About Those ‘Hedge-Fund Guys’

By Kevin D. Williamson

Tuesday, September 22, 2015

Donald Trump has promised that he will ease burdens on the middle class by going after “the hedge-fund guys,” who, he believes, do not pay enough in taxes. “They’re making a tremendous amount of money — they have to pay taxes,” he says. Because the one thing in which Trump is consistent is his vagueness, it is not 100 percent clear whether what he is talking about is the so-called carried-interest loophole, which is very much on the minds of people with economic-policy views similar to Trump’s — meaning Bernie Sanders and Hillary Rodham Clinton and other cookie-cutter progressives — but in any case, it is worth having a look at the reality and the myths of how hedge funds and other financial firms are taxed, assuming that we want to start with facts and proceed to opinion rather than go like a crab backward.

The myth is this: Hedge-fund managers take home tremendous paychecks that are really plain old payments for services but which are disguised as long-term capital gains, meaning that they get taxed at 15 percent rather than the 39.6 percent I pay on my salary, which is fundamentally unfair.

The thing about myths is, they’re myths.

If you will forgive a brief little dip into finance gobbledygook, some clarification is in order here. The first thing to understand is that “hedge fund” has come to be used the way the Left (and science-fiction writers) use the word “corporation,” meaning: men and institutions with a great deal of money doing things that I do not understand, who must, therefore, be evil. Indeed, the current discussion about the taxation of financial firms is a terrific example of how the good-guys/bad-guys school of policy analysis makes people stupid. Whether you believe that financial firms are the nexus of evil in the 21st century or are the last outpost of heroic Randian capitalism, it is worth your time to understand what they are and what they do, inasmuch as solutions to problems you don’t understand aren’t generally good ones.

The carried-interest question is in fact something that is rarely very relevant to hedge funds. It is of much more interest to private-equity firms, which are a different animal. Hedge funds are partnerships that generally pursue high-risk, high-yield (and generally high-leverage) investment strategies on behalf of people and institutions with lots of money; they are called “hedge” funds because their original purpose was to provide big investors with a hedge against unexpected developments in their less exotic portfolios. Prominent hedge funds include Bridgewater Associates, BlackRock Advisors, and Paulson & Co., and they are involved in everything from high-frequency trading to event arbitrage. They rarely have the opportunity to avail themselves of the 15 percent long-term capital-gains tax rate, because that applies only to assets held for a year or more, and most hedge funds operate on a much shorter timetable than that. (There are exceptions; John Paulson is a collector of Steinway pianos, and Paulson & Co. purchased the struggling Steinway & Sons outright a few years ago.) Their management fees are generally taxed as ordinary income, as are most of their profits. In the event that a hedge fund holds an investment for a year or more, any associated capital gains would be taxed at the 15 percent long-term rate — the same as they would for any other company, or for you as an individual.

Which isn’t to say that hedge funds happily turn 40 percent of their profits over to federal/state/local governments; they pursue all sorts of tax-avoidance strategies, but the carried-interest strategy isn’t usually one of them; there’s a very good discussion in the New York Times under the headline “Why Hedge Funds Don’t Worry about Carried-Interest Tax Rules.” If you want to raise taxes on hedge funds, changing carried-interest rules isn’t how you do it — it would be a lot more complicated than that.

Carried interest — a share of the profits from a company or an investment paid to the investment manager as a form of payment beyond funds invested — is of much more acute concern to private-equity investors. (A complication: Some hedge funds make private-equity investments.) The distinction between the two kinds of companies is not mere financial esoterica, especially if you are campaigning to be put in charge of tax reform. There are many different kinds of private-equity investors: There are private-equity firms that invest in troubled companies with the goal of restructuring them and creating something profitable, which is what Mitt Romney did (with great success) at Bain Capital. Your Sand Hill Road venture capitalists funding Silicon Valley technology startups are another species of private-equity investor, as are the so-called angel investors (high-net-worth individuals who put money directly into private companies, also generally startups). And that is where the carried-interest rule really comes into play.

While the analogy is not 100 percent accurate, if you’ve ever been given stock options as part of your compensation, you’ll recognize the general outline. Somewhere in a shoebox, I have a stock-option document entitling me to buy a certain number of shares in a now-defunct newspaper-publishing company; the options were part of my compensation as a newspaper editor. If memory serves, I was given the option to buy stock at $27 a share at a time when the shares were trading at $18. That’s not unusual — the idea is to get managers personally invested in the well-being of the company (as reflected in its share price) in order to create good management incentives. Because the options have no value at the time they are issued (you’re no richer for having the opportunity to pay $27 for an $18 stock), there is no tax liability at that point. But if you hold onto them and the company becomes more valuable, then you stand to make some money. If the share price should go up to $50 (alas, this did not happen with my newspaper company), then those $27 options are valuable — you can make $23 a share. Assuming that you’ve held those options for more than a year, you’d be taxed at the 15 percent long-term capital-gains rate rather than at the individual-income-tax rate.

Private-equity firms don’t just bring money to the table: They bring (at least theoretically) expertise and labor, in exchange for which they are given a percentage of ownership or profits beyond that associated with the money they put up. If they hold those investments for a year or more and there are profits realized, then they are taxed the same way you would be, i.e., at the 15 percent rate. This is true even when they haven’t put up investment capital for that portion of the deal, but have instead put up what is sometimes called “sweat equity,” i.e., their work. If the deal goes south, then the private-equity investors will not necessarily have lost money on the management-fee portion of the deal, but they will have lost opportunity, time, effort, etc. And in most cases they will have lost money, too, especially in the case of venture capitalists, who much of the time will have put up practically all the investment capital in a startup.

The case against the carried-interest rule is, in short, that private-equity firms shouldn’t be allowed to treat investment income as a long-term capital gain in situations where they didn’t have money at risk. (This argument is, to be sure, not without some merit.) But private-equity firms are not the only investors who profit on sweat equity. Consider the case of the Silicon Valley worker bee: A programmer who might command $200,000 a year at a Microsoft or a Google decides to go to work for a startup that cannot afford to give him a salary like that; instead, he accepts equity in the firm, in the hopes that it will be successful and he’ll get a big payday down the road. Say the company in its early stages is valued at $20 a share and he is given options at $22 a share — there is no “taxable event” in being given those worthless (at the time) options, and if he ends up making $10 million on them five years down the road, he pays the 15 percent rate, not the top individual-income-tax rate, even though what he put up was his time and work, not investment capital. The case for taxing the carried interest of private-equity firms at ordinary income rates is also the case for taxing those Silicon Valley foot soldiers at the ordinary rate. What that would mean is that the tax incentives we give in exchange for risk-taking would be applicable only to capital, while labor was shut out.

Which brings us to the question of why some forms of income are taxed at different rates than others. We have a long, bipartisan tradition of taxing long-term capital gains and dividends at lower rates for a couple of reasons. In the case of dividends, the question is mostly double taxation: Dividends are paid out of post-tax corporate income, which means out of a pool of money that already has been taxed at the corporate tax rate — and the United States has the developed world’s highest corporate tax rate (39 percent). For private investors, investments are generally made out of income that already has been taxed: You pay 39 percent on your salary and, if you have the prudence to save some of that salary and invest it, you get taxed again on any money you make, and it strikes many people as sensible that the second bite be smaller than the first. Where double taxation is not a concern, the idea is that we need entrepreneurs and startups, and the firms that invest in them, to make the economy go: If we’re all salaried middle-managers at Bob’s Insurance Inc., then there’s not much innovation, and little if any of the dramatic growth and dynamism provided by innovative new firms. It may be that you think this is a bad policy — and I think there is a pretty good case for taxing all income regardless of its source at the same rate, once — but that’s an argument against lower tax rates for investment categorically, not an argument against lower tax rates for investors you don’t like. It’s also an argument against having corporate income taxes and other sources of double taxation.

My own view is that private-equity firms do a great deal of good for our economy, especially the venture-capital firms that fund startups. Hedge funds and other more exotic financial specimens do valuable work, too, although the benefits they provide (mainly risk mitigation) are less obvious to the general population. But it is the case that where certain kinds of income receive preferential tax treatment, firms and individuals will seek to organize their incomes in such a way as to benefit from those rules. Similarly, unless Washington should take the (unthinkably destructive) step of banning U.S. firms from having overseas subsidiaries and partnerships, the offshoring of profits for the purposes of shielding them from high U.S. corporate tax rates is inevitable.

It is useful to meditate on that sky-high U.S. corporate tax rate. On paper, it is, as noted above, the world’s highest; in reality, most U.S. firms, especially large and politically connected firms, pay a lot less than the official rate. That’s partly because the U.S. tax code is larded with political favoritism, and partly because companies engage in other forms of tax minimization. One of the difficulties of financial regulation is that Goldman Sachs is regulated mainly by people who weren’t smart enough to get jobs at Goldman Sachs; by the same token, the people who write the tax code aren’t as smart or as motivated as the people who have billions of dollars at stake reacting to it. You can jack up the tax rate on investments to whatever you like — that doesn’t mean that anybody is going to pay it.

But don’t call it a “loophole.” This isn’t an unintended feature of the tax code. The tax code was written the way it was for a reason. Maybe you don’t think that it’s a good reason, but it isn’t an accident. And there are no special rules for hedge funds or private-equity companies — they play by the same rules the rest of us do, even if they’re better at it.

Not that this matters all that much in the big fiscal picture. As Mr. Fleischer of the Times points out, the top 25 hedge-fund managers earned between them about $21 billion in 2013. Those are very big paychecks, but there aren’t a lot of them. If Washington were to take 70 percent of that haul, that would be only $14.7 billion, which in total would fund federal operations from about 8 a.m. to 9:45 p.m. on any given Tuesday. A few Democratic grandees might experience an enjoyable frisson from sticking it to “the hedge-fund guys,” to be sure. So, “Let them eat fairness.”

One possible solution to all this would be to reform the tax code in such a way that it was less costly to pay the tax man than to pay a team of lawyers, accountants, and financial engineers to run interference against the tax man. Crazy talk, right? Regardless, soaking Wall Street will not solve the fundamental political problem underlying our unbalanced national finances: The American middle class wants a much larger welfare state than it is willing to pay for.