The U.S. economy is currently experiencing a long run of impressive growth, driven in part by a dynamic and vibrant private equity sector that is geared to promoting entrepreneurship. But recognizing exactly how private equity influences economic activity is essential to understanding several current political debates.

Prior to the advent of the modern private equity sector, there was an unmet need for long-term patient capital that could be deployed to co-opt growth opportunities or to compel change in companies or industries. Existing financial institutions did not have the risk appetite, requisite knowledge, or capital availability to undertake long-term equity investing. Additionally, the United States has long had a complex regulatory regime for financial institutions that effectively divorced “banking” from “commerce.” Prior to 1980, regulations limiting pension fund investments also limited the formation of a modern private equity sector.

But after 1980, the combination of pension reform, financial deregulation, and shrewd entrepreneurship led to private equity's rapid expansion, with firms now managing over $2 trillion in leveraged capital (up from about $5 billion in 1980). The boom in private equity has in turn played a critical role in the growth of U.S. productivity and corporate profits over the last quarter century, which has spurred the creation of jobs and material wealth. In brief, private equity’s most important economic effects include the following:

Improved corporate governance. A wide body of research, led by Harvard Business School economist Michael Jensen, has discerned the presence of “agency problems” inside companies that can destroy corporate value. The preeminent agency issue is the conflict of interest between the often passive shareholder owners of a firm (the “principals”) and their hired active management team (who act as “agents” for the principals). The interests between principals and agents often diverge: for instance, principals bear the costs of agents’ making unnecessary acquisitions that dilute firm value but confer more power and prestige upon managers.

The private equity governance model mitigates agency issues through a combination of measures, starting with higher levels of debt in the firm’s capital structure. This makes managers focus on paying down the debt, thereby discouraging them from wasteful spending. Private equity firms also tend to have performance incentive plans linked to profit growth, and up to 20 times the level of performance-based compensation as publicly traded firms.

The boom in private equity has played a critical role in the growth of U.S. productivity and corporate profits over the last quarter century, spurring the creation of jobs and material wealth.

But perhaps most important, private equity control is tantamount to governance by active investors. Public company boards of directors—who are often celebrities, credentialed figureheads, or “rubberstamp” confederates of senior management—represent what can amount to tens of thousands of dispersed owners, few of whom have any incentive to closely monitor the firm. By contrast, private equity-backed boards are smaller, more decisive, more aggressive in firm oversight, and comprised of experts who can truly add value.

The results-oriented focus imposed by a leveraged capital structure, pay-for-performance compensation that aligns owner and manager interests, and superior monitoring and strategic oversight by active investors have all contributed to strong growth in corporate productivity and profits.

Superior promotion of entrepreneurship. Private equity has played a crucial role in the restructuring of various industries. In some cases, it has rejuvenated solid companies victimized by moribund management or poor strategic decisions. In others, it has provided strong managers with the capital and ancillary resources they need to expand.

More efficient capital allocation. Private equity has greatly increased the liquidity and flexibility of the corporate buyout sector. Tens of thousands of private firms now have an efficient mechanism for gauging the value of new initiatives in strategy, technology, operations, and governance. Through the capitalization and liquefaction of small and mid-sized businesses, especially, private equity has allowed for an explosion of activity in fragmented industry consolidation, business reconfiguration, and intergenerational wealth transfer. In each case, corporate assets are moved to owners and managers who are better able to maximize firm value. This aspect of private equity makes the entire U.S. economy more flexible and adaptable; it is, indeed, a major reason for America’s superior growth and job creation over the past quarter century.

Nevertheless, private equity has recently fallen into Washington’s regulatory crosshairs. Federal Trade Commissioner William Kovacic has argued that acquisitions involving multiple private equity firms (so-called “club deals”) deserve antitrust scrutiny. Meanwhile, bills have been introduced in both the House and the Senate to increase the rate of capital gains tax paid by private equity managers from 15 percent to 35 percent.

Imprudent regulation of private equity would be deleterious to economic growth. Private equity syndicate deals have mitigated business risk and advanced the scale of possible transactions, thereby aiding the market process. Capitalism often involves the cooperation of “competitors” whose interests coincide; this merely reflects the trial-and-error process of financial deal-making. In fact, the lack of prior regulation is a key reason why the private equity sector is so vibrant today.

The increased taxation of managers’ earnings on their carried interest would similarly stifle private equity investment—and, at the margin, it would also damage returns to investors such as pension funds. It would overturn the decades-old precedent that profits earned from a risky business venture are taxed more favorably than ordinary income. This tax differential helps induce the capital formation that drives economic growth.

By raising taxes on private equity, Congress would be raising taxes on the world’s foremost institutional vehicle for promoting entrepreneurship. The modern private equity sector is enormously important to growth and trade, and any repression of it, even marginally, would hinder our future economic prospects.

John L. Chapman is an NRI fellow in economics at the American Enterprise Institute. This is the second in a two-part series, which began yesterday. Part one can be found here.