Jim Cramer just went on a great Twitter tirade about the outrageousness of the tax loophole that allows hedge-fund and private-equity managers to pay 15% “capital gains” taxes while you and I pay much-higher “ordinary income” rates.This loophole, which some think is one reason GOP front-runner Mitt Romney is scared to release his tax returns, is absurd.
To be clear:
There is no theoretical justification for it.
The fact that the loophole exists is merely a function of the enormous power the financial industry has over Washington.
The argument that some hedge-fund moguls and their defenders make for the tax break is that, because they are paid based on the performance of their funds, their compensation somehow represents a “capital gain.”
That is just ridiculous.
Anyone paid any form of performance-based bonus could make this argument.
Most hedge-fund and private-equity managers, including venture capitalists, are paid with a combination of a management fee (1%-3% of assets under management) and a performance-based fee (generally 20%-50% of the “gains” on their funds). The managers are generally paid these fees regardless of whether the gains are due to their own performance or simply the market going up. (Most hedge funds are a horrible deal for hedge-fund investors, but since investors are still dumb enough to line up around the block to put their money in, that’s their problem).
In both cases, however, the fees the managers receive are compensation for service, not “capital gains.”
The justification for lower taxes on capital gains is to encourage people to invest capital for the long term. Capital investments generally help the economy, by funding new companies and projects. The capital that is invested, moreover, has already been “earned” (and, thereby, taxed). So there are reasonable arguments for having lower taxes on long-term capital gains than on ordinary income.
But the management and performance-based fees paid to hedge-fund and private equity managers are NOT capital gains. They’re ordinary income. Just because they don’t arrive in a monthly paycheck and are based on performance doesn’t change that.
Now, there are some instances in which hedge-fund and private-equity managers have their own capital invested in their funds. And there are other instances in which the managers take their management fees and reinvest them in their funds.
In these cases, when the managers actually have their capital at risk, they should be entitled to capital-gains tax treatment.
(Mitt Romney’s income may well fall under this category. As long as he paid taxes on his management fees when he received them, and then reinvested what was left in the funds, his income should be treated as capital gains. But if he simply deferred his fees and is receiving them now at a 15% tax rate, it’s no wonder that he’s terrified about releasing his returns.)
In his tweets, Jim Cramer says that, in private, his hedge-fund friends know how outrageous this tax treatment is and can’t believe that they have persuaded the government to give it to them. But he also says they’re smart enough not to say this publicly, lest they threaten the golden goose that allows them to pay less than half the taxes other executives pay.
One smart thing that hedge-fund and private equity managers did, of course, was come up with the term “carried interest” to describe their performance-based fees. Calling these fees “carried interest” makes them sound like something other than fees, and thus helps the managers make the argument that they should be treated differently than normal income.
But they shouldn’t be treated differently. They’re normal income, albeit performance-based.
And the sooner this preposterous tax loophole is eliminated the better.