Hedge Funds Don't Deserve a Special Tax Break

By Derek Thompson

Normally, jobs bills don't raise the ire of Wall Street. But these aren't normal times.

The $150 billion Senate stimulus bill that extends unemployment insurance and multiple tax cuts will try to recoup some of that money taxing hedge fund managers -- not by raising the income tax, but by applying the income tax.

Private equity and hedge fund managers tend to get paid according to what's known as the principle of 2 and 20. They charge 2% annual fees for managing the portfolio of assets, and they collect 20% of the fund's annual profits.

There's nothing strange about this arrangement. It makes sense to align managers' financial interests with their clients'. There is something strange about the way the government taxes these revenue streams. The 2% fees are considered income, so they're taxed up to the 35% marginal rate. The 20% profit returns are considered capital gains, so they're taxed at the long-term capital gains rate of 15%.

This amounts to quite the tax break for private equity managers. Their primary source of income is taxed at half rate as long-term capital gains, even if the managers' own capital contributed little or nothing to the gains.*

The Senate stimulus provision would tax three-quarters of this carried interest as income, bringing in billions of dollars to pay for unemployment benefits and COBRA extensions for the poor. Wrangling over the bill has come to resemble a crucible of class warfare. We're taxing the rich to pay the poor jobless. From a political standpoint, that's the point.

From a policy standpoint, it's confusing the debate by making senators sound like Robin Hood wannabes rather than sound policy architects. The carried interest loophole has long had critics from across the political spectrum, and Warren Buffet famously rails against it. It's symptomatic of a financial industry that has cleverly learned to build its revenue streams around rules and taxes and defended the existing rules and taxes with aggressive lobbying.

Hedge fund managers aren't evil, they're just playing by a different set of rules. This is a loophole worth closing.
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*As Chuck Marr at CBPP notes, "there's no logical reason why a leveraged buyout (LBO) specialist at a private equity firm should be taxed differently than a mergers and acquisitions expert at an investment bank (who pays as much as 35 percent in taxes), since both people are doing basically the same kind of work."

This article available online at:

http://www.theatlantic.com/business/archive/2010/05/hedge-funds-dont-deserve-a-special-tax-break/57358/