In a prior post, I hypothesized that Warren Buffett’s guilt-ridden 17.7% effective Federal tax rate is most likely a consequence (unintended ?) of the capital gains tax rate cut and the functional failure of the AMT to do its job.
Another group of low capital gains tax rate benificiaries shows no Buffett-like remorse: private equity partnerships, and their close cousins, the hedge funds.
* * * * *
In brief, hedge funds are partnerships and are legally positioned to benefit from favorable capital gains tax treatment. But, hedge funds cavalierly push the law to the limits with some contested schemes.
Specifically, hedge funds have made an art form of “carried interest” — a claim that current operating income should be classified as returns on their invested capital and then taxed at capital gains rates (which are, of course, much lower than regular income rates.
Many (most? all?) disinterested observers smell a rat — a Enron-like loophole that you can drive a truck through.
Why doesn’t the loophole get closed? Simple politics. Sen. Shumer (NY) keeps blocking action because he fears hedgers will head off-shore, and — some cynics reckon — stop their super-sized contributions to the Democratoric Senatorial Re-election Committee — which, coincidentally, Shumer runs.
The likely fix: raising everybody’s capital gains rates — to avoid the appearance of singling out a prized political support group.
* * * * *
For details re: carried interest, below are summaries and links to a couple of good sources.
* * * * *
Carried Interest – The Issue
From : Senate Testimony: “The Taxation of Carried Interest”
by Peter R. Orszag, CBO Director
July 11, 2007
“A growing amount of financial intermediation is occurring through private equity and hedge funds, which are typically organized as partnerships or limited liability companies and … are growing rapidly for many reasons, including their tax advantages over traditional financial services corporations.
A general partner of a private equity or hedge fund typically receives two types of compensation: a management fee tied to some percentage of assets under management and “carried interest” tied to some percentage of the profits generated by those assets.
The management fee is taxed as ordinary income to the general partner. Taxation on the carried interest is deferred until profits are realized on the fund’s underlying assets, and any resulting profits to the general partner are taxed at the capital gains tax rate …
Most economists, however, would view at least part and perhaps all of the carried interest as performance-based compensation for management services provided by the general partner rather than a return on financial capital invested by that partner … and suggest taxing at least some component of the carried interest as ordinary income, as most other performance-based compensation is currently treated …
Much of the complexity associated with the taxation of carried interest arises because of the differential between the capital gains tax rate and the ordinary income tax rate, which creates an incentive to shift income into a form classified as capital gains. Further widening of the differential between the taxation of ordinary income and of capital gains would create even stronger incentives to shift income into the tax-preferred capital form.
Full testimony (worth reading):
http://www.cbo.gov/ftpdocs/83xx/doc8306/07-11-CarriedInterest_Testimony.pdf
* * * * *
Carried Interest – The Politics
According to Bloomberg:
Democratic Senator Charles Schumer of New York is fighting a plan to raise taxes on hedge funds and buyout firms with his own legislative poison pill … saying that he would agree to the proposals only if taxes were also raised on oil-and-gas, venture-capital and real-estate partnerships.
Schumer may be trying to shield both his Wall Street constituents [i.e. keeping jobs in NYC] and his party’s electoral war chest … based on federal filings, contributions from employees of private-equity firms and hedge funds to the Democratic Senatorial Campaign Committee, which Schumer heads ,,, far exceed the industry’s contributions to the Republican Senate committee.
http://www.bloomberg.com/apps/news?pid=20601103&sid=a9DpYagBpVIo&refer=us
* * * * *
Want more from the Homa Files?
Click link => The Homa Files Blog
Leave a Reply