No, F%$k You

No Mr. Sperling, it is pretty much 100% direct compensation for work and therefore regular income. A nearish parallel would be with stock options held for many years. If you use a cashless exercise at some point, even if you had the options for more than a year, it gets counted as income.

Let’s see if I understand this. You get a management fee of 2% of assets plus 20% of the (capital) appreciation. Because the underlying appreciation (of someone else’s capital) is capital gains, your percentage commission for doing the work to earn those gains on someone else’s capital is a capital gain?
So if you use a similar fee structure to manage a portfolio of tax-free municipal bonds (and someone out there would be stupid enough to invest in it), your commissions would be tax-free?

Sperling is entitled to a 15% rate on the profits of whatever money _he_ puts into the fund, just as his investing partners do. But the 20% of the profit^*^ that a manager takes is part of the manager’s compensation, not his investment, and should clearly be taxed as income, not a capital gain. How the IRS accepted this system is beyond me.

^*^ While private equity and hedge funds clearly do well, the 20% of profits usually only applies if a fund has a rate of return higher than some benchmark, say LIBOR plus or the Dow. The benchmark level is usually treated as proprietary information, but let’s say a fund returns only 4% in a year — it is likely that the fund gets nothing above the 2% it took off the initial investment.

Sounds similar in principle to the IR35 stuff in the UK last decade – consultants (particularly in the IT industry) would incorporate themselves as a business, sell their own personal services, pay themselves minimum wage to avoid income tax, and then pay themselves out the ‘companies’ profits as dividends which attracted a lower tax rate.

Shocked. Shocked I tell you. The very idea that an intelligent wealthy individual would exploit a loop hole in the tax structure. Next you will tell me that these individuals give donations to canidates to create such loop holes.

As Alan Blinder says, the question is why capital gains should be taxed differently from income at all:

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best, and there are better ways to spur investment, like, say, the investment tax credit. Besides, lower taxes on capital gains reduce the tax bills of the rich relative to the rest of us — after all, they own most of the capital. But in this age of hyper-inequality, shouldn’t we be making the tax code more progressive, not less?

A far more important objection is that the tax preference for capital gains undermines capitalism — a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. … The government thus induces people to make bad investments, which is a good way to run an economy into the ground. Come to think of it, that’s just what the old Soviet Union did. It invested copiously, but badly.

Hell, Mr Sperling is really Fictitious Capital. We can’t tax him, because he doesn’t exist.

And for me, he doesn’t. I will let you bourgeois liberals worry about him. No offense.

While I agree with Blinder’s larger point, unless he’s setting up a punchline like “We make it up on volume” I don’t see how this is mathematically possible: When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate.

If an investment loses money before tax there is no gain to be taxed, no? If I invest $1,000 in a stock, sell it in a year and a day, for $999. I have a capital loss, not a capital gain.

Scuttlebutt in the D.C. tax community is that any bill to the tax treatment of carred interests is currenly dead dead dead.

Bernard, I’m guessing that Luskin doesn’t spend too much time and energy discussing tax distortions which benefit the rich.

Belle: “You are really not helping your case for massively preferential taxation here, hedge fund guy::

This assumes that they can’t sh*t in our mouths, tell us it’s chocolate, bill us for the gourmet treat, and have 50% of the American people + 90% of the American mass media + 80% of Congress go along with the charade.

Ugh, do you mean that any bill raising their taxes is dead, or any bill giving them continued lower taxes is dead?

15: it’s mathematically possible if the money-losing investment allows you to convert some other stream of ordinary income into capital gains.

Also think in terms of expectation. Consider an investment where our best estimate is that before tax will lose 100k 1/2 the time and gain 100k 1/2 the time. That’s O EV, so we wouldn’t do it if there is no tax unless our discount rate was negative.

But if the 100k loss can offset ordinary income (because it’s business expenses, rather than a capital loss), while the 100k potential gain can be taxed as a long term capital gain (because it’s in the form of increased value for some security or real estate), then after tax this gamble is +EV. And the 17% tax gap (more if in a high tax state) might well be enough to make the deal quite profitable after tax considerations.

Yet in terms of efficient capital allocation this deal is a loser for the economy — we now have an entity taking on a lot of risk in order to provide an expected economic value of zero.

Michael,

Right. But you get the same problem, in reverse, with capital gains taxes and +EV projects.

Let’s say that capital losses can only offset capital gains; imagine a set of 4 projects (A-D), each with a 25% chance of getting 5x your money for a $100 investment. Each of them has a +25% EV. Let’s stipulate a 40% tax rate (because I can do it in my head), and imagine that A succeeds and B-D fail.

If you invest in A, you earn 300. If you invest in B you lose 100. But if you invest in A and B, you still earn $240; the possibility of offsets makes risky investments more attractive. (If you were 90% sure A would pay out, B could be negative-EV and stilla ttractive.)

“But if the 100k loss can offset ordinary income (because it’s business expenses, rather than a capital loss)”

Isn’t this why capital losses can only offset capital gains?

by the way, I would like it to be known that I tried, really I tried, to avoid mentioning that the man quoted is actually a “private equity guy”, not a “hedge fund guy”, but in the end the unequal battle against the forces of pedantry proved too much for me.

but in the end the unequal battle against the forces of pedantry proved too much for me

I lost the same battle with regard to Monsoons here a week or so ago.

I assume that Luskin is talking about the same basic thing, but confess that I can only hazard vague guesses as to the subtleties of “hedge fund guy” vs. “private equity guy”. Particularly in contrast to the crystal green clarity of my envious fury at “People making $600 million a year are cheating.” But at least I get to be righteous about it in blog comments, that’s worth something, right … right?

if we raise taxes on hedge fund managers we’ll get fewer hedge fund managers.

What exactly is in the category “things you’d do for $500 million that you wouldn’t do for $400 million”?

But thank God we have those hedge fund guys.
MSNBC headline:
Hedge funds could be behind late stock swings Last week’s end-of-session wild swings can be caused by mass trades

Analysts believe this kind of a pattern is bad for the market — and should be discounted. Hedge funds now account for half the daily volume on the New York Stock Exchange, with average volume this week running about 2 billion shares.

I know, cheap shot.

Re #23, Thanks. That makes more sense than what Blinder wrote.

But there’s is just as much an argument that the business expense deduction distorts efficient capital allocation as low capital gains tax.

The arguments that capital gains should be taxed equivalent to income should really be that capital gains are income for many people.

Isn’t this why capital losses can only offset capital gains?

Capital losses only offset capital gains, not because of the rate difference, but because of the opportunity for deferral. For example, suppose you bought a stock and also shorted it. At the end of the year, one of those positions will be in a loss, but it will be perfectly offset by the gain position, leaving you flat. If you could deduct capital losses from ordinary income, you could close out the loss position, offset it against ordinary income, and pay less tax, even though you have no net change in you economic position. Sure you would have to pay when you close out the gain position, but who knows when that might be.

Screw you guys. If this tax gets raised, I’m going home to live in my parents basement and get food stamps from public welfare! Who is going to manage your money then? Who, Paul Krugman?

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I ♥ Luskin