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 today’s 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 partnerships—which are already treated favorably for tax and liability purposes—are 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.

Not only do these rich individuals have no need of tax breaks, the hedge fund and private equity industries have demonstrated time and again that they are not exemplary economic citizens who deserve privileged tax treatment. While most fund managers are probably law-abiding investment advisors, there are innumerable examples of wrong doing. The major types of failures and illegal activities include insider trading, IPO manipulation, embezzlement, and defrauding mutual fund investors.²

Defending this tax break are highly paid lobbyists such as Douglas Lowenstein and Grover Norquist who loudly and repeatedly make the claim that taxing hedge fund managers like everyone else will harm the average working family. They claim that taxing hedge funds like normal income will harm pension fund returns. This is wrong on two levels. First, the tax change would apply to hedge fund managers and not investors (many pension funds invest in hedge funds). Second, pension funds do not pay taxes. These lobbyists also claim that it would increase the cost of consumer goods and services because so many stores and chain restaurants are owned by private equity firms and hedge funds. This, too, is preposterous because, again, the tax does not apply to the investors or owners of those businesses but only the investment advisors who manage the funds of those investors. Moreover, the businesses owned by private pools of capital will have to compete with other similar businesses providing consumer goods and services—only now on a level playing field—and they will not be able t
o arbitrarily raise their prices.

The revenue costs

How much revenue does this loophole cost the federal government? The following analysis creates a reasonable estimate using what information is available from the unregulated, non-transparent hedge fund industry.

The data come from market research firms Greenwich Associates and HedgeFund.net. These firms study the industry in order to help investors become more informed about the size, returns, and range of opportunities available in the area of professionally managed private capital pools. The size of the hedge fund industry is best measured by the amount of capital invested in these funds. HedgeFund.net estimates what is called “assets under advisement” to be $2.4 trillion for 2006. Greenwich Associates regularly reports on its survey of a large number of fund managers, and the results for the past three years show that hedge fund investments’ across-the board-investment strategies returned 10.5% to investors after fees. This implies that returns were 13.1% before fees, and if investment managers received the industry standard 20%, then their remuneration treated as “carry” was $63 billion for 2006 (20% of returns calculated as rate of return times capital of $2.4 trillion).

Of course not all hedge funds are located in the United States, but estimates are that 70% of hedge funds measured by capital invested are based domestically.³ The funds may also have subsidiaries in the Cayman Islands for certain other tax purposes, but the fund managers are taxed based on where they live, and most live in the United States. If we take a more conservative estimate that 50% of hedge fund assets under advisement are managed by advisors located in the United States, then half of those investment advisory earnings are taxable under U.S. law. At the current 15% capital gains tax rate, the taxable amount would result in $4.75 billion in tax payments; at the top rate (35%) on ordinary income, it would sum to $11.05 billion. The loss to the U.S. Treasury, therefore, amounts to at least $6.3 billion a year.

In addition to these aggregate numbers, there are a few specific figures coming out of the private capital market worth considering. Alpha Magazine’s figures for the top hedge fund managers and its estimates of the break out of compensation between salary and bonus can be used to further estimate the revenue implication by applying that break out to the portion of total compensation that is likely treated as capital gains. The different tax rates then can be used to calculate how much these three individuals benefit from this quirk in the tax law.

A simple calculation shows that this preferential tax treatment for the top 25 individuals alone costs the Treasury almost $2 billion.⁴ It serves to suggest that our estimates of tax losses are indeed conservative, as the losses from these 25 managers alone amounts to almost a third of our total.

Conclusion

Congress has the opportunity to correct a bad economic policy and free up resources to fund better priorities. This analysis points to the need to update the nation’s tax laws dealing with private pools of capital. The current law is generating inefficiencies and great inequality by granting tax breaks to individuals who do not need and do not deserve such favors. The nation has greater and more deserving priorities. If the amount of tax revenue lost to private equity firm managers is equivalent to that lost with hedge funds, then the combined amount would be $12.6 billion. This forgone revenue stream could, for example, fully fund the five-year, $35 billion expansion of SCHIP, the public health insurance program for low-income children.

Notes
1. While investment advisors often invest their own capital in the funds they manage, this tax issue concerns the returns on their labor and not their capital.

2. As for insider trading, the SEC is investigating numerous cases of hedge funds exploiting insider information about merger and acquisition announcements to trade ahead in the credit derivatives markets. In terms of IPO manipulation, Deutsche Bank and several hedge funds were recently prosecuted in France for manipulating an IPO of a telecom firm. Dozens of hedge funds have also been found to have ripped off mutual fund investors by late trading and market timing a large number of mutual funds. This problem was brought to light by Eliot Spitzer’s investigation into Canary Capital Hedge Fund and Bank of America. For recent examples of embezzlement look to the cases involving Bayou Capital, IPOF Fund, and Wood River. In addition there have been some colossal failures, including: Long Term Capital Management (interest rates), Amaranth and Mother Rock (energy), Red Kite (copper), and Bear Sterns’ hedge funds (subprime debt).

3. Alpha Magazine reports that 77 of the largest 100 hedge funds are located in the U.S., and that the 100 largest hedge funds manage 70% of the total capital invested in hedge funds.

4. The calculation is based on Alpha Magazine figures for average compensation breakdown between salary and bonus, which is 70% bonus, and assumes the bonus was treated as capital gains. Thus 70% of compensation is taxed at 15% capital gains rate and benefit is the difference between that and 35%. If entire compensation were taxed at capital gains rate, then the benefit would be 43% higher.