Public Debt and Financial Overhaul

I normally do not post on issues in the political realm, but what I hope to do here is make clear the dangers that lie hidden in the current financial overhaul bill recently passed by the Senate. With the rhetoric around the bill giving away nothing and being spun around preventing financial catastrophe, I think it useful to put the bill in the proper context of the current fiscal climate of the country. I then explain one provision I know something about impacting the commercial real estate sector: the carried interest provision. Simply put my argument is that :

1. Our nation does not have the luxury to live off of borrowed money for much longer.
2. In order to face the very real problems relating to fiscal imbalances and public debt, we must do all we can to grow the economy through promoting entrepreneurial activities.
3. The carried interest provision will serve the opposite purpose by disincentivizing capital to back entrepreneurial activity in the commercial real estate sector.

I am not going to take much space expousing on 1 above as I think this is obvious to most people. For some perspective on the magnitude of the issue please see the below video I produced from a recent lecture from the introduction to macroeconomics given by Kenan-Flagler Business school professor Christian T. Lundblad.

2. In order to face the problems relating to fiscal imbalances and public debt, the economy must grow through incentivizing entrepreneurial activities.

Peter Drucker, in his 1985 book Innovation and Entrepreneurship: Practice and Principles (1985), (yes 25 years ago) articulates why an entrepreneurial society and tax structure promoting entrepreneurship was needed then in America. He foresaw the worker skill gap created by the decline of smokestack industries due to the forces of globalization, and proposed that innovation and entrepreneurship would be our route to staying competitive in the global economy. Here are a few quotes: "........an entrepreneurial society and economy require tax policies that encourage the formation of capital." and "just as important......is protection of the new venture against the growing burden of government regulation, reports, and paperwork".

Why is this even more important today than 25 years ago? If we as a nation are to have any chance of avoiding the true financial catastrophe looming do to unprecedented imbalances based on unfunded liabilities then we must do all we can do to promote the economic growth that will provide the tax base to deal with the situation without the burden of additional taxation.

I speculate that the future obligations are too large to expect that taxation alone can fund them as levels will need to be far too high to have a positive net impact. By this I mean that we will cross the point where tax revenues will actually be less due to the negative impact the tax burden will place on the economy.

3. Now, to the current bill on the table (and just signed I see). The "carried interest provision" is inserted evidently for the express purpose of limiting profits made by hedge fund operators and other investment partnerships. Most private real estate investment partnerships utilize structures whereby the sponsor or developer gets a profit share after a target return has been paid to investors. This happens because the sponsor takes on the burden of guaranteeing  the debt in a project and taking on inordinate risk as a result, and because of the fact that the sponsor is the party utilizing their expertise  to create value. The carried interest provision as it is written will increase operating taxes on the sponsors interest by 21% and more importantly, on the profit or capital gain by up to 150%. If this is not bad enough, it will also disallow the sponsor to claim any losses on the carried interest. This fact is important because the underlying assumption the bill is trying to establish is that the carried interest is compensation income and shouldn't be treated like investment income. How many workers do you know that guarantee the debt of their employers for the right to receive a paycheck? Below is a more detailed discussion of the impact from a recent webinar I participated in from ICSC. A copy of the complete presentation along with speaker bios can be found at http://www.icsc.org/

This provision of the new bill will only discourage the formation of capital in commercial real estate, add to the devaluation problems already occuring, and ultimately add to the larger problems of fiscal imbalances in our country while doing nothing productive to safeguard the financial system.