Private-Equity Billionaires and Lower Taxes

In Wall Street's pecking order the partners in private-equity firms are the true aristocrats. With their English tailored suits, country estates and oriental rugs, they have a taste for the trappings of gentry (even their secretaries, it seems, have English accents). Global in reach, able to marshal billions to buy big companies, they float above the grasping traders and get-rich-quick hedge-fund operators. Private-equity partners are not just in it for the money (though the successful ones make tons of it), but for the power to reshape whole industries. Unlike corporate CEOs, who are shackled by the short-term focus of shareholders, private-equity managers can swoop in and transform a troubled industry to create efficiency and growth. Private-equity managers see themselves as the new industrial statesmen, throwbacks to the age of J. P. Morgan a century ago, when an unregulated Wall Street was in many ways more powerful than Washington.

There is a catch to all this public-spirited, high-policy grandeur, however. The very rich in America pay taxes at a lower rate than most working people, and, due to a wrinkle in the tax code, private-equity partners enjoy some of the lowest tax rates of all. At a Hillary Clinton fund-raiser in New York last month, Warren Buffett, no stranger to wealth, told an audience filled with bankers and real-estate developers the system was, in effect, rigged. "This is what Congress in its wisdom did: the 400 of us [here] pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies, for that matter." Buffett (who is a director of NEWSWEEK's parent, The Washington Post Company) offered a million dollars to any fellow magnate who could prove he had higher tax rates than his secretary.

Buffett's pointed words may fuel a movement now laboring to pick up some steam in Congress. Lawmakers are considering various proposals to close federal loopholes, particularly for private-equity partnerships, which pay at the capital-gains rate—15 percent—rather than the 35 percent charged on ordinary income. Wall Street is scrambling to head off this assault on privilege as an attack on the virtues of free enterprise. At a time when the gap is growing between the rich and the poor—and the superrich and the merely rich—the lobbying battle will offer an important debate on tax fairness, as well as a fascinating clash of cultures. Most U.S. senators are not exactly humble, but they can be intimidated by Wall Street Masters of the Universe like Henry Kravis, who just filed to take public his multibillion-dollar firm, KKR. The clout of private-equity firms has grown to hard-to-imagine heights: Chrysler was just bought by Cerberus, a hitherto-obscure private-equity firm.

The current poster boy—or target—of the private-equity world is Steve Schwarzman, recently dubbed by Fortune Magazine as the "New King of Wall Street." Though usually smiling, Schwarzman is not known for his patience. He was recently caricatured by The Wall Street Journal for angrily complaining about the squeak of a waiter's shoe. Schwarzman controls about $88 billion as the head of the Blackstone Group. He is resented by some Wall Streeters for flaunting his wealth and then cashing in with a recent IPO, thereby drawing unwanted attention to private equity's low tax rates. For his 60th-birthday party, his wife, Christine, arranged to have a cavernous hall in the Seventh Regiment Armory decorated as a replica of their 35-room (13-bathroom) apartment on Park Avenue, down to the grandfather clock and the old masters on the walls. (Rod Stewart performed; Patti LaBelle sang "Happy Birthday," backed by the Abyssinian Baptist Church choir.) Schwarzman, whose apartment once belonged to John D. Rockefeller Jr., has at least once expressed some interest in becoming a Wise Man, in the tradition of Wall Streeters who went to Washington to perform public service during and after World War II. He told The New York Times three years ago that he saw Averell Harriman, a financier who became an envoy to Russia and adviser to Democratic presidents, as a kind of role model. When Schwarzman was a brash young Yale student in 1969, he wrote Harriman, asking for an audience (the two had been in the same secret society, Skull and Bones; Schwarzman was a class behind George W. Bush). Over lunch with the elder statesman, Schwarzman noted the white-jacketed waiter and admired the bust of Robert F. Kennedy on the mantel and the Monets on the wall and wondered, as he put it to the Times, "Wouldn't it be wonderful if I could have some elements of this in my life when I grow up?"

Schwarzman has become a patron of the arts and sits on the boards of numerous cultural and philanthropic organizations. He is the president of the Kennedy Center in Washington. But unlike those Wise Men, or present-day figures like former Clinton Treasury secretary Robert Rubin, he has never held a public job. Aside from cohosting a birthday party for Congressman Patrick Kennedy at the New York Yacht Club, he is not much of a Washington insider. He may have to spend some more time in Washington, however, because of the likes of Chuck Grassley.

As a senator from Iowa for the past 25 years, Grassley, a Republican, likes to keep close track of the taxpayers' money. A farm-country conservative, he tries to ferret out wasteful defense spending and other federal boondoggles. The plain-spoken, slightly ornery Grassley is such a tightwad himself that he keeps his air conditioning at 80 degrees. For many years, when he reached the top ramp of the Senate garage, he turned off his car and coasted down to his parking space, to save gas. At about the time Schwarzman took Blackstone public last month—making Schwarzman's shares worth about $8 billion—Grassley introduced a bill to raise the tax rates, from 15 to 35 percent, on certain private-equity partnerships, like Blackstone, that go public. It was nothing personal, Grassley insists; just a question of fairness. (And indeed, because the law would be slowly phased in on Blackstone, Schwarzman himself could escape most of the higher taxes.) But the legislation, known as the Blackstone Bill, sent a shiver through Wall Street.

Ever since the rise of the populists in the late 1800s, lawmakers have periodically threatened to soak the rich. Usually, these movements fizzle, partly because Americans hope that they, too, might one day become rich, and partly because there are good economic arguments against discouraging investment and the accumulation of wealth. But from time to time comes a tipping point. In the early 20th century, the Progressive Movement managed to impose a federal income tax, partly in reaction to the vast fortunes made during the late-19th-century Gilded Age.

There are rumblings on Capitol Hill and in the presidential race that the body politic is gearing up to tax the superrich. In the House, Rep. Sander Levin (Michigan Democrat) has introduced a bill to change the tax treatment of what is known as carried interest. Typically, private-equity firms raise a large pot of money to buy publicly owned companies, take them private, then sell them again—and pocket 20 percent of the profits. That 20 percent slice, known in the trade as carried interest, is taxed at 15 percent—the capital-gains rate paid by investors—not at the more than 35 percent rate levied on high earners. Reformers argue that since the private-equity partnerships do not invest much of their own money, and are really being paid to manage other people's money, they should be taxed at regular income rates.

To listen to the lobbyists hired by the private-equity firms, such a tax hike would, at a minimum, directly hurt regular working people. That's in part because giant public-employee pension funds invest with the private-equity firms; so, the argument goes, raising taxes on billionaires like Schwarzman could ultimately hurt retired firefighters and cops. It may be true that private-equity firms would pass along at least some of their tax increases as higher fees. But pension-fund managers contacted by NEWSWEEK were skeptical that their returns would be affected in any substantial way.

More generally, the lobbyists argue that any tax increase on people like Schwarzman, who stimulate wealth creation, is a bad idea. Getting rid of the carried-interest loophole across the board (on real estate and oil and gas, as well as private equity) would "disrupt thousands of partnerships around the country that provide the economic engine. It punishes innovators," says Wayne Berman, a well-connected Washington lobbyist representing Blackstone and the Carlyle Group, another major private-equity firm.

A bill that simply cuts out the carried-interest loophole is probably a loser on Capitol Hill. President Bush has signaled he would veto such legislation, and well-paid lobbyists could sink it long before it reached the president's desk. Democrats as well as Republicans depend heavily on Wall Street heavy hitters for campaign donations. Tinkering with the tax code just invites clever lawyers to find new loopholes. The best bet for real reform would come from across-the-board legislation that increases taxes on the very wealthy in order to pay for tax relief for the poor and middle classes.

In the end, it will probably take a push from the White House. All the Republican presidential candidates are against closing the carried-interest loophole as a tax increase. On the Democratic side, John Edwards, Barack Obama and Hillary Clinton last week all came out in favor of closing the carried-interest loophole. Senator Clinton, whose advisers include some big private-equity players, spoke about the need to reform the tax system "to get back to having those with the most contribute to this country." Schwarzman, who declined to be interviewed for this article, would no doubt agree that the statesmen of Wall Street should do more for their country. Just don't touch their tax breaks.