The IRS allows firms to take a tax deduction on the interest expense of corporate debt - and in the private equity world, taking on debt in the purchase of businesses is SOP. Author and Bloomberg Columnist William Cohan takes it from there:
Since corporate debt is the mother's milk of a leveraged buyout, there would be no private-equity/LBO industry without this huge tax benefit. Indeed, anyone who has used an Excel spreadsheet to model a leveraged-buyout -- you know who you are! -- knows that the magic of the entire industry depends almost solely on the interest-expense provision in the tax code. By loading up a company with debt and then deducting the resulting interest expense, tax payments are generally wiped out, allowing the remaining "free cash flow" to be used to pay down the debt taken on to buy the company in the first place. Given that tax revenue is necessary for the government to function, this means the rest of us provide a subsidy that allows the private-equity firms to thrive.
The problem, Cohan explains, is that the people working at these firms - people like Romney - get the additional benefit of paying tax on their profits at a 15 percent rate rather than 35 percent. Good luck trying to explain that away during a debate.
*Another dark view of the industry from the New Yorker's James Surowiecki:
Private-equity firms are increasingly able to profit even if the companies they run go under--an outcome made much likelier by all the extra borrowing--and many companies have been getting picked clean. In 2004, for instance, Wasserstein & Company bought the thriving mail-order fruit retailer Harry and David. The following year, Wasserstein and other investors took out more than a hundred million in dividends, paid for with borrowed money--covering their original investment plus a twenty-three per cent profit--and charged Harry and David millions in "management fees." Last year, Harry and David defaulted on its debt and dumped its pension obligations. In other words, Wasserstein failed to improve the company's performance, failed to meet its obligations to creditors, screwed its workers, and still made a profit. That's not exactly how capitalism is supposed to work.