U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

43–307 2008

FAIR AND EQUITABLE TAX POLICY FOR 

AMERICA’S WORKING FAMILIES 

HEARING 

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 

( 

smartinez on PROD1PC64 with HEARING

ii 

COMMITTEE ON WAYS AND MEANS 

CHARLES B. RANGEL, New York, Chairman 

FORTNEY PETE STARK, California 

SANDER M. LEVIN, Michigan 

JIM MCDERMOTT, Washington 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

STEPHANIE TUBBS JONES, Ohio 

MIKE THOMPSON, California 

JOHN B. LARSON, Connecticut 

RAHM EMANUEL, Illinois 

EARL BLUMENAUER, Oregon 

RON KIND, Wisconsin 

BILL PASCRELL JR., New Jersey 

SHELLEY BERKLEY, Nevada 

JOSEPH CROWLEY, New York 

CHRIS VAN HOLLEN, Maryland 

KENDRICK MEEK, Florida 

ALLYSON Y. SCHWARTZ, Pennsylvania 

ARTUR DAVIS, Alabama 

JIM MCCRERY, Louisiana 

WALLY HERGER, California 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

SAM JOHNSON, Texas 

PHIL ENGLISH, Pennsylvania 

JERRY WELLER, Illinois 

KENNY C. HULSHOF, Missouri 

RON LEWIS, Kentucky 

KEVIN BRADY, Texas 

THOMAS M. REYNOLDS, New York 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

JOHN LINDER, Georgia 

DEVIN NUNES, California 

PAT TIBERI, Ohio 

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. 

smartinez on PROD1PC64 with HEARING

iii 

C O N T E N T S 

Page 

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

WITNESSES 

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 

smartinez on PROD1PC64 with HEARING

smartinez on PROD1PC64 with HEARING

(1) 

FAIR AND EQUITABLE TAX POLICY FOR 

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:] 

smartinez on PROD1PC64 with HEARING

2 

ADVISORY 

FROM THE COMMITTEE ON WAYS AND MEANS 

FOR IMMEDIATE RELEASE CONTACT: (202) 225–1721 

August 30, 2007 

FC–14 

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. 

BACKGROUND: 

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 families. 

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.’’ 

FOCUS OF THE HEARING: 

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. 

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS: 

Please Note: Any person(s) and/or organization(s) wishing to submit for the hearing record must follow the appropriate link on the hearing page of the Committee 

website and complete the informational forms. From the Committee homepage, 

smartinez on PROD1PC64 with HEARING

3 

http://waysandmeans.house.gov, select ‘‘110th Congress’’ from the menu entitled, ‘‘Committee Hearings’’ (http://waysandmeans.house.gov/Hearings.asp?congress=18). 

Select the 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 to the address which you supply confirming your 

interest in providing a 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. 

FORMATTING REQUIREMENTS: 

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 format 

it according to our guidelines. Any submission provided to the Committee by a witness, any supplementary materials submitted for the printed record, and any written comments in response 

to a request for written comments must conform to the guidelines listed below. Any submission 

or supplementary item not in compliance with these guidelines will not be printed, but will be 

maintained in the Committee files for review and use by the Committee. 

1. All submissions and supplementary materials must be provided in Word or WordPerfect 

format and MUST NOT exceed a total of 10 pages, including attachments. Witnesses and submitters are advised that the Committee relies on electronic submissions for printing the official 

hearing record. 

2. Copies of whole documents submitted as exhibit material will not be accepted for printing. 

Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material 

not meeting these specifications will be maintained in the Committee files for review and use 

by the Committee. 

3. All submissions must include a list of all clients, persons, and/or organizations on whose 

behalf the witness appears. A supplemental sheet must accompany each submission listing the 

name, 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. 

f 

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, 

smartinez on PROD1PC64 with HEARING

4 

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 

package. 

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 

smartinez on PROD1PC64 with HEARING

5 

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 right. 

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, 

smartinez on PROD1PC64 with HEARING

6 

but many, particularly those between $80,000 and $150,000, got 

much less of a tax cut than was promised. 

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 again. 

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. 

[Laughter.] 

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 forsmartinez on PROD1PC64 with HEARING

7 

ward 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. 

STATEMENT OF LEONARD E. BURMAN, Ph.D., DIRECTOR, 

URBAN-BROOKINGS TAX POLICY CENTER 

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 alsmartinez on PROD1PC64 with HEARING

8 

most $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 tax. 

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 Govsmartinez on PROD1PC64 with HEARING

9 

ernment 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:] 

smartinez on PROD1PC64 with HEARING


43307a.001
10 

smartinez on PROD1PC64 with HEARING


43307a.002
11 

smartinez on PROD1PC64 with HEARING


43307a.003
12 

smartinez on PROD1PC64 with HEARING


43307a.004
13 

smartinez on PROD1PC64 with HEARING


43307a.005
14 

smartinez on PROD1PC64 with HEARING


43307a.006
15 

smartinez on PROD1PC64 with HEARING


43307a.007
16 

smartinez on PROD1PC64 with HEARING


43307a.008
17 

smartinez on PROD1PC64 with HEARING


43307a.009
18 

smartinez on PROD1PC64 with HEARING


43307a.010
19 

smartinez on PROD1PC64 with HEARING


43307a.011
20 

smartinez on PROD1PC64 with HEARING


43307a.012
21 

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. 

STATEMENT OF JASON FURMAN, DIRECTOR, THE HAMILTON 

PROJECT, 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 

smartinez on PROD1PC64 with HEARING

22 

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 longsmartinez on PROD1PC64 with HEARING

23 

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:] 

smartinez on PROD1PC64 with HEARING


43307a.013
24 

smartinez on PROD1PC64 with HEARING


43307a.014
25 

smartinez on PROD1PC64 with HEARING


43307a.015
26 

smartinez on PROD1PC64 with HEARING


43307a.016
27 

smartinez on PROD1PC64 with HEARING


43307a.017
28 

smartinez on PROD1PC64 with HEARING


43307a.018
29 

smartinez on PROD1PC64 with HEARING


43307a.019
30 

smartinez on PROD1PC64 with HEARING


43307a.020
31 

smartinez on PROD1PC64 with HEARING


43307a.021
32 

smartinez on PROD1PC64 with HEARING


43307a.022
33 

smartinez on PROD1PC64 with HEARING


43307a.023
34 

smartinez on PROD1PC64 with HEARING


43307a.024
35 

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. 

STATEMENT OF DOUGLAS HOLTZ-EAKIN, SENIOR FELLOW, 

THE PETERSON INSTITUTE, AND FORMER DIRECTOR, CONGRESSIONAL BUDGET OFFICE 

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 

smartinez on PROD1PC64 with HEARING

36 

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 

distribution. 

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 questions. 

[The prepared statement of Mr. Holtz-Eakin follows:] 

smartinez on PROD1PC64 with HEARING

37 

1 Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2007, 

p. xi. 2See Congressional Budget Office, The Long-Term Budget Outlook, December 2005. 

3This 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. 

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. 

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. postwar 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. 

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 flexibility. 

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

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 issues. 

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 fismartinez on PROD1PC64 with HEARING

38 

4See the final report at http://www.taxreformpanel.gov/final-report 

5This is referred to as determining the economic incidence of a tax. 

6See Kevin Hassett and Aparna Mathur, ‘‘Taxes and Wages,’’ AEI Working Paper #128, 2006. 

7See Congressional Budget Office, Historical Effective Tax Rates: 1979 to 2004, December 

2006. 

nance 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

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 Fed- eral 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

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 versa. 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. 

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 

smartinez on PROD1PC64 with HEARING

39 

8This section draws on Douglas Holtz-Eakin, ‘‘The Case for a Consumption Tax,’’ Tax Notes, 

October 23, 2006. 

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 policy. 

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. 

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 valueadded 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. 

smartinez on PROD1PC64 with HEARING

40 

9For 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. 

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 system: 

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

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 incensmartinez on PROD1PC64 with HEARING

41 

tives—extracting a double tax on equity in ‘‘C corporations’’, subsidizing leverage, 

and thus distorting the choices of business form and financing. The flat businesslevel tax does not depend on financial structure—it is focused on ‘‘real’’ business 

transactions—and yields the same liability regardless of legal organization. 

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 investors. 

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 

smartinez on PROD1PC64 with HEARING

42 

10See, 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 WellBeing, 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 transfers. 

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 progrowth 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 pattern.11

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 2007. 

smartinez on PROD1PC64 with HEARING

43 

12Michael 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 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. 

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 

Taxes 

Corporation Income Taxes Social Insurance 

Taxes Total Revenue 

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% 

smartinez on PROD1PC64 with HEARING

44 

Table 1 

Tax Receipts 1996–2006 

Year Individual Income 

Taxes 

Corporation Income Taxes Social Insurance 

Taxes Total Revenue 

Billions Growth Billions Growth Billions Growth Billions Growth 

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% 

f 

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. 

smartinez on PROD1PC64 with HEARING

45 

[Recess.] 

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 pocketbook? 

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. 

smartinez on PROD1PC64 with HEARING

46 

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 

smartinez on PROD1PC64 with HEARING

47 

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 spending. 

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 percent? 

smartinez on PROD1PC64 with HEARING

48 

Mr. FURMAN. Right. 

Mr. LEVIN OF MICHIGAN. As you can imagine, Dr. HoltzEakin, 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 

word. 

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 ninesmartinez on PROD1PC64 with HEARING

49 

ties, 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 taxpayer? 

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, 

smartinez on PROD1PC64 with HEARING

50 

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 AMT. 

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. 

smartinez on PROD1PC64 with HEARING

51 

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 policies. 

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 out. 

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 middleincome 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. 

smartinez on PROD1PC64 with HEARING

52 

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 uninsured. 

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 have. 

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 

smartinez on PROD1PC64 with HEARING

53 

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 

smartinez on PROD1PC64 with HEARING

54 

American people both in terms of Federal and state dollars. Is that 

an accurate statement? 

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. 

smartinez on PROD1PC64 with HEARING

55 

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 lowand moderate-income Americans to save for their future. 

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 moderateincome 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 families. 

Mr. LEWIS OF GEORGIA. Thank you very much. Thank you, 

Mr. Chairman. 

Mr. NEAL. We thank the gentleman. The gentleman from Pennsylvania, Mr. English, will inquire. 

smartinez on PROD1PC64 with HEARING

56 

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 cuts. 

Mr. ENGLISH. Outstanding. That’s extremely helpful. Now the 

point you were—— 

[Laughter.] 

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 here. 

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 

smartinez on PROD1PC64 with HEARING

57 

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 hightax states? Isn’t it also true that residents of many of these lowtax 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 highincome 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-thirds. 

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 correct. 

Mr. NEAL. Thank you. Mr. Eakin. 

smartinez on PROD1PC64 with HEARING

58 

Mr. HOLTZ-EAKIN. Mr. Furman was talking while you were 

giving your question so I didn’t actually get to hear you. I apologize. 

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 themselves? 

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 works. 

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. 

smartinez on PROD1PC64 with HEARING

59 

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 question? 

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 reform. 

Mr. HOLTZ-EAKIN. I think you’ve got the diagnosis exactly 

right. This isn’t a discretionary spending problem. It’s the mandasmartinez on PROD1PC64 with HEARING

60 

tory 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 shortterm fix is to raise taxes, however, that will always be the shortterm 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 inequality. 

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, neversmartinez on PROD1PC64 with HEARING

61 

theless 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 problem. 

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 formation. 

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? 

smartinez on PROD1PC64 with HEARING

62 

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 inquire. 

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-andspend 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 

smartinez on PROD1PC64 with HEARING

63 

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 progressive. 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 correct? 

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 

smartinez on PROD1PC64 with HEARING

64 

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. 

smartinez on PROD1PC64 with HEARING

65 

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 

respond. 

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 highincome 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. 

smartinez on PROD1PC64 with HEARING

66 

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 earning. 

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 

smartinez on PROD1PC64 with HEARING

67 

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 growth? 

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, intellectual—— 

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 respect—— 

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 

smartinez on PROD1PC64 with HEARING

68 

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 

taxes. 

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 

smartinez on PROD1PC64 with HEARING

69 

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 country. 

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 fairness. 

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 

smartinez on PROD1PC64 with HEARING

70 

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 us? 

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. 

Furman. 

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 inequality. 

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 

smartinez on PROD1PC64 with HEARING

71 

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 uturn 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 consmartinez on PROD1PC64 with HEARING

72 

cerned 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, SarbanesOxley 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 

smartinez on PROD1PC64 with HEARING

73 

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 coauthored, 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 

smartinez on PROD1PC64 with HEARING

74 

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 system. 

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. 

Blumenauer. 

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. 

smartinez on PROD1PC64 with HEARING

75 

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 

though. 

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 

smartinez on PROD1PC64 with HEARING

76 

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. 

[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. 

smartinez on PROD1PC64 with HEARING

77 

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. 

STATEMENT OF STEPHEN E. SHAY, PARTNER, ROPES & GRAY, 

LLP, 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 those. 

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. 

smartinez on PROD1PC64 with HEARING

78 

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 altogether. 

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:] 

smartinez on PROD1PC64 with HEARING

79 

smartinez on PROD1PC64 with HEARING


43307a.025
80 

smartinez on PROD1PC64 with HEARING


43307a.026
81 

smartinez on PROD1PC64 with HEARING


43307a.027
82 

smartinez on PROD1PC64 with HEARING


43307a.028
83 

smartinez on PROD1PC64 with HEARING


43307a.029
84 

smartinez on PROD1PC64 with HEARING


43307a.030
85 

smartinez on PROD1PC64 with HEARING


43307a.031
86 

smartinez on PROD1PC64 with HEARING


43307a.032
87 

smartinez on PROD1PC64 with HEARING


43307a.033
88 

smartinez on PROD1PC64 with HEARING


43307a.034
89 

smartinez on PROD1PC64 with HEARING


43307a.035
90 

smartinez on PROD1PC64 with HEARING


43307a.036
91 

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. 

STATEMENT OF LEON M. METZGER, ADJUNCT FACULTY, 

COLUMBIA, NEW YORK, AND YALE UNIVERSITIES 

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 shortterm capital; and, fourth, many funds elect section 475 mark-tomarket 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 lowtax jurisdictions. In general, the only U.S. tax paid by these corporations is the U.S. withholding tax on dividends received. Often, 

smartinez on PROD1PC64 with HEARING

92 

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. 2Flow-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. 4For 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. 5 A side-by-side structure could look like this: 

6For this testimony, the term, ‘‘adviser,’’ includes advisers, LLC managers, and general partners. 

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 middleclass 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 any. 

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 Committee: 

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

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-through2 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

Most hedge funds use one of two structures to satisfy the investors. In a side-byside arrangement,5 the fund adviser6 manages two or more pools of trading capital, 

smartinez on PROD1PC64 with HEARING

93 

7Splitting 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. 8 A master-feeder structure could look like this: 

9This table illustrates scenarios under a ten-year deferral: 

10Fund 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 

Continued 

one in the U.S. for taxable investors, and the others offshore for U.S.-tax-exempt 

and foreign investors, often by splitting tickets7 between or among the pools. 

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. 

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 believe. 

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

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

smartinez on PROD1PC64 with HEARING

94 

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. 12 IRS Probes Tax Goal of Derivatives, by Anita Raghavan, The Wall Street Journal, July 19, 

2007, page C1. 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. 14Statement Regarding Unrelated Debt Financed Income and ‘‘Blocker Corporations,’’ June 

27, 2007, Council on Foundations, http://www.cof.org/files/Documents/Government/ 

HedgeFundJune2007.pdf. 15 I thank my NYU students, who called my attention to this point. 16 In general, active business income other than trading in stocks, securities, and commodities. 

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

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 securities13 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. 

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. 

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 preferentialrate 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. 

smartinez on PROD1PC64 with HEARING

95 

17Should, 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. 18Market 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 4. 

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. 

CONCLUDING COMMENTS 

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 performance17 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. 

Does the U.S. economy truly benefit from preferential-income rates18 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. 

smartinez on PROD1PC64 with HEARING

96 

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. 

Graphic Unreadable. 

Graphic Unreadable. 

Graphic Unreadable. 

f 

STATEMENT OF JANNE G. GALLAGHER, VICE PRESIDENT AND 

GENERAL COUNSEL, COUNCIL ON FOUNDATIONS 

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 funds. 

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 use. 

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. 

smartinez on PROD1PC64 with HEARING

97 

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. 

smartinez on PROD1PC64 with HEARING

98 

• 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 lowtax 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 

smartinez on PROD1PC64 with HEARING

99 

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 profitseeking 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. 

f 

STATEMENT OF SUZANNE ROSS MCDOWELL, PARTNER, 

STEPTOE & JOHNSON, LLP 

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 

smartinez on PROD1PC64 with HEARING

100 

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 taxexempt 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 debtfinanced 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 

smartinez on PROD1PC64 with HEARING

101 

1Taxing 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). 2 IRC § 512(b)(4); 514(a)(1). 

3 IRC §§ 512(b)(1), (2), (3), (5). 

4 IRC § 512(b)(1), (a)(5). 

5 IRC § 512(b)(1). 

6 IRC § 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). 

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 LLP 

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

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. 

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

Unrelated Debt-Financed Income Rules. The exclusion for ‘‘passive income’’ 

does not apply to the extent that such income is derived from debt-financed propsmartinez on PROD1PC64 with HEARING

102 

8Section 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 § 514(c)(1). 

10 IRC § 514(a)(1). 11S. 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. 12See, 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). 13See Kern County Electrical Pension Fund v. Comm’r, 96 T.C. 845 (1991). 14Mose & Garrison Siskind Memorial Foundation Foundation v. United States, 790 F.2d 480 

(6th Cir. 1986). 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). 17Gen. Couns. Mem. 39620 (April 3, 1987). 18Gen. Couns. Mem. 39615 (March 23, 1987). 

erty.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

The debt-financed income rules were passed in 1969 to foreclose abusive saleleaseback 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

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

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 contracts19

are not treated as debt-financed property and are not subject to UBIT. 

smartinez on PROD1PC64 with HEARING

103 

19Treas. Reg. § 1.512(b)-1(a)(1). 20 IRC § 514(c)(9). 21 IRC § 514(c)(9)(B)(i)-(v). 22 IRC § 514(c)(9)(B)(i)-(v). 23 IRC § 514(c)(9)(E). 24 IRC § 512(c). 25Priv. Ltr. Rul. 199952086 (Sept. 30, 1999). 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. 27For 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 borLimited 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

‘‘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 debtfinanced 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

Discussion 

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 rules.26

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. 

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 

smartinez on PROD1PC64 with HEARING

104 

29 According to the NCCUSL, UMIFA has been adopted in 47 states. 30When 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), § 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 states. 32 UPMIFA § 3(e)(2). 

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

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. 

Recommendations 

Rather than focusing on the use of blocker entities to avoid the unrelated debtfinanced 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 property. 

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 investsmartinez on PROD1PC64 with HEARING

105 

ments 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. 

Conclusion 

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. 

f 

STATEMENT OF DANIEL S. SHAPIRO, PARTNER, SCHULTE, 

ROTH & ZABEL, 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 funds. 

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. 

smartinez on PROD1PC64 with HEARING

106 

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 

smartinez on PROD1PC64 with HEARING

107 

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:] 

smartinez on PROD1PC64 with HEARING


43307a.037
108 

smartinez on PROD1PC64 with HEARING


43307a.038
109 

smartinez on PROD1PC64 with HEARING


43307a.039
110 

smartinez on PROD1PC64 with HEARING


43307a.040
111 

smartinez on PROD1PC64 with HEARING


43307a.041
112 

smartinez on PROD1PC64 with HEARING


43307a.042
113 

smartinez on PROD1PC64 with HEARING


43307a.043
114 

smartinez on PROD1PC64 with HEARING


43307a.044
115 

smartinez on PROD1PC64 with HEARING


43307a.045
116 

smartinez on PROD1PC64 with HEARING


43307a.046
117 

smartinez on PROD1PC64 with HEARING


43307a.047
118 

smartinez on PROD1PC64 with HEARING


43307a.048
119 

smartinez on PROD1PC64 with HEARING


43307a.049
120 

smartinez on PROD1PC64 with HEARING


43307a.050
121 

smartinez on PROD1PC64 with HEARING


43307a.051
122 

smartinez on PROD1PC64 with HEARING


43307a.052
123 

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 interest? 

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 entities. 

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 requirements. 

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 

smartinez on PROD1PC64 with HEARING

124 

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 

credit? 

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 

smartinez on PROD1PC64 with HEARING

125 

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 experiencing. 

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. 

smartinez on PROD1PC64 with HEARING

126 

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 besmartinez on PROD1PC64 with HEARING

127 

tween 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. 

smartinez on PROD1PC64 with HEARING

128 

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 deferral. 

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, 

smartinez on PROD1PC64 with HEARING

129 

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 

capital. 

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. Chairman. 

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 corsmartinez on PROD1PC64 with HEARING

130 

porate 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 

smartinez on PROD1PC64 with HEARING

131 

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 percent’’? 

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 

smartinez on PROD1PC64 with HEARING

132 

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 

smartinez on PROD1PC64 with HEARING

133 

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 necessary. 

Mr. VAN HOLLEN. Thank you. Thank you all. Thank you, Mr. 

Chairman. 

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. 

smartinez on PROD1PC64 with HEARING

134 

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. 

[Laughter.] 

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. 

smartinez on PROD1PC64 with HEARING

135 

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 numbers? 

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? 

smartinez on PROD1PC64 with HEARING

136 

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. Metzger. 

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 

smartinez on PROD1PC64 with HEARING

137 

considering international tax reform, are there things that we 

should or should not try and do? 

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 issue? 

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 debtfinanced 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 debtfinanced 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 

smartinez on PROD1PC64 with HEARING

138 

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 offshore. 

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 inquire. 

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 

smartinez on PROD1PC64 with HEARING

139 

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:] 

smartinez on PROD1PC64 with HEARING

140 

smartinez on PROD1PC64 with HEARING


43307a.053
141 

smartinez on PROD1PC64 with HEARING


43307a.054
142 

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 helpful. 

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. 

[Laughter.] 

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 

smartinez on PROD1PC64 with HEARING

143 

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 point. 

Ms. BERKLEY. How much revenue would that bring in? 

Mr. METZGER. How much revenue would be brought in? I do 

not know. 

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. 

smartinez on PROD1PC64 with HEARING

144 

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. 

smartinez on PROD1PC64 with HEARING

145 

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 request. 

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 in. 

Mr. MCCRERY. I think it would do Members well to read both 

letters. They can judge for themselves the merit of each letter. 

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 inquire. 

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? 

smartinez on PROD1PC64 with HEARING

146 

If one of you could make only one change to our international tax 

law, what would it be? What would it be? Anybody. 

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. 

Mr. LEWIS OF GEORGIA. Yes? 

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 offshore. 

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 investments? 

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. 

smartinez on PROD1PC64 with HEARING

147 

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. 

Correct? 

Mr. METZGER. Yes. 

Mr. BECERRA. Does one fund manager behave differently from 

the other fund manager if it’s an onshore or offshore investment? 

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 possible? 

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 preferentialrate 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 onshore? 

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 

smartinez on PROD1PC64 with HEARING

148 

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 fund. 

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 fund. 

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. Shay. 

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 correct? 

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 gensmartinez on PROD1PC64 with HEARING

149 

erated 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 prohibited. 

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 income. 

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 

smartinez on PROD1PC64 with HEARING

150 

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 reasoning. 

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 lunch. 

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. 

smartinez on PROD1PC64 with HEARING

151 

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. 

STATEMENT OF PETER R. ORSZAG, DIRECTOR, 

CONGRESSIONAL BUDGET OFFICE 

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. 

smartinez on PROD1PC64 with HEARING

152 

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 returns. 

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:] 

smartinez on PROD1PC64 with HEARING

153 

smartinez on PROD1PC64 with HEARING


43307a.055
154 

smartinez on PROD1PC64 with HEARING


43307a.057
155 

smartinez on PROD1PC64 with HEARING


43307a.058
156 

smartinez on PROD1PC64 with HEARING


43307a.059
157 

smartinez on PROD1PC64 with HEARING


43307a.060
158 

smartinez on PROD1PC64 with HEARING


43307a.061
159 

smartinez on PROD1PC64 with HEARING


43307a.062
160 

smartinez on PROD1PC64 with HEARING


43307a.063
161 

smartinez on PROD1PC64 with HEARING


43307a.064
162 

smartinez on PROD1PC64 with HEARING


43307a.065
163 

smartinez on PROD1PC64 with HEARING


43307a.066
164 

smartinez on PROD1PC64 with HEARING


43307a.067
165 

smartinez on PROD1PC64 with HEARING


43307a.068
166 

smartinez on PROD1PC64 with HEARING


43307a.069
167 

smartinez on PROD1PC64 with HEARING


43307a.070
168 

smartinez on PROD1PC64 with HEARING


43307a.071
169 

smartinez on PROD1PC64 with HEARING


43307a.072
170 

smartinez on PROD1PC64 with HEARING


43307a.073
171 

smartinez on PROD1PC64 with HEARING


43307a.074
172 

smartinez on PROD1PC64 with HEARING


43307a.075
173 

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 income? 

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? 

smartinez on PROD1PC64 with HEARING

174 

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 coauthor 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 prosperity. 

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), § 312 E&P calculations, § 302 redemption recharacterizations, § 305 

stock dividend rules, § 306 tainted preferred stock, § 368 reorganizations, and 6 

mind-numbing interest deduction disallowance rules. 

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. 

smartinez on PROD1PC64 with HEARING

175 

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 economy. 

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 partner. 

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 clients. 

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 computercompany 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 ramifications. 

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? 

smartinez on PROD1PC64 with HEARING

176 

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 growth. 

Sixth question, will a slowdown in venture capital/private equity investing hurt 

only fat cat venture capital/private equity professionals? 

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 profits. 

I would be happy to answer any questions. 

Mr. LEVIN OF MICHIGAN. Thank you. 

Mr. Steuerle. 

f 

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 

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. 

smartinez on PROD1PC64 with HEARING

177 

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 economy. 

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, UrbanBrookings 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 efficiency. 

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 

smartinez on PROD1PC64 with HEARING

178 

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 zerorate taxpayers, and the least highly taxed items are owned by taxpayers facing 

higher rates. The tax system has provided enormous incentives for creating a debtmagnified 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 

taxed. 

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 organizations. 

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 realized. 

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 

smartinez on PROD1PC64 with HEARING

179 

deals and the character of their transactions, convert labor to capital gains income, 

and transfer money into and out of different instruments and tax jurisdictions. 

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. 

smartinez on PROD1PC64 with HEARING

180 

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 immediately. 

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, 

smartinez on PROD1PC64 with HEARING

181 

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 source. 

• 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. 

f 

Mr. LEVIN OF MICHIGAN. Professor Jones. 

STATEMENT OF DARRYLL K. JONES, PROFESSOR OF LAW, 

STETSON 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 

smartinez on PROD1PC64 with HEARING

182 

with theories, opinions and even dire predictions. But I’d like to 

point out one thing that we know absolutely for sure. 

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 $7,500. 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 capital. 

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: effismartinez on PROD1PC64 with HEARING

183 

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). 2Michael 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/tax/ 

index.html. 3Some 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 inflation. 

ciency 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 Committee: 

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. 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. 

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. 

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 

smartinez on PROD1PC64 with HEARING

184 

4To 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. 5See http://www.senate.gov/∼finance/hearings/testimony/2007test/071107testkm.pdf. 

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. 

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 

smartinez on PROD1PC64 with HEARING

185 

6The 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). 7There 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. 

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 

Year Appreciation Value Annual Tax on increase 

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. 

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 rasmartinez on PROD1PC64 with HEARING

186 

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 (2002). 9 RC 112 (1986). 

tionale 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. 

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 economy. 

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 

smartinez on PROD1PC64 with HEARING

187 

10http://www.senate.gov/∼finance/hearings/testimony/2007test/071107testes.pdf. 11 IRC 751 (1986). 12 IRC 702(b) (1986). 13Mr. 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. 14Weisbach’s paper can be found at http://www.privateequitycouncil.org/wordpress/wp-content/ 

uploads/carried-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. 

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 un- necessary 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

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. 

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

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 

smartinez on PROD1PC64 with HEARING

188 

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 profits. 

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. 

f 

Mr. LEVIN OF MICHIGAN. Thank you. 

Professor Fleischer. 

STATEMENT OF VICTOR FLEISCHER, ASSOCIATE PROFESSOR 

OF LAW, UNIVERSITY OF ILLINOIS COLLEGE OF LAW 

Mr. FLEISCHER. Thank you for inviting me here to present my 

views. 

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 money. 

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 executives. 

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. 

smartinez on PROD1PC64 with HEARING

189 

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:] 

smartinez on PROD1PC64 with HEARING

190 

smartinez on PROD1PC64 with HEARING


43307a.076
191 

smartinez on PROD1PC64 with HEARING


43307a.077
192 

smartinez on PROD1PC64 with HEARING


43307a.078
193 

smartinez on PROD1PC64 with HEARING


43307a.079
194 

smartinez on PROD1PC64 with HEARING


43307a.080
195 

smartinez on PROD1PC64 with HEARING


43307a.081
196 

smartinez on PROD1PC64 with HEARING


43307a.082
197 

smartinez on PROD1PC64 with HEARING


43307a.083
198 

smartinez on PROD1PC64 with HEARING


43307a.084
199 

Mr. LEVIN OF MICHIGAN. Thank you very much. 

Professor Gergen. 

STATEMENT OF MARK P. GERGEN, PROFESSOR OF LAW, THE 

UNIVERSITY OF TEXAS SCHOOL OF LAW, VISITING PROFESSOR, HARVARD LAW SCHOOL 

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 together. 

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 capital. 

Victor Fleischer has talked about one of them. They will make 

an interest free non-recourse loan to create a capital account. 

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 contribusmartinez on PROD1PC64 with HEARING

200 

1Section 1402 also should be amended to make this income subject to the self-employment 

tax. 2David 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 § 7872. 

tion 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. 

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 allocation. 

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 

smartinez on PROD1PC64 with HEARING

201 

3See Notice 2005–43, 2005–24 IRB 1221. 

4Diamond 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. 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. 

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. 

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. 

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. 

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 

smartinez on PROD1PC64 with HEARING

202 

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. 9Section 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). 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). 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 capital. 

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. 

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. 

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

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. 

smartinez on PROD1PC64 with HEARING

203 

12Some think this is required. Such adjustments are standard in partnership agreements, 

which often are drafted to track tax law rules. 

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. 

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 venture. 

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 

smartinez on PROD1PC64 with HEARING

204 

13The rule in § 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. 14See Two and Twenty: Taxing Partnership Profits in Private Equity Funds, forthcoming 

NYU L. Rev (2008). The paper is available on SSRN. 15 Under § 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. 16 I use this number for illustrative purposes. 

with the case of an individual who sells such property created by her personal efforts.13

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 labor. 

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 compensation.15

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. 

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 

smartinez on PROD1PC64 with HEARING

205 

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. 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 payments. 

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 manageable. 

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 share17 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. 

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 distribution. 

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

* 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. 

f 

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. 

smartinez on PROD1PC64 with HEARING

206 

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 first. 

Mr. TANNER. Thank you, Mr. Chairman. I like this rule. 

[Laughter.] 

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 observation? 

smartinez on PROD1PC64 with HEARING

207 

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 managers? 

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 income. 

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 

smartinez on PROD1PC64 with HEARING

208 

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 

smartinez on PROD1PC64 with HEARING

209 

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. taxation. 

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. 

smartinez on PROD1PC64 with HEARING

210 

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? No. 

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 

pays—— 

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 

smartinez on PROD1PC64 with HEARING

211 

level of gain realized for the investors, the partners do not get as 

much return; is that right? 

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 have? 

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 impact. 

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 jobs. 

smartinez on PROD1PC64 with HEARING

212 

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 well. 

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. 

smartinez on PROD1PC64 with HEARING

213 

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 question. 

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 testimony. 

‘‘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 corsmartinez on PROD1PC64 with HEARING

214 

porate 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 house. 

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 investment. 

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. 

smartinez on PROD1PC64 with HEARING

215 

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 testimony. 

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 involved? 

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 

smartinez on PROD1PC64 with HEARING

216 

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 treatment. 

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 intangibles. 

Mr. DOGGETT. Separate from the Levin bill, is there any action 

that we need to take to address circumvention by moving offshore? 

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? 

smartinez on PROD1PC64 with HEARING

217 

[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 rule. 

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 go. 

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. 

smartinez on PROD1PC64 with HEARING

218 

Mr. GERGEN. It does not necessarily follow that you would 

but—— 

Mr. RYAN. Come on, we are on a roll. Everybody else is saying 

yes. 

[Laughter.] 

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 ordismartinez on PROD1PC64 with HEARING

219 

nary 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.’’ 

smartinez on PROD1PC64 with HEARING

220 

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 IPO. 

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 alternative? 

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. 

[Laughter.] 

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 asking. 

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 debate. 

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 

smartinez on PROD1PC64 with HEARING

221 

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. 

smartinez on PROD1PC64 with HEARING

222 

One can point out that since this country began its careful reexamination 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 country. 

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 witnesses. 

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 

smartinez on PROD1PC64 with HEARING

223 

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. 

Blumenauer. 

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 

smartinez on PROD1PC64 with HEARING

224 

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 it. 

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 edition)—— 

Mr. LEVIN OF MICHIGAN. Which book? 

[Laughter.] 

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. 

smartinez on PROD1PC64 with HEARING

225 

Mr. LEVIN OF MICHIGAN. With that note, and I think we all 

agree, thank you very, very much. This has been really informative. 

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. 

STATEMENT OF LEO HINDERY, JR., MANAGING DIRECTOR, 

INTERMEDIA PARTNERS 

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 Broadband. 

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. 

smartinez on PROD1PC64 with HEARING

226 

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 income. 

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. 

smartinez on PROD1PC64 with HEARING

227 

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 hole. 

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 partnerships. 

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 

smartinez on PROD1PC64 with HEARING

228 

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 poppycock. 

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. 

f 

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 

smartinez on PROD1PC64 with HEARING

229 

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 patience. 

William Stanfill, founding partner of TrailHead Ventures. Thank 

you for being here. 

STATEMENT OF WILLIAM D. STANFILL, FOUNDING PARTNER, 

TRAILHEAD VENTURES 

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 

smartinez on PROD1PC64 with HEARING

230 

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– 

smartinez on PROD1PC64 with HEARING

231 

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 

smartinez on PROD1PC64 with HEARING

232 

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-serving? 

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 

breaks. 

Conclusion 

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. 

f 

smartinez on PROD1PC64 with HEARING

233 

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. 

STATEMENT OF ORIN S. KRAMER, CHAIRMAN, NEW JERSEY 

STATE 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 costs. 

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 

smartinez on PROD1PC64 with HEARING

234 

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 assets. 

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 fees. 

f 

AFTER 6:00 P.M. 

smartinez on PROD1PC64 with HEARING

235 

Chairman RANGEL. Thank you. The Chair would now like to 

recognize Jonathan Silver, Managing Director of Core Capital Partners. Thank you for your patience. 

STATEMENT OF JONATHAN SILVER, MANAGING DIRECTOR, 

CORE CAPITAL PARTNERS 

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. 

smartinez on PROD1PC64 with HEARING

236 

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 fund. 

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 

smartinez on PROD1PC64 with HEARING

237 

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 financing. 

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 system. 

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 inflict. 

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:] 

smartinez on PROD1PC64 with HEARING

238 

smartinez on PROD1PC64 with HEARING


43307a.085
239 

smartinez on PROD1PC64 with HEARING


43307a.086
240 

smartinez on PROD1PC64 with HEARING


43307a.087
241 

smartinez on PROD1PC64 with HEARING


43307a.088
242 

smartinez on PROD1PC64 with HEARING


43307a.089
243 

smartinez on PROD1PC64 with HEARING


43307a.090
244 

smartinez on PROD1PC64 with HEARING


43307a.091
245 

smartinez on PROD1PC64 with HEARING


43307a.092
246 

smartinez on PROD1PC64 with HEARING


43307a.093
247 

smartinez on PROD1PC64 with HEARING


43307a.094
248 

smartinez on PROD1PC64 with HEARING


43307a.095
249 

smartinez on PROD1PC64 with HEARING


43307a.096
250 

Chairman RANGEL. Thank you. 

Next is Adam Ifshin, President of DLC Management Corporation 

in my hometown in New York, Tarrytown. Thank you. 

STATEMENT OF ADAM IFSHIN, PRESIDENT, 

DLC MANAGEMENT CORPORATION 

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 multiethnic 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 risks. 

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 

smartinez on PROD1PC64 with HEARING

251 

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 deal. 

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 properties. 

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. 

smartinez on PROD1PC64 with HEARING

252 

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 country. 

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 mediumsize 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 composmartinez on PROD1PC64 with HEARING

253 

nent 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 Investors 

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. 

smartinez on PROD1PC64 with HEARING

254 

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 Analogy 

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 backer. 

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 place. 

• 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 

smartinez on PROD1PC64 with HEARING

255 

$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’ return. 

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. 

smartinez on PROD1PC64 with HEARING

256 

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. 

Conclusion 

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 country. 

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 Roundtable: 

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 

APPENDIX A 

FACTS ABOUT THE REAL ESTATE INDUSTRY 

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. 

smartinez on PROD1PC64 with HEARING

257 

• U.S. commercial real estate is worth approximately $5 trillion. 

• 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 people). 

• 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. 

f 

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. 

STATEMENT OF BRUCE ROSENBLUM, MANAGING DIRECTOR, 

THE CARLYLE GROUP, AND CHAIRMAN OF THE BOARD, 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 fund. 

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. 

smartinez on PROD1PC64 with HEARING

258 

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 profitability. 

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 environment. 

smartinez on PROD1PC64 with HEARING

259 

1The 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. 

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. 

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 besmartinez on PROD1PC64 with HEARING

260 

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. 

tween 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. 

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. 

smartinez on PROD1PC64 with HEARING

261 

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 operate. 

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 

smartinez on PROD1PC64 with HEARING

262 

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 respects. 

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 option. 

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. 

smartinez on PROD1PC64 with HEARING

263 

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 gain. 

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 ‘‘loophole.’’ 

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, 

smartinez on PROD1PC64 with HEARING

264 

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 business. 

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. 

smartinez on PROD1PC64 with HEARING

265 

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 womenowned 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 naı ̈ve, 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 

smartinez on PROD1PC64 with HEARING

266 

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 meaningful. 

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. 

smartinez on PROD1PC64 with HEARING

267 

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. 

f 

Chairman RANGEL. Thank you, Mr. Rosenblum. Members are 

waiting to ask questions. I just want to confine mine to Mr. Silver. 

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 compensation. 

It has been difficult for a lot of Members of this Committee, without targeting you or anyone else, to see how you feel comfortable 

smartinez on PROD1PC64 with HEARING

268 

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 couple. 

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 together. 

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 

smartinez on PROD1PC64 with HEARING

269 

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 asset. 

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 available. 

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 

smartinez on PROD1PC64 with HEARING

270 

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 financing. 

Mr. IFSHIN. Representative McCrery. 

Mr. MCCRERY. Quickly, because I want to give Mr. Stanfill a 

chance. 

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 this? 

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 gains? 

Mr. STANFILL. Not capital gains that apply to compensation, 

sir. 

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 Comsmartinez on PROD1PC64 with HEARING

271 

mittee. 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 undertaken.’’ 

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 potential. 

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 scale. 

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 Francisco. 

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, 

smartinez on PROD1PC64 with HEARING

272 

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 proceeds. 

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 not. 

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 apply. 

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? 

smartinez on PROD1PC64 with HEARING

273 

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 imposed. 

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 accounts. 

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. 

smartinez on PROD1PC64 with HEARING

274 

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 activities. 

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 day. 

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. 

smartinez on PROD1PC64 with HEARING

275 

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 distinction. 

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 question. 

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 Code. 

Mr. LEVIN OF MICHIGAN. You can shape it that way. 

smartinez on PROD1PC64 with HEARING

276 

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 equitable. 

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 themselves. 

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. 

smartinez on PROD1PC64 with HEARING

277 

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 same. 

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 classes. 

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 obvismartinez on PROD1PC64 with HEARING

278 

ous 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. 

[Laughter.] 

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 capital. 

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 class. 

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 funds. 

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 

smartinez on PROD1PC64 with HEARING

279 

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 country. 

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 vensmartinez on PROD1PC64 with HEARING

280 

ture capital funds much more involved with the management of 

what are often start up or fairly new enterprises? 

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 cofounding/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. 

[Laughter.] 

Mr. DOGGETT. I know there will be one. 

Chairman RANGEL. Mr. Blumenauer. Thank you for your patience. 

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. 

smartinez on PROD1PC64 with HEARING

281 

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 brief. 

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 is. 

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? 

smartinez on PROD1PC64 with HEARING

282 

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 down? 

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. 

smartinez on PROD1PC64 with HEARING

283 

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 losers. 

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 list. 

smartinez on PROD1PC64 with HEARING

284 

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 it. 

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. 

smartinez on PROD1PC64 with HEARING

285 

Ms. SCHWARTZ. Anyone else want to disagree with that? Mr. 

Rosenblum. 

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 investors. 

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. 

smartinez on PROD1PC64 with HEARING

286 

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:] 

[INFORMATION NOT AVAILABLE AT THIS TIME] 

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:] 

f 

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 businesses 

• 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 mortsmartinez on PROD1PC64 with HEARING

287 

gage 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 employerprovided 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 investment. 

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 accident 

• 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 businesses. 

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 

smartinez on PROD1PC64 with HEARING

288 

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 taxpreferred 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. 

f 

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. 

Background 

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, www.uschamber.com/publications/reports. 

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 longterm 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 

smartinez on PROD1PC64 with HEARING

289 

1 Internal Revenue Service, 2007, Data Book 2006, (United States Department of the Treasury, Washington, D.C.). 2Metrick, Andrew, and Ayako Yasuda, 2007, The Economics of Private Equity Funds. 

3 Internal Revenue Service, 2007. The weighted average calculated as [(49.8)(.35)+(50.2)(.15)]/ 

100=24.96 percent. 4 Jensen, M.C., 1993, The modern industrial revolution, exit, and the failure of internal control 

systems, 

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 world. 

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

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 way. 

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 percent.3

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. 

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 

smartinez on PROD1PC64 with HEARING

290 

5The Wall Street Journal, 2007, Trading Shots: Taxing Private Equity, (The Wall Street Journal). 6Miller, Jonathan D., 2006. Emerging Trends in Real Estate (ULI-the Urban Land Institute, 

Washington, D.C.). p. 21. 7 Cumming, Douglas, Donald S. Siegel, and Mike Wright, 2007, Private equity, leveraged 

buyouts and governance, Journal of Corporate Finance 13, 439–460. 8Kaplan, S.N., 1989a, The effects of management buyouts on operating performance and 

value, Journal of Financial Economics 24, 217–254. 9Wright, 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. 

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

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 billion).6

Below is a detailed review of several key articles written on this topic: 

1. Cumming, Siegel, and Wright (2007) 7

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

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

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 

smartinez on PROD1PC64 with HEARING

291 

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. 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. 12 Jensen, M., 1989, The eclipse of the public corporation, Harvard Business Review 67, 61– 

74. 13 Jensen, M.C., 1993, The modern industrial revolution, exit, and the failure of internal control systems, Journal of Finance 48, 865–880. 14Knoll, 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). 

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

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

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

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 frontend fees because it provides strong incentives to do good deals, not just to do deals. 

7. Jensen (1993) 13

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

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 includsmartinez on PROD1PC64 with HEARING

292 

15Fleischer, 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). 16Weisbach, David A., 2007, The Taxation of Carried Interests in Private Equity Partnerships. 

ing 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 

transaction. 

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 collections. 

9. Fleischer (2006) 15

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

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 acsmartinez on PROD1PC64 with HEARING

293 

17 Abrams, Howard E., 2007, Taxation of Carried Interests, Tax Notes. 18Fenn, 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.). 

complished satisfactorily, fund managers would have little problem avoiding the 

bulk of these new taxes by acquiring non-recourse loans from limited partners. 

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

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 nonprofit 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

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. 

Conclusion 

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. 

smartinez on PROD1PC64 with HEARING

294 

1Publicly traded partnerships are also referred to as ‘‘master limited partnerships’’ or MLPs. 

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. 

f 

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. 

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 ususmartinez on PROD1PC64 with HEARING

295 

2The vast majority of corporations are never publicly traded. 

ally 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 rollups; 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 distributions. 

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

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 

smartinez on PROD1PC64 with HEARING

296 

3 ‘‘In the case of natural resources activities, special considerations apply. Thus passive-type 

income from such activities is considerably broader. . . .’’ 

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 corporatelevel 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. 

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. 

smartinez on PROD1PC64 with HEARING

297 

4Some members also have corporate subsidiaries which generate qualifying income, as part 

of an acquisition or joint venture, or for other reasons. 

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 purpose. 

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 flowthrough treatment, to act as a ‘‘safety valve’’ for the qualifying income test. 

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 funds. 

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 sectors. 

Table 1 

Publicly Traded Partnerships on 

Major Exchanges 

Percent Market 

Capital 

Percent 

Number* of Total ($B) of Total 

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% 

smartinez on PROD1PC64 with HEARING

298 

Table 1 

Publicly Traded Partnerships on 

Major Exchanges 

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. 

MISSING GRAPHICS 

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 passthrough 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 

smartinez on PROD1PC64 with HEARING

299 

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 2007 

PTP-Owned 

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 stated: 

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 form. 

• 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. 

smartinez on PROD1PC64 with HEARING

f 

300 

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 higher. 

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 resmartinez on PROD1PC64 with HEARING

301 

form 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. 

MISSING GRAPHIC 

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 $330,000. 

• 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. 

smartinez on PROD1PC64 with HEARING

302 

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 poor. 

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 flattax proposal would encourage people to solve these problems on their own. 

A Higher Rate of Economic Growth 

GRAPHIC MISSING 

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 taxes. 

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 imsmartinez on PROD1PC64 with HEARING

303 

proving 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 taxation: 

• Only people pay taxes. 

• Consumption tax rates are self-limiting. 

• Uniformity of taxation wards off special interest manipulation. 

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. 

Conclusion 

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. 

f 

Statement of National Taxpayers Union, Alexandria, Virginia 

Introduction 

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. 

smartinez on PROD1PC64 with HEARING

304 

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 wideranging 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 value. 

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 

smartinez on PROD1PC64 with HEARING

305 

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 oneyear 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 elsewhere. 

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, 

smartinez on PROD1PC64 with HEARING

306 

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. 

Conclusion 

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. 

f 

Statement of NGVAmerica 

Introduction 

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 reliance. 

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 

smartinez on PROD1PC64 with HEARING

307 

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 §§ 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 incentives. 

Conclusion 

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. 

Æ 

smartinez on PROD1PC64 with HEARING