Both the Obama administration’s budget and a bill passed last month by the House alter a nonsensical portion of the tax code that allows hedge fund and private-equity managers to pay taxes a far lower rate than other workers. The change will be taken up by the Senate when it reconvenes on Jan. 20th, and in the meantime, lobbying groups are “girding for a fight”:
Lobbyists have issued statements aimed at heading off a tax increase, arguing that it would stifle risk-taking by shrinking potential rewards for fund managers. “Private equity will endure, but the draconian tax hike, if enacted, will unquestionably slow the flow of capital to companies struggling to get back on their feet during this very fragile economic recovery,” said Doug Lowenstein, president of the Private Equity Council, a trade group.
At stake here is a provision of the tax code pertaining to “carried interest.” Hedge fund and private equity managers are typically paid in two ways: a set fee and then a percentage of the proceeds should the fund make a profit. Under current law, the latter portion — the carried interest — is subject to the capital gains rate of 15 percent, far below the top income tax rate of 35 percent. (Considering that top hedge fund managers make $657 million per year, I’m going to go ahead and put them all in the top income tax bracket.)
This makes absolutely zero sense. We have a lower capital gains rate because people earn capital gains from investing their own money. To encourage some risk taking, we’ve decided that profits from such investments, should they materialize, are subject to a lower tax rate.
But hedge fund and private equity managers are not investing their own money. They’re merely managing other people’s money. Why is the income they collect, when they are paid by the actual risk-takers, taxed at a lower rate? Yes, they make a percentage based on their success as a manager, but plenty of people earn money based on performance and still pay the normal income tax rate. Office of Management and Budget Director Peter Orszag made this point:
A wide range of performance based compensation, including arrangements in which service providers accept the entirety of the risk of the success or failure of the enterprise, is effectively labor income and taxed as ordinary income for services. Contingent fees based on movie revenue for actors, for example, are taxed as ordinary income, as are performance bonuses, most stock options, and restricted stock grants.
A proposal that movie stars pay a lower tax on their portion of a film’s revenue would rightly be regarded as nuts. But that’s exactly how we treat the income that hedge fund managers make, even though they just show up to work every day like any other worker. As the Boston Globe wrote in a recent editorial, “hedge fund managers and private equity partners are merely beating the system when they pay lower tax rates than their own secretaries and janitors.”
“It’s amazing to me that at the same time the U.K. is imposing a 50% excise tax on bankers’ bonuses, the private-equity guys aren’t even willing to pay the usual ordinary income rate,” University of Colorado tax law professor Victor Fleischer said. “You would think they would recognize a fair deal when it’s offered.” The Senate should ensure that this fair deal ultimately becomes law.