Time to Trim the Hedge

Opinion pieces and speeches by EPI staff and associates.

[ THIS PIECE ORIGINALLY APPEARED IN THE TPM CAFE BLOG ON ON MAY 23, 2007. ]

Time to trim the hedge

By Jared Bernstein

Over at the NY Times, columnist David Leonhardt provides a really interesting look at hedge funds, focusing on their returns and the compensation schemes (my word, not his) for those who run the funds.

But the article doesn’t speak to what’s becoming one of the most closely watched issues regarding these guys’ (yep, they’re all ‘guys’) compensation: should it continue to be taxed at the lower capital gains tax rate of 15 percent, or treated like regular income and taxed at 35 percent?

Guess which one I vote for?

As Leonhardt explains, the managers’ payments come from two sources: a small percentage for running the fund, and a big one based on the fund’s profits. Given the size of these funds—the top ten average $25 billion—even the two percent management fee can mean serious bucks. But the real money comes from the cut of the profits: typically 20 percent, but as high as 44 percent in one the top funds reviewed in the Times’ piece.

The industry argues that since the lion’s share of their compensation is keyed off the appreciation of the fund, it should be treated as a capital gain. A growing number of critics disagree. Look at their job title: they’re managing other people’s money. Sure, they often reinvest their own returns, but their income from managing the fund is just that: income derived from doing their job.

And, man, the US Treasury is foregoing some big payouts based on this favorable treatment. My colleague Randall Dodd, who’s been doing great analysis of the good and bad of hedge funds, is working on quantifying the amount of revenue that would result from making the change from taxation based on cap gains to income. He’s not quite done, but we could be looking at $20 billion per year.

That’s over three years of SCHIP funding, the public health insurance program for low-income kids that Bush proposes to cut for lack of revenue. Congress is resisting the cuts, looking under rocks to find the needed funds, but here they are, over by the hedge.

Now, Congress could, and probably will, have all kinds of deep, philosophical arguments about how to treat this compensation. After all, these guys are smart investors: they’ve ploughed millions into campaign coffers.

But here’s what I’d like to see: every presidential candidate should start jawboning this one, advocating for the switch to the higher income tax rate. The D’s, especially Edwards (who knows a little bit about hedge funds), are already saying a lot about excessive compensation and the unprecedented income gaps that confront us today. Here’s a simple idea that would surely resonate with those of us not managing hedge funds. I’ve even heard some conservatives say the switch makes sense.

So, get out the hedge clipper and let’s get to work!

Jared Bernstein is a senior economist at the Economic Policy Institute in Washington, D.C.

[ POSTED TOVIEWPOINTS ON MAY 31, 2007. ]