Just 255 miles separate the U.S. Capitol in Washington, D.C. from Wall Street. But judging from the latest tax debate, the real distance is much greater. Perhaps Congress is from Mars and Bankers are from Venus.

Last week, the Chairman and Ranking Member of the Senate Finance Committee, Senators Baucus (D-Montana) and Grassley (R-Iowa), introduced legislation and issued a press release declaring their intent to close the door on a tax strategy used by a couple of Wall Street private equity firms. These firms, Fortress Investment Group, which went public last February, and Blackstone Group, scheduled to go public today, would be denied the opportunity to remain a partnership for tax purposes and avoid corporate level tax if the Baucus-Grassley proposal becomes law.

The issue that has seized the attention of Congress (and now Wall Street) appears at first glance to be small: How should you tax a private equity company after it goes public? The Baucus-Grassley proposal wouldn’t prevent these companies from being publicly traded but instead would ensure a change in their tax status. In place of the single-level partnership tax treatment that they now enjoy, they would be subject to a double tax structure that adds on the corporate tax code to their cost of doing business; the same corporate tax code that disadvantages our multinational corporations in the global marketplace and hurts our workers here at home.

The tax change will, by discouraging private equity firms and hedge funds from going public, frustrate advocates of greater transparency among these firms.

The specific question is whether these firms can continue to receive the same tax treatment that “passive” publicly traded entities such as oil and gas partnerships and real estate investment trusts get—such entities are exempt from the 35 percent corporate tax paid by other publicly traded companies—or must pay the corporate tax like almost all other public companies. The proposed change would create a significant tax disadvantage for publicly traded private equity firms, vis-a-vis those that remain privately held.

How will the “Blackstone tax” affect the health and viability of the private equity industry? We don't know the answer yet. But since firms like Blackstone, Carlyle Group, and KKR have thrived for decades without ever needing to go public, it seems unlikely the industry will be crushed or even severely wounded if this tax change occurs. However, there will be losers if the Baucus-Grassley legislation is enacted: ordinary investors like you and me. You, without the millions of dollars required to participate in private equity funds, will lose the opportunity to buy a $30 share in a private equity firm and share in the prosperity currently reserved for those with eight-figure bank accounts. 

The tax change would also, by discouraging private equity firms and hedge funds from going public, frustrate advocates of greater transparency among these firms. Why? Because publicly traded companies are legally required to disclose more information about their business than privately held firms. We know far more about Blackstone and Fortress than we do about any other private equity firm.

This tax proposal reinforces the unintended consequences of the Sarbanes-Oxley legislation. Sarbanes-Oxley’s impact can be viewed as a tax on publicly traded businesses in the form of high compliance costs and litigation risks. In many cases Sarbanes-Oxley legislation has been a “tipping point” and private equity funds have seized the opportunity to take some publicly traded firms private. While private equity firms are providing a critical function in the market by ensuring the maximum value for investors, the super-sized rates of return the funds have enjoyed are not easily available for the ordinary investor.

The Baucus-Grassley proposal, if it becomes law, will have a chilling effect that results in fewer (if any) future private equity IPOs, denying ordinary Americans the opportunity to fully participate in the global marketplace and be buyers of all types of capital.

The thrust of the concern in Washington is meta-equity: equity (fairness) in private equity (capital). Should publicly traded private equity firms pay less tax than publicly traded clothing companies or publicly traded investment banks? At first glance, that certainly seems unfair.

The trouble with this argument is that of the roughly six million companies that have employees, 99 percent are privately held. Sole proprietorships, LLPs, LLCs, S Corps, REITs and RICs are all business structures that avoid paying the corporate income tax. These companies employ roughly half the workforce, produce roughly half the nation’s output and all face just one level of tax. The relatively few publicly traded companies, those that pay the corporate income tax, often compete directly against firms that don’t face this tax. The fundamental tax policy question is not whether Blackstone should pay corporate tax but rather whether any company should pay corporate income tax.

Congress has taken a number of steps over the last few years to reduce the tax on capital. Recognizing that capital can now easily flow around the globe in search of the highest after-tax returns, Congress cut the tax on dividends and capital gains in 2003. That change, which is set to expire in 2010, has resulted in an increase in investment, equity prices and dividend payouts. Policies that burden capital markets would undermine this progress. Sarbanes-Oxley legislation is one example that corporations are struggling with already and that threatens to reduce the opportunities for ordinary investors seeking to be owners of capital. If the Baucus-Grassley proposal becomes law, it will further chip away at the financial marketplace and ultimately the free market. We are applying band-aids to assumed scrapes and bruises in the corporate tax code. Instead, Congress should think about major surgery. Prepping the corporate tax code for amputation is worth considering.

The Honorable Bill Thomas was Chairman of the House Committee on Ways and Means from 2001-2007 and is now a Visiting Fellow at the American Enterprise Institute and Senior Advisor to Buchanan, Ingersoll & Rooney, P.C. Alex M. Brill is a Research Fellow at the American Enterprise Institute and Economic Policy Advisor to Buchanan. He was Chief Economist and Senior Advisor on the House Committee on Ways and Means, where he worked from 2002-2007.

Image credit: O'Halloran/Library of Congress [VIA PINGNEWS]