Hiking Hedge Fund Taxes: No Help to the Deficit

President Barack Obama
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President Barack Obama

Yesterday, President Barack Obama proposed killing a quirk of the tax code that allows managers of hedge funds to pay lower tax rates on a substantial portion of their compensation.

Unfortunately, the tax hike is unlikely to do very much to close the federal government’s budget deficit.

Hedge fund managers typically receive two forms of compensation: a management fee, typically around two percent of a fund’s total assets, and "carried interest," which is typically around 20 percent of the firm's gains above a certain threshold. The management fee is taxed as ordinary income. The carried interest is taxed as a capital gain, meaning managers pay rates as low as 15 percent on that part of their compensation.

For several years now, lawmakers have been threatening to change the tax code so the “carried interest” is treated as ordinary income.

The argument is that this is really just a form of payment for services, and therefore should be treated like almost every other form of income.

Those proposals have usually failed on Capitol Hill, in part because ending the carried interest loophole would not just impact upon hedge fund managers. The partners of investment firms specializing in venture capital, private equity, real estate and natural resources would also be hit.

The White House now seems to be planning to limit the tax hike to hedge fund managers, hoping to limit political opposition to the plan.

Of course, this would also limit the revenue that could be raised through the reform—possibly eliminating any revenue-generating potential altogether.

The White House estimates this narrower increase would raise just $400 million over the next 10 years, according to HedgeFundNet. (I haven’t been able to find the source of this estimate. It seems a bit low.)

According to estimates made last year by the Joint Committee on Taxation, a broader proposal to tax carried-interest of all financial professionals would raise an average of $1.7 billion a year of additional tax revenue over the next 10 years. Even this number is barely a blip in our $1.4 trillion annual budget deficit.

Those revenue estimates may be too high. The typical partnership structure of hedge funds was designed specifically to achieve favorable tax treatment. A change in the tax code would likely result in the hedge funds restructuring themselves to avoid the tax, by moving to off-shore tax havens or creating loan facilities that allow hedge fund managers to buy their shares of the funds by borrowing from the funds themselves.

“It is thus possible that there would be little or no net increase in tax collections from taxing carried interests as ordinary income once the industry adjusts in response,” University of Pennsylvania professor Michael Knoll wrote in a law review article that attempted to estimate revenues from taxing carried interest as ordinary income.

The reason it is so hard to achieve higher revenue from taxing carried interest is that the underlying activity is investment activity—generating the kind of income that is usually taxed at the lower capital gains rate. It only differs from capital gains because hedge fund managers earn their share in the fund by contributing “sweat equity”—their trading and investment ideas—rather than capital.

Outside investors, known as limited partners, pay capital gains taxes because they contribute their cash.

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