Is Tax Uncertainty Hurting Private Equity Dealmaking?

Is tax uncertainty hurting private equity deal making?

In about a month, the new year – 2013 – will ring in a number of new or renewed tax increases.  In either a direct or indirect manner, the rate increases will affect virtually all individuals and businesses.

In a direct manner, individuals with capital gains or other investment type income will be shortchanged the most.  This is largely due to, among other things:

• The rate increases imposed by repealing the tax burden reduction initially authorized by President Bush during his first term in office; and
• Second, the newly imposed taxes from the congressional overhaul of health care, known as the Affordable Care Act or Obamacare.

Should the Bush tax burden reductions expire, the total tax increase is anticipated at about $200 billion, with about 90 percent of that falling on individuals with capital gains, dividends, and other investment income.

In addition to the potential rate increases on capital gains, dividends, and other investment type income should the Bush rates sunset, the Affordable Care Act imposes an additional 3.8 percent tax on capital gains, dividends, annuities, royalties, net rents, interest, and passive income in partnerships and S-corporations.

Individuals and businesses who feel they are unaffected by the upcoming tax changes are likely to be sorely mistaken.  Because tax policy changes behavior, the changes will, depending upon the industry and other economic conditions, induce companies to either raise prices to cover forgone profit, shift employment to lower cost areas, or restructure operating procedures to cover the monetary effects of materialized tax increases.

With this background in mind, one might ask: is there really evidence to back up the behavioral effects of tax policy on private equity employment?   Well, yes, probably.

To investigate the relationship between private equity employment and tax policy changes, a simple multivariate regression correlated the effect of tax policy changes on estimated private equity employment while controlling for the overall state of the national economy.  The graphical results are given in the following figure, repeated from above.

The red portions of the graph represent year of overall tax increases, whereas green portions represent years of overall tax decreases.  As is shown, the red lines of 1993 and 2010 are followed by decreased private equity growth, while the green lines are either followed by an increase or, in the one instance when there is a decrease, accounted for by controlling for the entire economy’s employment conditions.  Overall, after controlling for the national economy, the impending tax increases of 2013 may decrease private equity employment by 0 to up to 3 percent, with the anticipated employment effect of -2 percent.

Economists and private equity professionals have a number of reasons for the observed negative relationship between tax rate increases and negative private equity employment (or tax rate decreases and positive private equity employment), including lowering the value of potential deals and decreasing overall expectations of future economic activity.

In all, it’s not a myth that tax policy affects professionals in different ways.  There’s real evidence that tax policy does shift behavior; and private equity is certain to be one of those industries adversely affected by potential tax increases.