Thursday, September 15, 2011

Hedge Fund Fair Tax Can Cut Deficit By $18 Billion

By Peter Cohan

President Obama suggested that we help finance the American Jobs Act, in small part, by asking hedge funds to pay what I think is a fair tax. And if they do, the budget deficit will drop by $18 billion.

The proposed tax change would require hedge funds to pay an ordinary income tax rate (35%) instead of the current capital gains rate (15%) on their so-called carried interest. Carried interest is the money that hedge fund managers get paid as a reward for making profits on their fund’s investments.

Hedge funds typically get paid through a combination of management fees and carried interest. For a hedge fund managing $5 billion, the management fees might be $100 million a year (2% of the assets under management). And if the hedge fund returned 10% — adding $500 million to the value of that asset pile, the fund’s investors would get $400 million (80%) and the hedge fund managers’ carried interest would total $100 million (20%).

Currently that $100 million is taxed at 15%. To understand why it should be taxed at 35%, it helps to understand the rationale for setting the capital gains rate below that of ordinary income. As I discussed on CNBC with the Wall Street Journal’s Alan Murray back in 2007, we want to encourage putting capital at risk so we tax the gains from such risk at a lower rate.

The reason that raising that rate for hedge fund managers is fair, in my opinion, is because the money that hedge funds invest is partially that of the hedge fund managers themselves and mostly that of the hedge fund’s investors. The hedge fund manager should not be rewarded with a lower tax rate for putting someone else’s money at risk.

Simply put, carried interest is a blend of at risk and not at risk profits, so it should be taxed in a blended way. To the extent that a general partner is putting his or her own capital at risk in a deal, then the carried interest in that deal should be taxed as a capital gain.

However, to the extent that the general partner is putting the limited partners’ capital at risk, the pro-rata share of the carried interest should be taxed to the general partner at the ordinary income rate.

Simply put, since general partners put very little of their own money at risk, most of the carried interest is really a fee for managing other people’s money and that fee should be taxed at the ordinary income rate. After all, any income that is part of regular trade or business normally is taxed at ordinary tax rates. And for most hedge funds, profiting with other peoples’ money is a regular occurrence.

How well will this argument go over in Washington? If money buys votes, then the answer as of April 2011 is pretty simple — like a lead balloon. That’s because according to the Center for Responsive Politics, hedge funds have shifted the lion’s share of their money from the Democratic Party to the Republicans. Specifically, in 2008 hedge funds gave $12 million to Democrats and $7 million to Republicans but by 2010 the split had shifted to $4.5 million for the Democrats and $13 million for the Republicans.

I’d challenge a hedge fund manager to defend the idea that it’s as risky for them to put a client’s money into a trade as it is to bet their own cash. It doesn’t seem defensible to me though. After all, if the client loses money on a trade, that doesn’t cost the hedge fund manager much beyond the client’s frustration. It’s only when he loses his own money, that he feels the burn in his own bank account.

Being a hedge fund manager is the world’s most lucrative job — in 2010, the nine highest paid made over $1 billion personally. If hedge funds paid a fair tax, their managers would still be the highest paid people in the world.

Even if a few people did drop out of the hedge fund industry because they had to pay a 35% tax rate on their profits, do hedge funds really create so much value for society that those drop-outs would be missed?

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