Promising fiscal responsibility, the Democrats in Congress passed a pay-go budget rule requiring offsets for proposed spending increases. But because the Dems have so many new spending demands — more health care for kids, more farm subsidies — there is a desperate search for added revenue and a rush to impose new taxes without adequate thought regarding the possible damaging consequences.

Enter the private equity industry. As Congress has increased regulations on public markets, private equity has boomed as an efficient tool to restructure businesses while channeling the savings of pension funds, foundations, and university endowments into productive, high-return investments.

But where some people might see financial innovation and growth, Congress sees a pot of money to raid with higher taxes. I’m not a private equity (PE) expert, but here is a big picture perspective on the economics of PE taxation:

Private equity firms are partnerships. Earnings of partnerships are not taxed at the entity level but flow through to individual owners of the firm.

General partners of PE funds channel some of their own savings, but mainly savings of outside limited partners, into investments in businesses. As a return, general partners receive a management fee (taxed at ordinary income tax rates) and a share of future profits of the assets owned by the fund. The latter return, called carried interest, is typically 20 percent of fund profits.

The carried interest comes mainly from capital gains realized on the sale of businesses owned by the fund. So let’s say a fund called the Edwards Group bought a poorly managed company called Reynolds Motors for $100 million, then turned the company around with better management, and sold it a few years later for $200 million.

The $100 million of capital gain on the sale would flow through to both the limited partners and the general partner, who receives a 20 percent share. The return to both types of partners is taxed at the 15 percent federal capital gains rate, because indeed the underlying transaction generated a capital gain.

The carried interest return is contingent upon the success of the fund. An advantage of providing a capital gain return to fund mangers is to align their interests with the interests of the outside investors. If managers do a good job in growing the value of businesses owned, then both limited and general partners win (and so does the economy).

However, some members of Congress are arguing that the return to general partners should be treated as labor income or “compensation for services,” not capital income, and subject to ordinary tax rates, which top out at 35 percent.

You can read what the Congressional Budget Office says about the issue here. CBO has a concise summary, but their discussion reveals an underlying Haig-Simons view of the world. In this view, which favors a very broad-based income tax, capital gains would be heavily taxed and the deferral of capital gains disallowed. One of the problems with determining the “proper” tax treatment in the PE case, and with capital gains in general, is that our tax system is a hybrid between a Haig-Simons income tax and consumption-based taxation.

Many economists want to move the current tax system toward more efficient consumption-based taxation, under which there would be no capital gains tax. Capital gains from share appreciation represents double-taxation. Business valuations represent the present value of expected future returns. Thus when an individual or investment fund sells shares in a corporation and realizes a gain, that gain represents profits that will be taxed in the future under the corporate income tax.

If we moved the tax system toward a consumption base, we would drop the capital gains rate to zero. That sounds radical, but even a number of countries with ostensibly income tax systems, including Netherlands, New Zealand, and Taiwan, have capital gains tax rates of zero.

Suppose a small business person invests $100,000 and opens a restaurant, and then uses her “sweat-equity” to grow the venture into a business worth $500,000. She sells the business, nets $400,000 in capital gain, and pays the 15 percent capital gains tax. She put up the risk capital, but it seems that it was mainly her “labor” (brains and hard work) that created the gain. Part of her “compensation for services” for years of work is a capital gain.

That is similar to the PE story. Managing partners put sweat-equity into building the value of the businesses that the fund owns. If that sweat-equity results in boosting the value of the assets, it would seem that that gain should be taxed at the capital gains rate.

The CBO notes on page 8: “In the paradigmatic private equity case, most profits arise from long-term capital gains, so the profit allocated to the general partner’s carried interest will be taxed as long-term capital gains.”

However, partnership taxation is hugely complicated, so perhaps I’m missing something. Proponents of higher taxes argue that many of the people getting carried interest are just managers who don’t put up their own capital. It is interesting that general partners put up perhaps 5 percent of the capital of funds, but they receive 20 percent of the returns.

Nonetheless, the underlying economic events generating the carried interest returns are capital gains on the sales of businesses, and under a reformed tax system would not be taxed at all. Note that capital gains are not included in gross domestic product or the subcomponent called “national income.”

However, it is also true that the value-added, or compensation, of people in the PE industry is included in measures of GDP and national income. That value-added should be taxed once, but only once. In other industries, worker wages are taxed and employers deduct wages paid against their business taxes to avoid double-taxation. If proposals to increase taxes on PE managers move ahead, it seems appropriate to provide offsetting deductions somewhere else in the system.

Note that the current battle over the tax treatment of private equity firms has broader implications because the partnership form is used in many other industries, such as real estate and venture capital. Will Congress change the tax treatment of partnerships for all industries or just carve out private equity for special punitive treatment?

The hullabaloo over the PE issue does suggest some underlying unease about the lower rate of the capital gains tax in general. But any of us wage slaves could quit our jobs and try making our living off of stock trading from our home computer. If one is successful, one could be earning 100 percent of our income in the form of capital gains and paying just 15 percent tax. Is that fair? I think so. For one thing, you need to consider every level of taxation, including corporate-level taxation, to determine what is fair and efficient. But clearly more general education on capital gains is in order.

A final note: The economy has grown strongly in recent years, the unemployment rate is remarkably low, and the venture capital and private equity industries are pumping billions of dollars into new and restructured businesses. Interestingly, the basic structure of the 2 percent management fee and 20 percent carried interest has been used in the VC industry since its modern birth in the late 1970s. The financial structure of the industry has worked spectacularly well, with a very long list of VC success stories—Genentech, Cisco, Intel, Apple, and thousands of others.

With global economic competition increasing, I don’t think we want Congress to be throwing a wrench into the works of the nation’s hugely successful innovation financing system. Rather than hiking taxes on PE, Congress ought to move to a more neutral, lower-rate tax system that treats all industries equally.