Wall Street's Obama Fury: Sometimes Even Spoiled Brats Have a Point

Guest post by Dr. Manhattan, a lawyer in New York City who represents, among others, clients in the investment management industry. Paul Krugman argues in his current column that "Wall Streeters" are nothing but a bunch of spoiled brats throwing temper tantrums (who have contributed nothing of value to the economy, to boot). Krugman's view echoes those of other commentators such as Alec MacGillis' epic March cover story in the New Republic about how the hedge fund community loved Obama in 2008 and has since turned on him. However, MacGillis' story points to at least one very rational reason why the hedge fund and private equity communities have turned on Obama, which is at odds with the "spoiled brats" narrative.

Specifically, everyone knows how the Obama administration wants to tax "carried interest" received by general partners of hedge and private equity funds as ordinary income rather than as capital gains. On the one hand, that's a clear attack on the economic interests of the people running those funds (and making big donations with the proceeds); on the other, there's a clear argument that the carried interest should in fact be treated as compensation for services rather than capital gains. However, the Obama administration's proposals in fact went much further, as MacGillis summarizes:

The fault line that emerged was over the treatment of carried interest, the "hedge fund loophole," which allowed partners in investment firms to have their compensation--typically, a 20 percent cut of profits--taxed at the 15 percent capital gains rate instead of the 35 percent top rate for ordinary income.

Despite its name, the loophole benefited private-equity partners more than most hedge fund managers, who often trade on too short-term a basis to qualify for it. But hedge funds and private-equity firms alike bucked as it became clear that Congress was intent on closing the loophole in such a way that would hit all of them in a place that hurt: their profits, should they decide to sell stakes in their firm. Tax reformers had worried that, if the loophole was closed, managers would respond by selling shares in their firms to a third party. The money they gained from the sale--essentially, up-front payment for the firm's expected cut of investment gains--would be taxed at a lower rate as capital gains. In order to prevent one loophole being replaced by another, the emerging legislation would tax part of the sale of a stake in a firm at the much higher rate for ordinary income.

To many fund managers, this approach, which they dubbed the "enterprise value tax," was pure expropriation: They had built their firms from scratch and felt they deserved to have any sale taxed as capital gains. In his letter in 2010, Loeb declared the proposal an "arguably unconstitutional Bill of Attainder." The lobbyist who has represented hedge funds says: "The biggest thing that's infuriating to the hedge fund industry--the single biggest thing--is this enterprise-value tax. They feel they've been singled out. ... [It] is what they're metaphysically upset about. (Emphasis added.)

Hedge and private equity fund managers may be every bit the spoiled brats that MacGillis and Krugman say they are, but sometimes even spoiled brats are treated unfairly. The proposed "enterprise value tax" would in fact go far beyond putting carried interest on par with ordinary income; it would single out the sale of one kind of business for tax treatment not applicable to (as far as I know) any other kind of business at all. (I would like to know if there are other examples of business sales not being eligible for capital gains treatment.)

And how in the world is realizing capital gains by selling a portion of one's business a "loophole?" The proposed tax isn't aimed at some types of sale transactions which could be argued don't actually transfer the business interest; it would apply to any sale of any amount of a business which advises such funds (see page 139 of the proposed American Jobs Act).  Is selling stock after holding it for 1 year rather than 364 days a "loophole" because the sale then qualifies for long-term capital gain treatment?) If selling some or all of a business is a "loophole," then the term "loophole" has no meaning other than "something which enables people I don't like to reduce their taxes."

Substantively, this is no different than, say, if revulsion at Mark Zuckerberg inspired a proposed tax code change to render the sale of shares in technology company IPOs ineligible for capital gain treatment. I'd respectfully suggest that if such a change was ever mooted, the reaction from Silicon Valley and their fans would make the billionaire egotists excoriated by Krugman and MacGillis' piece seem like Buddhists by comparison.  Sometimes even paranoids have real enemies, and it's not surprising that they'd oppose people who have targeted them in such unique fashion. Even if they really are a bunch of spoiled brats.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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