Policy Memo #120

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This policy memo focuses on the privileged tax treatment given to hedge fund managers that results in a conservative estimate of over $6 billion in forgone tax revenue.

Private investment companies, organized as hedge funds or private equity firms, have recently grown into major economic forces in the U.S. economy. They mobilize capital, and often leverage it with borrowed funds, in order to accumulate a tremendous amount of assets under their management. These investments include leveraged buyouts; market-neutral investment strategies in publicly traded stocks and bonds, energy, and other commodities; various arbitrage strategies; as well as many lesser known and some entirely unreported transactions. Hedge funds are big players in the large corporate take-over activity that reached $3.6 trillion in 2006 and they are also responsible for a significant share of trading volume on the major stock exchanges and in some over-the-counter derivatives markets.

These private pools of capital are unregulated, or exempt from Securities and Exchange Commission (SEC) regulation, under both the Investment Advisors Act and the Investment Company Act. While these exemptions were once justified on the grounds that such investment firms were small, closely held, and did not raise their capital in public capital markets, the exemptions are no longer consistent with todays reality. Today these firms are huge, have a wide number and range of investors, and the Internet has blurred the distinction between public and private marketing.

In addition to being unregulated, these financial institutions also reap substantial benefits from special tax provisions that, like the regulatory framework, are no longer appropriate. The professional fund managers of these hedge funds and private equity firms are allowed to treat a substantial portion of their compensation as capital gains, meaning they are most likely taxed at 15% rather than the 35% rate that applies to ordinary income such as wages and salary. Such an exemption, however, makes little sense: in economic terms, the fund managers (also known as investment advisors) perform a professional service, much like lawyers or doctors, and receive remuneration for their labor.

These investment advisors and hedge fund managers can take advantage of this tax structure because they are often compensated through a scheme that, in part, pays them according to the returns on the fund. The industry standard for hedge fund managers is two and twenty, which is shorthand for an overhead fee of 2% of capital under management plus carried interest (often called a carry) of 20% of the returns on the fund. Thus a $100 million fund earning 20% would pay its fund manager $2 million for overhead and $4 million in carry. The carry portion of their compensation is treated under the tax code as capital gains for the fund manager and is taxable at the much lower capital gains tax rate of 15%.

This policy memo focuses on this special tax break, explaining why it is not economically sound and offering reasonable estimates of what it costs the U.S. Treasury and ultimately other tax payers in terms of lost tax revenue.

Tax treatment distorts economic incentives

There are two things economically wrong with this special tax provision for hedge fund managers. First is its impact on economic efficiency. It creates inconsistent economic incentives (i.e. distortions) for some labor income to be treated as ordinary income while other labor income is treated as capital gains, and the work done by investment advisors is undeniably a professional, laboring activity. 1 Fund managers at pension funds, trusts, and endowments who provide similar professional services are paid a salary and possibly a bonus, and these are all treated as ordinary income. Only because hedge funds and private equity firms are organized as limited liability partnershipswhich are already treated favorably for tax and liability purposesare these same professional services taxed differently. The result is a distortion in the compensation and after-tax income between these super rich hedge fund managers and millions of others in the workforce.

The second thing wrong with this exemption is that these super rich fund managers do not need and certainly do not deserve special tax breaks. Alpha Magazine reports the compensation for hedge fund managers each year. The top earner for 2006 received $1.7 billion, the second highest received $1.4 billion, and the third $1.3 billion. That adds to $4.4 billion for three people. The top 25 hedge managers received, on average, $570 million for a total of $14.25 billion.