Commercial Real Estate. and Changing the Tax Treatment of Carried Interest. Douglas Holtz-Eakin Prepared for The Real Estate Roundtable

Transcription

1 Commercial Real Estate and Changing the Tax Treatment of Carried Interest Douglas Holtz-Eakin Prepared for The Real Estate Roundtable October 2007

2 Executive Summary Congress is currently considering proposals to increase the taxation of carried interest. 1 Increasing taxes on the equity investments in real estate will further damage a market that is threatened by current credit conditions. The proposal to re-characterize carried interest from capital gains to ordinary income would constitute a potentially large tax increase on real estate partnerships, both in dollar terms and relative to the income generation of the affected partners. The specter of these tax implications will force real estate ventures to engage in legal restructuring to minimize the tax impact, harming the currently-successful business models. Regardless of that effort, the tax will crowd out valuable real estate investment transactions (development, acquisitions and renovations) that cannot carry the additional tax burden, and thus diminish overall economic performance and job creation. Over time, the greatest damage will occur because higher taxes on carried interest will rob commercial real estate of managerial talent, as the entrepreneuriallyinclined are deterred by these higher taxes and seek their outlets elsewhere in the economy. Key Points: There are over 2.5 million partnerships, managing $13.6 trillion dollars in assets, and generating income of roughly $450 billion. Real estate accounted for 45 percent of these partnerships and roughly $1 trillion in equity investment plus another $350 billion in debt financed investment. Changing the tax treatment of carried interests, assuming no changes in investment behavior, would result in a tax increase of $13 billion annually, and $5 billion in real estate alone. These taxes would constitute 15 to 20 percent of general partners income. The economy-wide lost economic income from distorting taxes on real estate partnership capital would be $15 to $20 billion annually, and as much as 10 to 25 times greater once the detrimental impact on entrepreneurial talent is incorporated. Workers would bear the impact of higher taxes in the form of reduced jobs in construction and real estate activities and lower earnings overall. 1 Carried interest is a general partner s share of the profits generated by appreciation in the value of a partnership s investment activities that exceeds his proportionate share of capital contributed to the partnership.

3 Introduction Congress is currently considering proposals to increase the taxation of carried interest. 1 Carried interest is an integral feature of the financial arrangements of partnerships, a management structure broadly utilized in the United States and especially prominent in commercial real estate. This structure provides the general partners with a share of profits that is more than proportional to their capital contribution only if those general partners are successful in achieving the investment goals of the partnership. The financial structure allows entrepreneurs to match their expertise with a financial partner, assume risks, and align the parties economic interests so that entrepreneurial risk taking is viable. The real estate industry employs partnerships with carried interests on projects ranging from small property development to large multibillion dollar investment funds. While tax increases are never desirable per se, this initiative occurs at a time when the residential real estate sector is slumping (and the effect seeping into the commercial sector), financial market volatility is pronounced, and the construction and credit market shocks have weakened overall economic growth. This white paper examines the impact of changing the tax treatment of carried interest. It begins by reviewing the current tax treatment and the proposed changes to carried interest tax policy. Next, I turn to the extent and scale of partnership operations, and the range of impacts that higher taxes might deliver and follow this with analysis of the likely channels by which raising taxes on carried interest would affect the commercial real estate sector, and the United States more generally. The final section is a summary. 1 In a related development, it is also examining changes to the tax treatment of publicly traded partnerships. While these proposals are discussed below, this paper is focused primarily on changing the taxation of carried interest.

4 To anticipate the conclusions, increasing taxes on carried interest would constitute a potentially large tax increase on real estate partnerships, both in dollar terms and relative to the income generation of the affected partners. The specter of these tax implications will spawn reactions ranging from legal restructuring to crowding out valuable real estate transactions that are not sufficiently profitable to carry the additional burden. Perhaps most damaging, the higher taxes on carried interest will rob commercial real estate of managerial talent, as the entrepreneurially-inclined are deterred by these higher taxes and seek their outlets elsewhere in the economy. The Tax Proposals Many real estate ventures indeed, many business ventures in all sectors are organized as limited partnerships. Investors such as pension funds, endowments, foundations, individuals, and others contribute capital and become limited partners (LP) in the partnerships. One or more general partners (GP) provide entrepreneurial management of the partnership and is paid a management fee that is typically one to two percent of the overall partnership s capital. In a typical real estate partnership, the GP also contributes capital alongside the investors capital. This ranges from 1-10 percent in most cases. The GP also receives an interest in the overall profits above the share allocable to his capital contribution. This interest is commonly referred to as a promote, profits interest, or carried interest. Typically, the carried interest is 20 percent of the profits and is generated from appreciation in the value of the partnership s property. In the case of real estate, this means that after a period of between five to 10 years, the GP receives a payoff linked to the degree to which the entrepreneurial input has resulted in higher asset prices

5 The carried interest provides powerful incentives to align the interests of the GP and the LPs. While the GP also receives a management fee that covers administrative overhead, operating costs, and managers salaries, that fee is fixed and does not provide incentives to improve the performance of the real estate. The management fees are taxed as ordinary income. The carried interest, however, is taxed at the time of sale. The tax character of the income is consistent with that distributed by the partnership. The sale of the partnership s real property produces long-term capital gain taxable at the capital gain rates (maximum 15 percent). Recent proposals would re-characterize the carried interest as ordinary income and thus subject it to tax at rates reaching 35 percent. Proponents of such a change argue that the current tax treatment is unfair because it accords a particular form of GP compensation preferential tax treatment. They argue that the GP is providing services to the partnership and services are taxable as ordinary income. Neither claim stands up to sustained scrutiny. To begin, a greater unfairness inherent in the proposal is that it would cause similar taxpayers to be taxed differently. If enacted, investments in real estate would face different effective tax rates depending upon whether they are undertaken by an individual, C Corporation, through a real estate investment trust, or via the limited partnership structure. Next, carried interest is not the same as other compensation. The carried interest is a potential share of partnership profits and not considered compensation for services by the partners management and other annual fees constitute such compensation. These not insubstantial fees are taxed at ordinary income rates. They are based on the entire amount of partnership capital under management and paid annually by the partnership. The management fee is typically 2 percent of capital under management but can also include other fees like acquisition, development and leasing fees. If a partnership under-performs, they are the only income the general partner receives. Simply stating that the - 3 -

6 carried interest is compensation for services ignores the economic relationship of the partners in the partnership. The tax change is potentially unfair from a third perspective as current proposals are not exclusively changes in the prospective treatment of carried interest. That is, they do not rule out retroactive tax increases on investments undertaken assuming that carried interests would be characterized as capital gains for tax purposes. Treating carried interest as ordinary income would not move the tax code toward a more efficient system. There is now a wide consensus that fiscal policy in the United States must promote the most sustainable pace of long-term economic growth. As part of this, it is essential to keep taxes on the return to saving, investment, and entrepreneurial innovation as low as possible. As a benchmark, for example, pro-growth tax reforms that focus on taxing consumption typically permit a full deduction from the tax base for all capital contributions to investments as the appropriate offset for taxing the future cash flow returns at a full rate. The proposed tax change on carried interest imposes the latter taxation, without the corresponding deduction. In sum, from the perspective of tax policy, it is neither a genuine move toward more fairness in the current tax system nor a movement of the current system toward a more desirable overall tax code. As noted at the outset, a related initiative is a proposal to subject certain publicly-traded partnerships to the corporation income tax. There is now a large and persuasive literature documenting the undesirability of subjecting the return to equity investments in the corporate sector to a second layer of tax. Public finance economists have long advocated integrating the corporation and individual income taxes to achieve a single layer of tax and tax-neutrality of investment decisions. 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

7 Impacts of Changing the Tax Treatment of Carried Interest A straightforward approach to analyzing the impact of changing the tax treatment of carried interest begins noting that partnerships are a pervasive part of the economic landscape. Table 1 displays selected characteristics of partnerships using data for 2004 drawn from the Internal Revenue Service s Statistics of Income data series. The data indicate that there were over 2.5 million partnerships comprising nearly 15 million partners. These enterprises managed over $13.6 trillion dollars in assets and generated net income of roughly $450 billion. 2 Clearly, more than doubling the tax treatment of such a broadbased business structure will have potentially dramatic impacts on the economy. Counted by number, partnerships are most prominent in real estate (45 percent), finance and insurance (11 percent) and retail trade (5 percent). Viewed from the perspective of total assets, the finance sector (55 percent) appears larger than real estate (22 percent). Table 2 draws on the information in Table 1 and focuses attention on the potential magnitudes involved in changing the tax treatment of carried interests, with particular emphasis on the finance, insurance and real estate industries. 3 Specifically, consider the first column that shows the economy-wide partnerships. It indicates that of the $802 billion in net income generated by partnerships, roughly $324 billion is has the character that would potentially lead it to be classified as carried interest (the sum of Net long-term capital gain and Net section 1231 gain ). Assuming that 20 percent of this income flow is the share of general partners yields an estimate of the income that might be subject to reclassification for tax purposes -- $65 billion. As shown in the bottom panel 2 The dollar values have been inflated for economic growth occurring between 2004 and the second quarter of 2007 using the ratio of Gross Domestic Product (GDP) in 2007Q2 to GDP in The data in Table 2 are restricted to those returns that permit the allocation of income to partners, a crucial consideration as the tax treatment of carried interests is focused on general partners

8 Table 1: Characterstics of Partnerships, 2004 All Forestry, Fishing Transportation Finance and Industries Hunting Mining Utilities Construction Manufacturing Wholesale trade Retail trade and Warehousing Information Insurance Number of partnerships... 2,546, ,632 26,009 3, ,599 42,685 43, ,955 34,484 34, ,404 Number of partners... 15,556, , ,726 65, , , , , , ,502 3,284,997 Total assets... 13,645, , , , , , , , , ,753 7,431,291 Income and deductions from a trade or business: Total income... 3,552,191 30,878 96, , , , , ,957 88, , ,449 Business receipts... 3,313,761 25,195 90, , , , , ,337 83, , ,312 Ordinary income from other partnerships and fiduciaries... 57, , ,074 2, ,751 3,663 16,532 Farm net profit... 4,168 4, Net gain, noncapital assets... 12, , , , ,748 Other income , ,649 1,806 3,201 10,837 5,252 7,077 2,402 6,990 78,825 Total deductions... 3,309,434 32,340 68, , , , , ,135 83, , ,960 Salaries and wages ,000 1,797 1,802 1,755 8,710 24,094 13,893 24,172 6,539 22,959 35,559 Portfolio income (loss) distributed directly to partners ,010 2,168 5, ,132 6,149 1, , ,781 Interest income , , ,805 76,795 Dividend income... 57, , ,728 43,189 Royalties... 14, , , ,444 2,178 Net short-term capital gain (loss)... 32, ,317 Net long-term capital gain (loss) ,783 1, ,235 1, ,302 Net rental real estate income (loss)... 33, Net income... 97, ,078 Loss... 64, ,869 Other net rental income (loss) Net income... 7, Loss... 6, , Total net income (loss) [2] , ,028 1,585 22,389 44,274 11,778 2,510 5,747 7, ,829 Net income ,643 6,145 37,393 7,412 28,847 58,068 15,483 8,084 9,982 29, ,933 Loss ,358 6,113 5,365 5,827 6,458 13,794 3,704 5,574 4,235 21,928 23,105 Dollar values in millions; adjusted for economic growth to 2007 Q2. Source: IRS Statictics of Income Division, Fall SOI Bulletin, February 2007.

9 Table 1 (continued): Characteristics of Partnerships 2004 Real estate Lessors of Professional All Rental and Real Nonresidential Scientific and Adminstrative Educational Health care and Arts, entertainment, Accommodation Other Industries Leasing Estate Buildings Technical Services Management and Support services Social Assistance and Recreation and Food Services Services Other Number of partnerships... 2,546,877 1,179,731 1,146, , ,045 24,221 52,105 8,316 56,709 45,126 90,705 58,418 2,506 Number of partners... 15,556,553 6,642,700 6,456,651 2,264, , , ,003 22, , , , ,106 6,688 Total assets... 13,645,628 3,101,269 2,988,034 1,283, , ,588 35,303 2,858 82,806 68, ,494 15, Income and deductions from a trade or business: Total income... 3,552, , ,379 11, ,201 27,678 64,183 3, ,291 46, ,423 21, Business receipts... 3,313, , ,435 9, ,392 15,194 62,130 3, ,016 40, ,579 20, Ordinary income from other partnerships and fiduciaries... 57,263 11,281 11, ,839 8, , Farm net profit... 4, Net gain, noncapital assets... 12,242 2,786 1, Other income ,757 12,889 9,941 1,133 10,566 3,205 1, ,979 4,580 4, Total deductions... 3,309, , ,112 11, ,534 27,365 60,471 3, ,852 48, ,546 20, Salaries and wages ,000 13,557 11,589 1,226 70,527 2,575 14, ,093 11,247 24,737 3,286 9 Portfolio income (loss) distributed directly to partners ,010 54,044 50,983 9,664 4,430 20, , Interest income ,382 13,372 12,414 3, , Dividend income... 57,943 4,209 4, , Royalties... 14,176 2, , Net short-term capital gain (loss)... 32,725 1,583 1, Net long-term capital gain (loss) ,783 32,377 32,037 4,815 2,124 9, , Net rental real estate income (loss)... 33,566 32,577 32,381 35, Net income... 97,843 92,365 92,047 53, Loss... 64,277 59,788 59,667 17, Other net rental income (loss) Net income... 7,124 4,643 1, Loss... 6,663 4, Total net income (loss) [2] ,286 63,904 65,712 41,461 65,850 11,583 4, ,811-1, Net income , , ,765 60,477 73,466 20,575 6, ,353 5,013 8,976 2, Loss ,358 78,080 69,053 19,016 7,617 8,992 1, ,542 6,460 8,297 1, Dollar values in millions; adjusted for economic growth to 2007 Q2. Source: IRS Statictics of Income Division, Fall SOI Bulletin, February 2007.

10 Table 2: Static Implications of Changing the Taxation of Carried Interests (Dollar Values in Millions of 2007 Dollars) Finance and All Industries Insurance Real Estate Number of partnerships 2,534, ,008 1,176,903 Number of partners 15,438,554 3,247,969 6,634,533 Total income (loss) $ 951,773 $ 446,058 $ 198,313 Ordinary business and real estate rental income $ 276,324 $ 37,699 $ 43,456 Net long-term capital gain $ 209,783 $ 155,302 $ 32,377 Plus Net section 1231 gain $ 114,142 $ 5,856 $ 91,927 Equals Total Income at risk to higher tax $ 323,925 $ 161,159 $ 124,304 20% Equals Potential Carried Interest Basis $ 64,785 $ 32,232 $ 24,861 Total deductions $ 149,468 $ 87,144 $ 16,058 Net Income $ 802,305 $ 358,914 $ 182,256 Net Income Allocated to All Partners $ 791,908 $ 352,016 $ 181,482 Limited partners $ 576,521 $ 283,301 $ 135,520 Individual general partners $ 84,540 $ 7,609 $ 23,610 Partnership general partners $ 51,835 $ 29,997 $ 10,001 All other partners $ 79,013 $ 31,109 $ 12,351 Taxation of Carried Interests Tax on carried interests at 15% rate $ 9,718 $ 4,835 $ 3,729 Tax on carried interests at 35% rate $ 22,675 $ 11,281 $ 8,701 Increased tax -- carried interests of general partners $ 12,957 $ 6,446 $ 4,972 Tax Increase: % Income of Individual general partners 15.3% 84.7% 21.1% Tax Increase: % Income of Individual & Partnership general partners 9.5% 17.1% 14.8%

11 of the table, these data suggest that changing the tax treatment from a 15 percent tax rate to a 35 percent tax rate would increase total taxes from this source from $10 billion to $23 billion a tax increase of $13 billion. The remaining columns indicate that a similar accounting exercise suggests that the finance industry the putative target of the tax increase faces a potential rise of nearly $6.5 billion, while the real estate sector presumably an innocent bystander would face a $5 billion increase, or threequarters as large as the finance industry. Regardless of the original intentions of advocates for the change, the overall potential increased taxation of carried interest would be roughly $50 billion (for real estate) and $130 billion (overall) over the next decade. Any tax change of this magnitude will likely have substantial economic impacts. Table 2 offers an alternative metric of the increase in the size of the tax increase. Ideally, one would like to know what fraction of an individual general partner s income would be subject to greater tax, and just how much higher (in absolute or percentage terms) the partner s taxes would be. Unfortunately, general partners incomes could come from a variety of sources multiple partnerships, wage and salary income from another job, portfolio investment income, spouses earnings, etc. and data that are organized by partnership will not be able to shed light on this impact. However, Table 2 does show the flow of income from partnerships to partners. Thus, for the real estate industry, approximately $23.6 billion flowed to individual general partners. Assuming that there is a single individual general partner for each of the 1.2 million partnerships, this corresponds to about $20,000 per GP. If there were two such general partners on average it would be only $10,000. In the other direction, if one assumes that partnership general partners income would eventually flow through to such individuals, the income being generated for general partners would be between $14,000 (two partners) and $28,500 (if there were a single individual general partners)

12 Similar computations for the potential rise in taxes on carried interests indicate a tax bill of between $2,100 and $4,200 per general partner. Combining the extremes indicates that at the low end ($4,200 and $28,500) the tax increase is nearly 15 percent of the income. However, using the upper bound combination ($4,200 tax and $20,000) indicates a tax increase of 21 percent of the income. It is important to emphasize that these computations are not a revenue estimate because they assume no change in the underlying behavior. Given the magnitudes involved, the absence of reaction is implausible unless the law precludes the ability to adjust to the new tax environment. I turn now to the ability and nature of such responses. The Retroactive Components of Higher Carried Interest Taxation. Because these estimates are built off historical data (adjusted to rough 2007 magnitudes as noted above) and assume that there is no change in partnership behavior, they serve as a rough guide to the impact of a change in the tax treatment of carried interests if those impacts are confined to existing partnerships. If, for example, the higher tax was imposed retroactively and exclusively on existing partnerships, the partnership contractual arrangements would be fixed and GPs would be forced to absorb these increased taxes without an avenue to minimize their impacts. Importantly, the current proposals in Congress do not rule out retroactive taxation of existing partnerships. Thus, in the absence of change in the legislation, the impact of increasing taxes on carried interests will include at least in part these considerations

13 The Prospective Component of Higher Carried Interest Taxation. Going forward, however, there will be efforts to restructure partnership arrangements in response to the new, higher level of taxation. Significant additional time and capital will be spent by real estate LPs and GPs in order to restructure their investment vehicles so that the overall impact of the new tax on carried interests can be minimized or avoided altogether. By definition, these new legal arrangements will be inferior to the original. 4 Thus, this outlay and use of time will not improve economic performance overall, and will not contribute to the objectives of real estate investment managers, their institutional investors (such as pension funds) and their individual clients. Indeed, if at all possible, the real estate GPs will have the incentive to pass these higher costs to the institutional investors and individual clients, thereby reducing their received rate of return. A related avenue of adjustment would be to replace the incentive-based carried-interests structure between GPs and their investors with non-contingent, fixed compensation arrangements. Because of the absence of performance incentives, these types of compensation contracts will not elicit superior investment performance, with a declining return to commercial investment as a result. Moreover, depending upon the nature of these arrangements, they may raise little revenue as the taxed compensation to the GPs will be deductible to individual and corporate investors. 5 However, it is unlikely that legal adjustments alone will be sufficient to avoid the entire tax. If so, the real economic activity of commercial real estate and the partnership structure will be affected. Intuitively, placing a greater tax burden on carried interests will raise the overall tax burden on the investment. 4 If they were better, they would have been adopted in the absence of the new tax. 5 Not all investors are taxable; e.g., pension funds so there will not be a perfect offset. At the same time, the overall dollar value of compensation will have to exceed the existing carried interest to compensate GPs for their higher level of taxation. Knoll (2007) makes this argument

14 Unless the project is sufficiently profitable, it will not be possible to pay the annual operating expenses, cover depreciation of the property, meet the contractual obligations for debt-financings, pay taxes, and offer a competitive return to the equity partners in the investment. In such circumstances, the projects that don t make the cut will be dropped projects that likely will be in the more marginal locations or burdened with greater risk. In modern, competitive global financial markets, even small changes in margins move trillions of dollars of financial capital; the commercial real estate would be at a clear financial disadvantage and would lose capital to other investment opportunities. This impact the shifting of capital from one sector of the economy to another in response to a discriminatorily higher tax has been extensively analyzed in the context of the corporation income tax. The analogy is quite clear: the corporation income tax is a tax on the return to capital that is received through a particular business form the chapter C corporation. Raising taxes on carried interest is a tax on the return to capital that is received through a particular business form the partnership. The legal setting is different, but the economics are the same. One dimension to the cost of the discriminatory taxation of carried interests is that capital is shifted to less productive uses; damaging overall economic performance. The intuition is straightforward. For simplicity, imagine that there is no tax (or equal tax treatment) across all uses of capital, and all returns are equalized at a pre-tax return of 20 percent. Now, suppose that one sector (partnerships) faces a unique and higher tax to make the example simple of 50 percent. Immediately, the post-tax return falls to 10 percent in this sector, inferior to opportunities of 20 percent elsewhere and capital flows to those opportunities

15 The process will continue until post-tax rates of return equalize and eliminate incentives for capital shift. In this example, when pre-tax returns in the taxed sector are 30 percent and those in the less-taxed sector are 15 percent, the post-tax return will be 15 percent in both. The tax, however, generates a clear cost to the economy: capital is twice as productive (30 versus 15 percent) in the taxed sector as elsewhere. By driving capital from more productive to less productive activities, the tax reduces overall productivity of capital and shrinks the economy. The standard approach to quantifying this loss (dating to Harberger s 1966 analysis) places the value equal to the foregone output due to crowding out lessprofitable projects as equal to ½ tk l where t is the higher tax on capital and K l is the amount of capital that exits the taxed sector. The formula captures the net effect of the loss in the taxed sector offset by the (lower) productivity of capital employed elsewhere. Estimates indicate that there is roughly $1.35 trillion in capital in partnerships in the commercial real estate sector of which anecdotal evidence suggests about $350 billion is debt financed, leaving over roughly $1 trillion in equity capital. Given the typical holding periods, the complete adjustment would take roughly a decade, but over that time span capital is quite mobile so perhaps as much as one-half could exit. 6 In the context of the impacts shown in Table 2, the magnitude of the tax involved is roughly 3.5 percent. 7 Using the conventional Harberger analysis, this suggests that a rough estimate of the economic loss due to the crowding out of economically-viable projects because of the higher tax is between $15 billion and $20 billion annually. 6 Notice that with ongoing growth in the economy and thus the commercial real estate sector, this exit will manifest itself as slower growth in commercial real estate equity investment. 7 This tax is lower than those in Table 2 as the tax applies only to a portion of the financing (equity) and then only to a portion of the equity financing (GPs)

16 The Loss of Entrepreneurial Talent. The Harberger analysis focuses exclusively on the shifting of capital. More recent research by Gravelle and Kotlikoff (1989), however, suggests that this approach badly understates the detrimental impacts of higher taxes because it has too narrow a focus. Specifically, Gravelle and Kotlikoff reconsider the computations and incorporate the fact that canceling investment projects alone are not the only fallout of raising taxes. Rather, when taxes are raised they also drive away the key element of economic success entrepreneurial talent. More specifically, taxed (partnerships) and untaxed (real estate investment trusts, etc.) business forms are competing for the same entrepreneurial management talent and producing the same ultimate product (commercial real estate services). Common sense suggests that the imposition of the additional tax on carried interests will diminish not only the ability to attract capital, but also the same quality of managerial talent to make the capital productive in partnerships. The prospect of lower after-tax pay will lead prospective investment managers to examine other employment options in the market. Inevitably, the lower quality management will diminish performance. Gravelle and Kotlikoff compare the efficiency cost apparent from the standard Harberger analysis with an efficiency cost that captures the loss of entrepreneurial talent. Over a wide range of assumptions about the nature of production and competition, the costs are at least 10 times as great and as much as 25 times higher. Put bluntly, these results suggest that the economic costs of crowding out real estate projects plus the lower performance that comes from diminished entrepreneurial zeal will impair the real estate sector and the economy as a whole to the tune of up to $200 billion dollars. These economic costs are losses represent foregone income in the economy a cost to everyone

17 Specific Losers as a Result of Higher Taxes on Carried Interest. Should capital and talent leave the real estate sector there will be specific losers. One manifestation of this shifting will be reduced construction, particularly in more marginal projects that would have been located in less desirable locations. Highly attractive investments would likely continue, although these may be constructed at a slower pace. Moreover, the experience of having had an unexpected increase in taxation sets a precedent that would raise the probability of future tax increases on equity investments and generate policybased risk. This higher level of uncertainty and risk would lower the desirability of investments. 8 These impacts would be quite visible. The September 2007 payroll employment survey shows that construction of non-residential structures provided nearly 800,000 jobs; just under one percent of all employment. 9 These jobs are good paying, important opportunities. Roughly 20 percent of these workers were minorities and average weekly earnings in construction were $830, compared to $588 for the private sector as a whole. 10 In addition, the real estate industry employed 1.5 million workers, or about 1.3 percent of all employment. The loss of capital would translate directly into lower employment. If employment losses are proportional to capital lost, the real estate industry would lose 1,000 jobs for every $10 billion of lost capital. In light of the possibility of capital losses reach an order of magnitude higher, tens of thousands of real estate jobs would be at risk. 11 This phenomenon is one piece of an important literature dating from Harberger s (1962) analysis that has attempted to answer the question who 8 See Bulan, Mayer, and Somerville, See 10 Author s computations based on American Community Survey, Computed using $16,518 billion in real estate capital stocks (Table 5. Current-Cost Net Stock of Private Fixed Assets by Industry, Bureau of Economic Analysis) and 1,456,900 in payroll employment for

18 really pays a differential tax on capital. A recent re-examination of this question that acknowledges the importance of globalization of capital markets by Kevin Hassett and Aparna Mathur provides provocative evidence that the answer is workers. Because market rates of return are set globally, the cost of taxes is ultimately shifted to workers in the form of lower wages. Spillover Effects. A final aspect of the damage of higher taxes is that by taxing the return to equity more heavily, the tax change would encourage heavier use of debt finance, lead to increased leverage, and raise the financial fragility of the real estate sector. This damage could spill over into volatility and weakness of the Commercial Mortgage Backed Securities (CMBS) market an unpleasant side effect at a time of already-heightened financial volatility. This latter effect is emblematic of the types of unintended consequences that may result form higher taxation of carried interests. Increasing the tax will raise total taxes on real estate the transactions. Other this equal, this lowers the after-tax cash flows to the entire project and lowers it desirability. The most straightforward way to offset this impact is for the purchase price the property value to fall to offset the higher taxes. Partnerships could attempt to raise cash flows by increasing rents. Unfortunately, because partnerships compete with other real estate entities that don t have to raise rents, this would be uncompetitive and ultimately fail. The loss in property value would have a ripple effect on the CMBS market as rating agencies would be forced to downgrade CMBS debt. Summary and Conclusion There appears to be little merit to changing the tax treatment of carried interests. As indicated in a recent analysis by Michael Knoll (2007), taxing the

19 carried interest will raise modest amounts of revenue. 12 In return, the tax would likely inflict large damage on the commercial real estate sector, diminish its entrepreneurial talent pool, and lead to lower construction and wages in the real estate sector. 12 His analysis is probably an overestimate. Knoll 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

20 References Bulan, Laarni, Christopher Mayer, and C. Tsuriel Somerville, Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development, Brandeis University, Gravelle, Jane and Lawrence Kotlikoff, The Incidence and Efficiency Costs of Corporate Taxation When Corporate and Noncorporate Firms Produce the Same Good, Journal of Political Economy, Harberger, Arnold, The Incidence of the Corporation Income Tax, Journal of Political Economy, Harberger, Arnold, Efficiency Effects of Taxes on Income from Capital, in Effects of the Corporation Income Tax, M. Krzyzaniak (ed.), Wayne State University Press, Hassett, Kevin and Aparna Mathur, Taxes and Wages, American Enterprise Institute, Working Paper #128, Knoll, Michael S. The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income, unpublished, University of Pennsylvania,