and 
charitable deductions than higher-income taxpayers. While 43.4 percent 
of these individuals filed AMT in 2005, only 26.4 percent of taxpayers 
with incomes of more than $1,000,000 did, according to the Tax Policy 
Center. Ironically, the AMT does not achieve its original goal. Even 
with the AMT, 5,650 tax filers with incomes over $200,000 owed no 
income taxes in 2002.
The Regular Income Tax versus the AMT
    In the 1970s and 1980s, supply-side economists and journalists 
noted that high marginal tax rates create a large ``tax wedge'' between 
the after-tax income workers receive and the value society places on 
their output--and between the after-tax return on investment and the 
value of the production that investment makes possible. A big tax 
wedge, and high marginal tax rates, stunt economic growth by 
discouraging work and investment. For a given amount of tax revenue 
raised, the lower the marginal tax rate the better.
    The supply-siders' insight wasn't novel. In the United Kingdom, the 
top marginal tax rate in the 1970s was 83 percent on earned income and 
98 percent on interest and dividends. James Mirrlees, a ``left-wing'' 
economist and Labour Party adviser, concluded that the optimal top 
marginal tax rate was only about 20 percent and that rates for other 
income groups should be close to 20 percent. An optimal tax rate would 
generate substantial government revenue while not greatly reducing 
individual incentives to work and invest.
    In other words, Mirrlees provided an economic rationale for a 
``flat tax,'' such as an income tax that imposes the same rate at all 
income levels. Although such a reform is desirable, the odds that such 
a flat rate will ever be implemented are small. But it is possible to 
get much of the way there by flattening the AMT.
The AMT versus a Flat Tax
    Most flat tax advocates want a zero percent tax rate on a minimum 
level of income and a tax rate of about 19 percent on all additional 
income, with few, if any, deductions allowed. The current AMT differs 
from this flat tax system in three main ways: (1) The basic exemption 
is higher, (2) the marginal tax rates are substantially higher, and (3) 
the expenses that are deductible are more numerous than under a flat-
tax regime. All three aspects of the AMT could be modified easily, 
while raising the same amount of revenue for the Federal Government.
    Under the AMT, instead of basic deductions, the first $45,000 of 
income is exempt for a married couple filing jointly. The tax rate on 
this income is zero. As the figure shows:

      On income above $45,000 the marginal tax rate is 26 
percent, up to $150,000.
      Above $150,000 the marginal tax rate is 32.5 percent up 
to $206,000.
      Above $206,000 the marginal rate is 35 percent up to 
      Above $330,000 the marginal tax rate falls to 28 percent.

    Although the IRS publishes AMT tax rates of 26 percent and 28 
percent, in practice there are 4 rates since the exemption on the first 
$45,000 is phased out at higher income levels. After the exemption is 
completely phased out, the rate falls back to 28 percent.
    AMT reformers usually advocate raising the amount of income that is 
exempted, which has been done in past years. Instead, Congress could 
reduce the exemption, further limit deductions and cut the AMT marginal 
tax rate to 24 percent, or even 20 percent. As recently as 1986, the 
AMT marginal tax rate was 20 percent. (The 1986 Tax Reform Act raised 
the marginal AMT rate to 21 percent, the 1990 tax bill raised it to 24 
percent and the 1993 tax bill imposed the current nominal rates of 26 
percent and 28 percent.)
Is a Flat Tax-Rate Desirable?
    As supply-siders have emphasized, a low flat tax-rate has a 
positive effect on the incentives to earn, save, invest and become more 
productive, whether through training, education or experience. The 
lower the marginal rate, the stronger the incentives.
    Critics of supply-side economics have admitted that the marginal 
dollars taxpayers are allowed to keep are an incentive to earn more 
income. But they also argue that since cuts in tax rates make taxpayers 
better off, they may use this higher real income to ``buy'' leisure--
that is, work less. But this criticism warrants little attention unless 
the choice to work less resulted in less government revenue.   Instead, 
the tax system could be changed to keep the Federal Government's 
revenues constant by reducing AMT deductions in exchange for lower 
marginal tax rates. In economics jargon, the system could be changed so 
that there is a substitution effect (working harder in response to 
higher after-tax incentives), but no income effect (that is, working 
less hard because of the tax break on nonmarginal dollars). The net 
effect would be more work and more output.
Long-Term Solutions: Flat Tax or Consumption Tax
    As it is currently imposed, the AMT is complex and ineffective in 
ensuring that the wealthy pay taxes on their incomes. But even if it 
were repealed this year (while leaving the rest of the income tax 
system in place), by 2010, over 9,000 high-income filers would pay zero 
income tax, due to exemptions.
    Congress should create a system that taxes everyone fairly and 
efficiently, and simplifies the entire Federal Tax Code. One solution 
is to replace the bloated, complex income tax system with a flat income 
tax. Another, purer, solution would be to implement a national sales or 
consumption tax.
A Lower Rate Flat Tax
    A lower-rate flat tax can be structured in a way that:
      Ensures the rich continue to bear more of the burden than 
they currently do; thus, the plan can be more progressive than the 
current system.
      Taxes income only once (when it is earned), and does not 
tax savings or investments; thus, the plan promotes efficiency and 
economic growth.
      Does more to help low-income families by providing 
incentives to purchase health insurance and invest for retirement.

    Steve Forbes has proposed a flat rate of 17 percent, with generous 
personal exemptions for all families, so that a family of four would 
not pay taxes until its income exceeded $46,000. Moreover, the Forbes 
plan encourages growth by exempting income that is saved and invested. 
Which means that the Forbes plan approximates a consumption tax. It 
taxes people based on what they take out of the economy, not on what 
they put in. It is a good plan, but can be improved upon.
    The tax rate can be lowered further--14 percent as opposed to 17 
percent--and at the same time do more to help low-income people. With 
the assistance of Boston University economist Laurence Kotlikoff, an 
advocate of a national retail sales tax, the NCPA put together a plan 
that works in the following way.
    First, it would eliminate the across-the-board $9,000-per-person 
exemption in the Forbes plan. Why should billionaires like Bill Gates 
get an exemption? Forbes' plan gives too much money away to rich 
people. Eliminating the across-the-board exemption would allow the 
money to be rebated to the bottom third of earners, those who bring 
home roughly less than $25,000 for a family of four.
    Second, Forbes doesn't address the 12.4 percent Social Security 
payroll tax (split between employer and employee), although the payroll 
tax is an example of a pure flat tax. Currently, income over $90,000 a 
year is not subject to the tax. It is a regressive feature of the 
current tax system that a $50,000-a-year autoworker has to pay payroll 
taxes on all his income while a million-dollar-a-year auto executive 
does not. Under the NCPA proposal, the income ceiling would be lifted 
and all wages would face the same income and payroll tax rates.
    These changes should make a flat tax plan more politically 
appealing. Politicians are unlikely to adopt a new system that taxes 
the paychecks of the rich at a lower rate than those of blue-collar 
workers. Under the NCPA proposal, all wages would face the same income 
and payroll tax rates. And they would be taxed only once. All savings 
would accumulate tax free and be taxed only when withdrawn.
A More Progressive Flat Tax
    This plan allows a lower flat-tax rate and produces results that 
should appeal to liberals as well as conservatives. What conservatives 
most want is an uncomplicated system that taxes income only once (when 
it is earned) at one low rate. Liberals are more concerned about 
progressivity. They want the rich to bear more of a burden than the 
    The left objects to most consumption tax proposals because they 
mistakenly believe they aren't progressive. Low- and middle-income 
people would pay a greater share of what they earn than rich people. 
This proposed system is more progressive than the Forbes flat tax. It's 
also more progressive than the current system. Using economic modeling, 
Kotlikoff found that under the NCPA flat tax the rich would bear more 
of the burden than they currently do.
Health Care and Pensions
    Most flat-tax proposals ignore health insurance and retirement 
saving. Yet the failure to insure or save--especially for low-income 
families--is a social problem. For that reason, the rebate of tax 
dollars to the bottom third of taxpayers would be used to help solve 
these problems. For example, as a condition of receiving the 14 percent 
rebate, low-income families would be required to show they have health 
insurance and a retirement pension. Specifically, to get one-half the 
rebate (7 percent), they would have to produce proof of health 
insurance. This would encourage millions of people who qualify to 
enroll in Medicaid or in their employer's health plan. Barring that, 
families could apply the tax rebate to health insurance they purchase 
on their own. The other half (7 percent) of the rebate would be 
contingent on proof of a pension, an IRA, a 401(k) or some other 
savings account. So instead of national health insurance and more 
government spending on the elderly, this flat-tax proposal would 
encourage people to solve these problems on their own.
A Higher Rate of Economic Growth
    The tax system itself drags down the economy with the cost of 
keeping mountains of records and filling out voluminous forms. It also 
distorts economic decisions--everything from whether a spouse works to 
how much families save. The U.S. Government Accountability Office 
recently published estimates of these economic costs by various 
researchers. They found the efficiency cost of the tax system--the 
output lost over and above the amount of taxes collected--is 2 percent 
to 5 percent of gross domestic product. [See the figure.] In short, we 
lose between $240 billion and $600 billion every year just collecting 
    A post-card-sized tax return would slash compliance costs. A single 
tax rate applied to all wages would make the system more equitable and 
transparent. By improving economic efficiency, it would raise 
productivity and hence the rate of economic growth.
National Consumption Tax--The Fair Tax
    Another innovative tax reform proposal that deserves consideration 
is the national sales or national consumption tax, more recently called 
the Fair Tax. The Fair Tax would build on these fundamentals of 

      Only people pay taxes.
      Consumption tax rates are self-limiting.
      Uniformity of taxation wards off special interest 
    As described at fairtax.org, the Fair Tax proposal would replace 
all Federal income and payroll taxes with a progressive national retail 
sales tax. The Fair Tax would also incorporate a tax credit to ensure 
no Federal taxes are paid on spending up to the Federal poverty level. 
The Fair Tax would replace Federal personal and corporate income taxes, 
gift, estate, capital gains, AMT, Social Security, Medicare, and self-
employment taxes and it would be administered primarily by existing 
state sales tax authorities.
    Based on work done by Boston University economist Laurence 
Kotlikoff and Beacon Hill Institute, a Fair Tax rate of $0.23 out of 
every retail dollar spent on new goods or services would generate 
Federal tax revenues of approximately $2.6 trillion--about $350 billion 
more than the revenues generated by the taxes it would repeal. The Fair 
Tax would likely lower the lifetime tax burden for most Americans and 
would greatly simplify Federal tax compliance. The Fair Tax would also 
obviate the need for the Internal Revenue Service.
    The AMT has not achieved its intended goals. It is inefficient 
because it discourages investment. At the same time, the AMT is 
ineffective in taxing the super-rich. Left unabated, it will cause a 
major tax increase for middle income filers starting in 2007. Congress 
could use this problem as an opportunity for restructuring the Federal 
Tax Code.
    Both the flat tax and the consumption tax are big improvements over 
the current mess. A low-rate flat tax would help the economy. A rebate 
to the poor would enhance progressivity. Making the rebate contingent 
on the purchase of health care and saving for retirement will improve 
the quality of life. A national consumption tax--with a provision 
exempting spending up to the Federal poverty level--would dramatically 
shrink the costs of tax compliance and would promote an efficient, 
transparent means for Federal revenue generation.
    President Bush said that he wants to reshape our tax system. Many 
in Congress agree on the need for change. But an oft-repeated objection 
is that tax reform benefits high-income taxpayers at the expense of 
low-income taxpayers. With the ideas presented here, that objection 
need not apply.

      Statement of National Taxpayers Union, Alexandria, Virginia
    Chairman Rangel and distinguished Members of the Committee, thank 
you for the opportunity to submit written comments on behalf of the 
American Taxpayer regarding the important issues of tax fairness and 
tax equity. My name is Andrew Moylan, and I am Government Affairs 
Manager for the National Taxpayers Union (NTU), a non-partisan citizen 
group founded in 1969 to work for lower taxes and smaller government at 
all levels. NTU is America's oldest and largest non-profit grassroots 
taxpayer organization, with 362,000 members nationwide.
    I write to offer our comments on the issue of tax fairness in 
private equity and the Alternative Minimum Tax (AMT). Few citizen 
groups in Washington can match NTU's 38-year history of participation 
in the national debate over tax fairness and simplification. We have 
established a principled stance in favor of lower, simpler taxes on all 
individuals and businesses, not just those who are politically in 
fashion at a given moment. You can find further research into these 
topics on our website at www.ntu.org.
    Any discussion of tax fairness ought to begin with some context, by 
examining IRS data. Tax returns filed in 2005 indicate that on the same 
dollar, the wealthiest 1 percent of Americans paid an effective income 
tax rate nearly eight times higher than those in the bottom 50 percent. 
This picture does not change significantly even when taxes often 
thought of as ``regressive'' are included in the analysis.
    A December 2005 study by the Congressional Budget Office (CBO) 
provides some illuminating statistics to prove the point. It accounted 
for ALL Federal taxes, including income, payroll, and social insurance 
taxes, and broke the burden down by income quintile. CBO found that 
Americans in the lowest income quintile (who made an average of 
$14,800) paid 4.8 percent of their income in ALL Federal taxes. 
Meanwhile, the highest quintile (situated at an average of $184,500) 
paid 25.0 percent of their income in taxes. Additionally, the top 1 
percent of all income earners (who bring in an average of more than 
$1,000,000) pay 31.4 percent off the top in taxes.
    This is hardly the picture of a Tax Code that is insufficiently 
progressive. The richest among us pay the most in taxes, in both 
absolute and relative terms. Yet, in spite of that fact, some Members 
of Congress persist in poisoning the tax policy debate with false 
rhetoric about the Tax Code being tilted toward the wealthy.
Private Equity Taxation
    In the rush to find ``pay-fors'' to fund other priorities, some in 
Congress are now eyeing so-called ``carried interest'' taxes on private 
equity managers to raise additional revenue. These managers are 
compensated using the ``2-and-20'' method, which means that they get a 
salary worth 2 percent of the fund's assets and receive 20 percent of 
any capital gains the fund earns (also known as carried interest). If 
the fund suffers a loss, its manager receives nothing from the ``20'' 
portion and is compensated solely by the 2 percent portion.
    That 2 percent is taxed at normal income rates while, under current 
law, the ``20'' component is taxed at the capital gains rate of 15 
percent. One proposal, H.R. 2834 introduced by Representative Levin (D-
MI), seeks to change the treatment of the ``20'' share so that it is 
taxed at ordinary income rates as well. This would have the effect of 
raising taxes more than 230 percent on the capital gains of fund 
managers. Simply stated, the concept embodied in H.R. 2834 is a bad 
idea motivated by the quest for more revenue, not tax fairness.
    It is NTU's belief that the ``20'' portion should continue to be 
taxed at capital gains rates. Historically speaking, this portion of a 
fund manager's compensation has long been treated as a capital gain 
(and NOT ordinary income) because it represents the return on, or loss 
from, an investment. It is subject to the same risk factors as any 
other and receives capital gains tax treatment. It is only now that the 
capital gains tax rate has been lowered to 15 percent that attacks have 
been leveled at the ``fairness'' of this system. This suggests that the 
true complaints rest with the lower tax rate, not the supposedly 
improper treatment of the compensation.
    Indeed, it is notable that other ``fairness'' aspects of capital 
gains tax policy have so far not merited Congress's attention, even 
though their implications are wide-ranging for all investors. For one, 
current law does not allow a taxpayer to adjust the value of an asset 
for inflation when declaring a capital gain. Moreover, even though the 
government subjects the full computed value of a capital gain to 
taxation, only $3,000 of a capital loss on a jointly filed return is 
deductible for income tax purposes in a given year. Because these 
limits aren't even inflation-adjusted, any ``carryover'' loss amounts 
for future years are being taken against a deduction that's losing 
    Congress established the lower capital gains and dividend tax rates 
because it wanted to relieve the double-taxation and market distortions 
that high rates impose. When individuals invest their dollars, they do 
so after having already paid income taxes on them. The 15 percent rate 
was intended to alleviate this double-taxation and encourage the kind 
of bullish financial outlook for which Americans are renowned. Raising 
the capital gains tax rate on a small but convenient segment of the 
economy will only establish a foothold for higher capital gains taxes 
on everybody in the future.
    Higher capital gains taxes will discourage much-needed investment 
in many segments of our society. Thousands of colleges, pension funds, 
and charities invest their dollars in private equity plans so as to 
leverage scarce resources. Raising taxes would harm them immensely. 
Public employees, in particular, are heavily invested in the kind of 
plans that would be hurt by such a tax hike. It is difficult to believe 
that Congressional supporters of new tax treatment for carried interest 
intend to load an additional levy onto the pensions of teachers, police 
officers, and other public service workers. Such a policy would be all 
the more ironic, in light of the American Federation of State, County, 
and Municipal Employees' (AFSCME) official position that the 2003 
capital gains tax cut ``mostly benefits wealthy stockholders.'' If 
Congress travels further down the road toward taxing carried interest, 
AFSCME's members will learn a hard lesson about how harmful their 
union's stance is.
    In addition, higher capital gains taxes would be a significant step 
in undermining the advancements in savings and growth that have taken 
place in the last few years. Since 2001, an additional 12 million 
people have joined the investor class. Since 2003, household net worth 
has increased by an astounding $12 billion.
    Such trends were evident several years before George W. Bush took 
office. In 1997, Congress enacted and President Clinton signed the 
Taxpayer Relief Act. This law actually led to a much steeper decline in 
capital gains rates than the Jobs, Growth and Tax Relief Reconciliation 
Act of 2003. The long-term maximum capital gains tax rate was reduced 
from 28 percent to 18 percent in most instances, while an even lower 8 
percent rate was put into place for certain taxpayers. Although 
President Clinton expressed some ``concerns'' with the Taxpayer Relief 
Act, he predicted that the bill would ``encourage economic growth.'' He 
was right. According to a detailed analysis by Standard & Poor's DRI, 
the new law helped to trigger a bull market for stocks that led to the 
rise of the ``investor class.''
    Finally, it bears mentioning that even with higher capital gains 
taxes, revenues may not increase substantially. A 2002 CBO study 
pointed out that because such taxes are paid on ``realized rather than 
accrued gains, taxpayers have a great deal of control over when they 
pay their capital gains taxes.'' This makes the capital gains tax 
particularly subject to revenue fluctuations resulting from changes in 
the rate. In recent history, every capital gains tax cut has resulted 
in additional revenue and every capital gains tax hike has resulted in 
less revenue. Any revenue gained from such a tax hike would be far 
outweighed by the damage done to pensions, universities, and charities 
across the country.
Alternative Minimum Tax
    Much of the talk of raising private equity taxes would not be 
happening if it weren't for the Alternative Minimum Tax disaster. Like 
a parallel universe in the twilight zone of IRS rules and regulations, 
the AMT forces taxpayers to calculate their taxable income and 
liability under a different set of allowable exemptions, deductions, 
and credits. Because Congress designed the system so poorly and did not 
index the AMT threshold for inflation, it ensnares an ever-greater 
number of taxpayers each year.
    In 2006, 4 million unlucky taxpayers paid the AMT. If Congress 
doesn't act, there will be 23 million equally unlucky Americans in 
2007. These figures do not include millions of additional taxpayers who 
expended significant time either in tax planning to avoid being trapped 
by the AMT, or on IRS worksheets to determine whether they should 
complete Form 6251.
    Despite promises to ``fix'' this problem every year, neither the 
former Republican Congress nor the current Democratic Congress has 
enacted a truly lasting solution. As a 2004 National Taxpayers Union 
Foundation study noted, ``Continued delay will merely result in further 
losses to the economy and further corrective costs. It will also lead 
to a political motivation to design a solution which is `revenue 
neutral' and thus cause further damage to the fiscal stability of the 
nation.'' Since that time, Congress has done little more than ``kick 
the can down the road'' by enacting one-year AMT patches.
    Unfortunately, the new pay-as-you-go budget rules (PAYGO) make 
fixing the AMT highly unpalatable because of future revenue losses. 
Despite the fact that it was never intended to reach down into the 
middle class, the AMT now brings in substantial amounts of revenue each 
year. Under PAYGO, those ill-gotten receipts must now be offset so as 
not to violate its strictures.
    Yet, PAYGO itself violates the very principles of ``fairness and 
equity'' around which this hearing has been designed. Under current 
rules, any tax cuts or new direct (mandatory) spending programs 
relative to the official revenue and outlay growth baseline are 
required to be funded through tax increases or spending reductions 
    But not all baselines are created equal. The mandatory spending 
baseline is assumed to be perpetual for entitlements such as Social 
Security and Medicare, while the 2001 and 2003 tax cuts are on a 
baseline that terminates in 2011. This double standard allows massive 
expansions in programs like Medicare Part D to be added directly to the 
deficit, while tax reductions are allowed to vanish unless they are 
extended with offsets.
    Federal revenues have zoomed 28 percent over the past six years, 
and 2006's inflation-adjusted total exceeded the amount brought in 
during President Clinton's last year in office. During that same 
period, when Republicans controlled both branches of elected 
government, expenditures rose by an astonishing 49 percent. Recently 
enacted PAYGO rules create an inexcusable bias toward boosting Federal 
outlays while denying relief to taxpayers--thereby guaranteeing that 
this disparity will worsen.
    While NTU would argue that budget process reforms should favor 
shrinking government, in the interests of ``fairness and equity'' 
Congress should, at the very least, force spending-hikers to play by 
the same rules as tax-cutters. Rigging the process to grow already 
imperiled entitlement programs is not the kind of ``new direction'' 
that Americans were expecting from the 110th Congress.
    Congress ought to repeal the AMT outright. It is a confusing, 
economically destructive tax that has spiraled wildly out of control 
since its inception. It was created in 1969 to deal with 155 high-
income individuals who paid no income taxes. Today, it is a monster 
that threatens to grow even larger if it isn't vanquished once and for 
all. As it so happens, the encroachment of the AMT also provides a 
cautionary tale to those who believe that a ``small adjustment'' in the 
tax treatment of carried interest will remain so.
    The way to bring down that beast, however, is not to raise taxes 
elsewhere. Private equity fund managers, though a convenient political 
target, are an important cog in the massive machinery that is the 
American economy. Raising taxes on certain forms of compensation will 
be highly destructive to America's public employees, unions, college 
students, and charities that rely on private equity.
    Furthermore, while raising taxes is certain to be economically 
harmful, it is far from certain to enhance receipts. History shows that 
capital gains taxes constitute a fluid revenue source that fluctuates a 
great deal in response to rate changes.
    If lawmakers seek tax fairness, they ought to focus on a 
fundamental overhaul of the IRS code, not piecemeal reform that only 
adds to the problem. With such a commitment, tomorrow's taxpayers will 
be most grateful to today's Congress.

                        Statement of NGVAmerica
    NGVAmerica appreciates the opportunity to provide the following 
statement concerning tax policy and its impact on energy policy, 
security and the environment. NGVAmerica is a national organization of 
over 100 member companies dedicated to developing markets for NGVs and 
building an NGV infrastructure, including the installation of fueling 
stations, the manufacture of NGVs, production and use of renewable 
natural gas, the development of industry standards, and the provision 
of training.
    The Ways and Means Committee has indicated an interest in reviewing 
current alternative minimum tax (AMT) provisions. The primary purpose 
is to review the impact of this tax on working families and how it 
might be revised or amended to create more equitable treatment for 
taxpayers. NGVAmerica would like to encourage the committee to also 
consider how the current AMT provision limits efforts to stimulate the 
use of new energy efficient, non-petroleum technologies. Our statement 
addresses how AMT as currently structured discourages individuals and 
businesses from accelerating the introduction of alternative fuel 
technologies and ultimately limits efforts to reduce petroleum 
Impact of AMT Provisions on Incentives for Alternative Fuel Vehicles 
        and Infrastructure
    The Energy Policy Act (EPAct) of 2005 (Pub. L. No. 109-58) includes 
incentives to encourage the acquisition of dedicated alternative fueled 
vehicles (AFVs) and alternative fuel refueling stations, among other 
things. The vehicle and fueling infrastructure incentives are found in 
sections 1341 and 1342 of EPAct 2005. The AFV credit expires on 12/31/
2010 and the alternative fuel infrastructure credit expires 12/31/2009. 
NGVAmerica previously has submitted comments to the committee 
recommending that the credits be extended since the short timeframe for 
this incentive sends the wrong message to businesses and consumers 
about the government's support for AFVs, and is inconsistent with 
petroleum replacement goals espoused by the Administration and 
Congress. Congress has recognized this shortcoming and has introduced 
several measures that would extend these incentives.
    Simply extending these tax credits, however, will not address 
another major shortcoming, namely, the fact that, as currently crafted, 
these tax credits are subject to AMT. The recently passed energy bill 
(H.R. 3221) partially addresses this shortcoming but only with respect 
to vehicles acquired by individual consumers. There is no adjustment 
for businesses that buy these vehicles, and there is no change at all 
with respect to the fueling infrastructure credits. The EPAct 2005 tax 
credits have been largely successful in accelerating the introduction 
of hybrid electric vehicles like the Toyota Prius and Honda Civic. 
Modifying the vehicle credits so that they are not subject to AMT will 
make it possible for more people to take advantage of these new 
technologies. We applaud Congress efforts to expand these incentives 
for consumers. However, the proposed adjustment of the AMT provision 
for consumers is unlikely to help advance the use of AFVs among 
business fleets.
    As currently structured, the corporate AMT provisions significantly 
limit the benefit of the AFV and alternative fuel infrastructure 
incentives. The tax credits for vehicles and fueling infrastructure are 
general business credits that are subject to AMT limitations. This is a 
major stumbling block to encouraging business fleets to buy large 
numbers of AFVs. Based on our analysis, the majority of fleets that buy 
large numbers of new AFVs will only be able to take advantage of the 
tax credits for a limited number of vehicles (if these businesses are 
not currently paying any AMT) or not be able to take advantage of any 
tax credits (if they currently are paying an AMT). This means that most 
fleets cannot make a major commitment to AFVs (i.e. acquiring large 
number of AFVs) without shouldering the additional financial investment 
associated with these vehicles. Given that these vehicles can cost tens 
of thousands of dollars more than petroleum fueled vehicles, most 
businesses have been reluctant to make the necessary investments 
without government assistance.
    The most efficient way to commercialize AFVs is to encourage the 
purchase of these vehicles by large centrally fueled fleets. Focusing 
on large, centrally fueled fleets also is more efficient in terms of 
servicing and maintaining these vehicles (which may require special 
training), and providing alternative fuel infrastructure. 
Unfortunately, the Tax Code favors a strategy that requires industry to 
sell one or two AFVs to thousands of individual fleets in order to take 
advantage of the AFV incentives. This limitation also is likely to be a 
stumbling block for selling medium and heavy-duty hybrid vehicles to 
businesses as such vehicles become commercially available.
    The incentives are also similarly limited with respect to the sale 
of vehicles and fueling stations to tax-exempt entities. The tax 
credits for vehicles and refueling stations (EPAct Sec. Sec. 1341-1342) 
include provisions allowing the tax credits to be taken by the seller 
of the vehicles or fueling stations instead of the purchasers if the 
purchaser is a tax exempt entity. This provision was intended to ensure 
the Federal, state and local governmental agencies benefit from the tax 
incentives. This was viewed as an important provision in the law 
because government entities (e.g., municipal fleets, port authorities, 
transit agencies, school districts) in many cases are taking the lead 
in introducing AFVs. Congress provided this provision with the 
expectation that the seller would pass back some or all of the 
incentive to the buyer in the form of a lower purchase price. The Tax 
Code as modified by EPAct 2005 allows the AFV and alternative fuel 
infrastructure credits to go to the seller in the case of an 
acquisition by a tax-exempt entity. However, dealerships also are 
subject to AMT provisions and are, in most cases, only able to benefit 
in a limited way, if at all, from the sale of AFVs. Based on our 
discussions with numerous dealerships, we believe that most are not 
able to benefit from these incentives due to their tax status and, 
therefore, will not be able to pass any savings back to their tax-
exempt (i.e., primarily government) customers. This means that state 
and local government acquiring AFVs will not benefit from these 
    NGVAmerica urges the committee to amend the Tax Code so that the 
incentives for AFVs and alternative fuel infrastructure are exempt from 
all AMT limitations. The current AMT provisions limit the ability of 
large fleet customers to acquire AFVs and also limit the ability of 
governmental fleets to benefit from the incentives. Modifying the 
incentives so that they are not subject to the AMT provisions will 
encourage businesses to invest in these new technologies and reward 
them for promoting practices that reduce petroleum reliance. When 
Congress passed these incentives, it believed they would encourage 
investments in AFVs and refueling infrastructure. However, the 
limitations addressed in our statement indicate that these incentives 
are not being fully utilized and are not having the intended impact. We 
urge Congress to correct this situation.