In August 14, 2011, in an unusual move that made some of America’s richest and most powerful people wince, Berkshire Hathaway’s Chairman and CEO Warren Buffett called on Congress and the super-rich in America to support a reform in the tax code to treat capital gains as ordinary income.

This is by no means a novel idea, but the weight of Buffett’s opinion piece in the New York Times spurred immediate discussion. It is not only a question of how much impact such a policy move will have on resolving the budget crisis, but also who will rise to the challenge.

Capital gain or loss refers to the positive or negative returns realized on buying and selling assets, ranging from houses and cars to stocks and bonds. Capital gains are taxed depending on a taxpayer’s ordinary income tax bracket and the time period of gains.

For a long-term investor who generates his/her income from investments on the financial market, all of that earning is taxed under the current rate of 15%. This is the case for most hedge fund and private equity fund managers. They invest money garnered from various institutional investors and wealthy individuals, and make a living by keeping a portion of the returns, called carried interest, in addition to charging management fees.

It is exactly these alternative asset managers that the “Buffett Rule” targets. On September 12, the White House published a proposal on how to treat the carry. “Today, fund managers pay the capital gains rate of 15% but, under Obama’s proposal, it would be increased to an ordinary income rate that, for most fund managers, would be around 35%. This would apply to those managing funds in asset classes like private equity, hedge fund, venture capital, real estate, timber and oil and gas.” By taxing carried interest as ordinary income, the Congressional Budget Office projects an additional $21 billion in revenue over the next decade, $18 billion of which will go toward paying for the recently proposed American Jobs Act.

If such a reform has the potential of bridging the federal budget gap, why has there been such strong push back? The main argument from private equity managers is that taxing carry as income will disincentivize them to grow or acquire portfolio companies, therefore hurting job creation and innovation.

In response to Obama’s proposal, Steve Judge, president of the Private Equity Growth Capital Council said, “Proposals to raise taxes on carried interest have consistently been rejected for over four years because raising taxes on investments would only sideline employers and investors and create further uncertainty in an already struggling economy.”A 2010 study by the Council estimates that higher taxes on carry will decrease investments by $7 billion to $27 billion annually.

Political ideology also plays a major role in promoting the fight against changing the treatment of carried interest. “We do not have time to waste on political games and pushing big tax increases that will only make our economy weaker for all Americans,” said Sen. Patrick J. Toomey, a member of the deficit reduction special committee, in response to Obama’s proposal. Five republican presidential candidates have already declared their pledge to eliminate capital gains tax.

However, frontrunner Mitt Romney, cofounder of private equity firm Bain Capital, has not made reducing capital gains tax a part of his campaign platform. Even support from the Democrats has been mixed.  Timothy M. Kaine, former Democratic National Committee Chairman and former Virginia governor, has publicly opposed capital gains tax hikes.

Even if both sides can agree to heed the call of Buffett, the logistics of carrying out such a reform can be challenging. The IRS will first need to define middle-income family’s earnings and tax rate, which leads to complicated calculations for higher earners when taking itemized and state deductions into consideration. It will also require a more inclusive definition of income. “Writing a Buffett rule into law would require defining income and setting a minimum rate for it,” said Roberton Williams of the Tax Policy Center, “Every time you set up something like this, you’re opening the door for the tax lawyers to come in and get around the attempt to raise revenues.”

Carried interest taxation is, and likely will continue to be, a thorny issue. Warren Buffett’s public stance may have been a nice surprise to some Americans concerned about the deficit, but it has also renewed debate. For readers interested in alternative asset management or Dartmouth seniors heading to the industry after graduation, tax hikes on carried interest will not be the end of private equity or hedge fund investing. But in a fragile economy, it may be wise to keep in mind the worst case scenarios spelled out by fund managers.

On July 21, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. Touted by the left as a remedy to Wall Street’s excess and opacity, the bill severely increases regulations on the financial industry. But is it effective? In an address to the media, Obama claimed:”The American people will never again be asked to foot the bill for Wall Street’s mistakes. From now on, every American will be empowered with clear and concise information you need to make financial decisions that are best for you.”

It has been almost a year since the act’s passage and American consumers have yet to see substantial benefits from the reform. On the flip side, however, the banking and financial industry have been hit hard by Dodd-Frank, with the numerous regulations increasing costs and cutting into profits. Clearly, there is value to transparency on Wall Street, but the cost of reform begs the question of whether Dodd-Frank is truly a worthwhile endeavor.

Within its 2,300 pages, Dodd Frank has some merit, such as calling for greater accountability in rating agencies. But Alan Greenspan, former Fed Chairman, claims that the entire reform is flawed in theory. Citing Adam Smith’s “invisible hand,” Greenspan asserts that these massive regulations will inevitably create market distortions that could have devastating effects on the economy. Believing regulators are being given too much artificial authority, Greenspan stated that, ”regulators are being entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are importantly altered. No one has such skills.”

Greenspan’s theoretical objections to Dodd-Frank have already begun to materialize as the legislation has had unintended consequences. For instance, regulations preventing banks from placing certain charges on consumers—such as capping interchange fees at 7 cents a transaction—have caused banks to search for alternative means to charge clients. These alternate methods have included charging annual fees on debit cards and increasing ATM fees. Thus, just as Greenspan warned, regulations that distort the market can yield unpredictable consequences. In this particular example, consumers may actually be worse off, as banks are now levying more fees on consumers to account for their losses due to Dodd- Frank.

In addition to creating market distortions, Dodd-Frank fails to achieve its main purpose. Created in reaction to the 2008 Financial Crisis, the reform’s primary purpose is to prevent another potential meltdown. Yet Dodd-Frank’s insistence on consumer protection may actually be fueling another credit bubble—the underlying cause of the 2008 disaster. Regulation over the past decade has consistently resulted in the expansion of mortgage credit, which in turn created the housing bubble. While Wall Street was indeed partly at fault for the crisis, due to its proliferation of collateralized debt obligations and faulty credit ratings, government sponsored mortgage lending was the leading driver of the collapse. Supporting the subprime market through Fannie Mae and Freddie Mac, the government enabled the accumulation of high-risk loans that ultimately precipitated the meltdown. But instead of changing the government’s approach to mortgages, Dodd-Frank still maintains “government-imposed lending quotas” on banks, leading America down the same path that led to the financial crisis.

Rather than focusing on complex regulations, a simpler approach would be to address the dangers of easy credit. As demonstrated by Greenspan, the more complex economic regulations become, the more unpredictable the market becomes. While Dodd-Frank clearly attempts to aid the average American consumer, it may be doing more harm than good, while simultaneously ignoring the larger issue of credit.

The House has already voted to repeal Dodd-Frank, and GOP leaders in the Senate have introduced a repeal bill as well. However, this repeal bill has almost no chance of getting past a Democrat controlled Senate.

Regardless of what happens to the status of Dodd-Frank, it is important that policymakers know that regulation is not always the answer. In continuing to stress lending-quotas, Dodd-Frank is perpetuating a dangerous precedent that will ultimately need to be addressed.

Pier Carlo Trucco is the current managing director, co-founder and main shareholder of Keydos, a management-consulting firm based in Milan and Rome, Italy. He holds an MBA from UCLA and made his career as a partner in large multinational consulting firms including Ernst & Young and Deloitte Consulting. He advises large Italian and international corporations in the fields of strategic planning and organization. He has published a large number of articles in business journals and the general press. The Dartmouth Business Journal had the opportunity to ask Pier Carlo Trucco about his views on the field of management consulting, recent events in Italian industry and finance, and the connection between the Italian economy and the US economy in this time of financial crisis. 

Dartmouth Business Journal (DBJ): What led you to choose a career in management consulting?

Pier Carlo Trucco (PCT): For a young MBA, that was probably the most sought-after profession in Italy and Western Europe. I’m not sure it still is…

DBJ: Which do you feel was most valuable to the success of your career: your college and post-college studies or the experience you picked up on the job? What does an average day of work at your consulting firm entail?

PCT: Frankly, in my country, a U.S. degree is quite appreciated in the job market. That means you get a good start, which is essential. But, overall, I should say that what you learn on the field is way more valuable. Each day, we focus on results and on project deadlines. This may, and usually does, result in long workdays, including weekends. I have seen American colleagues getting home at 5 p.m. on a regular basis, though. This may have many explanations, including a more efficient way of organizing work on that side of the Atlantic.

DBJ: What, in your opinion is the most difficult or stressful part of the management consulting profession? What do you find most rewarding about it?

PCT: What is difficult and stressing is also the most rewarding: client satisfaction is the key. This is a very difficult and moving target, especially since competitors do exist.

DBJ: Has your consulting firm been involved with the airline industry in Italy? What, in your opinion, led to Alitalia’s decline?

PCT: I have worked for the airline industry and for Alitalia. The projects I’ve been involved in focused the matter of alliances and strategic development of routes.

Alitalia’s decline has come a long way. We can date it back some 20 years. I know this may seem like an exaggeration, but we must keep in mind that Alitalia, like many European flag-carriers, used to be a subsidized, state-owned company. Failure to cope with the changing market was its main problem. As the European Union acted against national monopolies, starting in the early nineties, two types of competitors emerged. The first type would be a European company with a similar cost structure but possessing a stronger hold on the market, granting it a lead in the business traveler segment. Examples are British Airways or Lufthansa. The second type of competitor was the emerging low-cost airline, such as Ryan Air or EasyJet. These names may mean little to an American, as they are point-to-point carriers dedicated to serving the European market. Think of Southwest, to give you an idea. While the dominant flag carriers weakened Alitalia’s competitive position with the European business passengers and on the intercontinental routes, the low-cost airlines hit the economy class passenger market. Alitalia found itself with an unchanged cost structure but with declining revenues. As we know, this is the path to bankruptcy, unless the government rescues you. However, the EU rules now prevent governments from rescuing airlines. So you can guess what happened then.

DBJ: So, it went bankrupt?

PCT: It underwent a procedure similar to that involved in Chapter 11 Bankruptcy in the United States. Then, an industrial group came and bought the majority of assets.

The US press has covered this rescue you refer to of Alitalia Airlines by an Italian industry group and an impending investment in Alitalia by Air France. How is the new Alitalia planning to stay afloat?
There are controversial opinions on the price paid for the so-called rescue. Most analysts believe that the price paid was too low. Furthermore, the government has suspended the anti-trust regulation for a period of six months in order to favor the new company’s take-off. European competitors are not exactly happy and have appealed to the EU. To answer your question, I would say that the new Alitalia heavily counts on preferential treatment and the ability to take its first steps in a protected environment.

DBJ: What, if anything, is fundamentally different in the new Alitalia that will make it successful?

PCT: The financial ratios of the new company are definitely better than in the previous version. Now, there appear to be decent profitability ratios, and the fleet is adequate with respect to the company’s operations. The routes will be focused on one main hub (Rome) while previously there was an ill-optimized strategy based on two hubs (Milan and Rome), which constituted too many for a medium-sized airline. Furthermore, the alliance with Air France will help to offer Alitalia passengers a truly global network with lots of destinations and frequencies.

DBJ: Has your consulting firm been involved with the Italian automotive industry? What, in your opinion, led to Fiat Group’s recent successes in that market?

PCT: Fiat has regained market share in the past few years, and profitability has come back. This has been the result of a more focused strategy, concentrating efforts on the automobile, as opposed to other traditional Fiat interests such as aerospace and industrial automation, as well as a renewed focus on domestic markets. I wouldn’t call this a long-lasting recovery though. In my opinion, Fiat’s thrust was on the downward slope even before the present global crisis. However, it is difficult to support this opinion with conclusive evidence since the European market is currently down 40% and Fiat’s stock is performing accordingly.

DBJ: The US press has covered the agreement between American automaker Chrysler Motors and Italian automaker Fiat S.p.A. to form a nonbinding, albeit strong connection between the two companies. What is the role of consulting firms in laying out the stipulations for this type of agreement?

PCT: I can only guess, having not been involved directly. I suppose management consulting firms may have advised on strategy, especially helping define the relative roles of the two partners in the future market. Some organization and project management consulting may follow. This should take one or more consulting firms that have strong expertise in the automotive industry.

DBJ: How has the global economic crisis we are currently experiencing affected your field of work? Do you think the crisis has hit Italy as hard as it has hit the United States?

PCT: I will begin by answering the second question. Analysts say that Italy may perform better than other countries in the present global crisis due to its peculiar business environment. We are stronger in the so-called real economy than in financial institutions. Although this used to be an issue, it no longer is. Our industrial structure is composed of a huge number of small and medium enterprises. Many observers make the point that this will dilute the risk of corporate failures, if adequate liquidity is provided to the system.
With regard to the management consulting industry, in theory we should be well-off, the same way as physicians prosper when you have some epidemic. In fact, we may meet the profound need for reorganization of companies affected by the crisis. The unanswered question is: will the patient have money left to pay for the doctor?

DBJ: How is President Obama perceived by the Italian business world? President Obama and his administration have announced plans to unfreeze the credit market and heighten financial regulations. What kind of effect do you think Obama’s new policies will have on Italian industry, if any?

PCT: Given the leading role of the American economy, any event developing in the US will clearly affect Europe. Nevertheless, I believe that the crisis will take different paths on the two sides of the Atlantic (and on the two sides of the British Channel). Continental Europe will suffer more from the recession than from “toxic finance”. The point of junction will undoubtedly be the liquidity crunch. However, I believe that from now on Obama’s actions will mainly be an American matter, i.e. they will have limited impact on Europe.

DBJ: What is the one piece of advice you would give to a college student interested in pursuing a career in management consulting?

PCT: It takes a real interest in the client to be a management consultant. So, take this test: if your dream is to spend your life in your beautiful office, don’t go for this job. Pursue management consulting only if your dream is to spend your life in constant contact with your client and on location in your client’s office.