Yes, there is something terribly wrong with taxation in the hedge fund industry — but it is not the perceived evil that the defeated Baucus/Grassley bill was attempting to “fix”. According to them, the problem was that the hedge fund operators get part of their compensation from (relatively low-tax) capital gains income.
However, the proposed changes to “carried interest loopholes” is for political gain only, creating a problem that isn’t there, in order to solve some mythical inequality. However, all it does shift the benefit of the capital gains lost by the operators to the investors. That fixes nothing.
Instead, the real problem is that the Internal Revenue Code (IRC), as strictly enforced by the IRS, requires generally that hedge fund investors pay taxes on huge amounts of “income” that does not exist. This is derived from rules that require investors to pay tax on investment income while denying them an offset for the expenses that were incurred to generate that income.
It is simply not uncommon for hedge fund investors to pay tax rates of 70-100% or more on the hedge fund income they earn.
Yes, you read that correctly. 100% or more. In fact, in my practice I see a few clients every year forced to pay more taxes on an investment than that investment earned. True, it is a small percentage of people affected in any given year, but this does not mitigate the blatant unfairness. How does this injustice take place?
It follows from what is the most inequitable provision of the current tax code, namely, the severe limitation on the ability to deduct the necessary expenses incurred by a hedge fund operator in order to earn income: investment fees and expenses, accountant’s fees, legal fees for collecting a settlement, etc.
The tax code requires those expenses — which include virtually all operation expenses of private equity hedge funds, including fees to the operators — to be listed under the category of “miscellaneous deductions”.
However, these deductions may not be claimed until and unless they reach 2% of the taxpayer’s entire income. The upshot of this is that most taxpayers do not get to benefit from these deductions. To add further insult to injury, that even if investors have expenses which exceed the threshold, these expenses become addbacks for the dreaded alternative minimum tax (“AMT”).
This taxpayer abuse then certainly discourages investment and is a major source of inequity in the code. If Congress were ultimately concerned with reforming the hedge fund industry, this problem — the inability to deduct necessary expenses incurred while earning income — would be the right one for Congress to fix. Trying to interfere with and fix who gets the capital gain rate in a “carried interest” transaction was a worthless and meaningless endeavor.
For over a decade, The Wall Street Journal and The Heritage Foundation, Washington’s preeminent think tank, have tracked the march of economic freedom around the world with the influential Index of Economic Freedom. Since 1995, the Index has brought Smith’s theories about liberty, prosperity and economic freedom to life by creating 10 benchmarks that gauge the economic success of 184 countries around the world. With its user-friendly format, readers can see how 18th century theories on prosperity and economic freedom are realities in the 21st century.
The Index covers 10 freedoms – from property rights to entrepreneurship – in 184 countries.
The late Dr. Milton Friedman cogently expels one of the most persistent economic fallacies regarding the government, spending, and producing. Take 3 minutes and be enlightened and entertained.
Tom Palmer, a senior fellow at the Cato Institute, penned the following piece over at Policymic. Tom rightly gets to the heart of the matter in his summation at the end of the essay.
“Government debts and printing-press money will harm future generations. It’s unfair. It’s immoral. And it’s going to be solved not by occupying Phoenix, or Wall Street, or Atlanta, but by demanding that spendthrift politicians stop the bailouts and the cronyism, put the brakes on spending, and pay attention to a truly radical concept: arithmetic. Those are sound Tea Party values.”
It seems like the administration and media these days are spending a lot of their energy complaining about the growing disparity between the haves- and have-nots. Many explanations are bandied about in an attempt to show that “devious policies” are causing the wide gulf between higher and lower income earners. These devious policies include special benefits for the wealthy, corporate welfare, and a tax system that favors those with higher incomes. But there are no special benefits for the wealthy; corporate welfare, though it exists only affects those few crony capitalist type industries and companies; and the tax system clearly favors those with lower incomes, not higher. Then why this imbalance?
The simple reason is that unlike people in the fastest growing countries, and unlike our own citizens in prior generations, the current middle and lower income lower classes have lost their inclination to invest in the future. I would argue that this is because the growing government welfare system is stripping individuals of their need to prepare and plan ahead. For the most part it is the upper middle and higher income individuals — those who are not the beneficiaries of government welfare and those with more entrepreneurial orientation — that are forcing themselves to save and put this money at risk into investments for their future.
China’s current economic success can be directly attributed to the financial attitude of their citizens with regard to investing. Almost all earners, even the middle and lower income ones, keep a certain amount of income each month and invest it in both entrepreneurial endeavors and the existing equity markets. It is common for even the minimum wage earners to save 25% – 50% of their income! Large or small sum, they regard investment as a priority and a path to prosperity.
Contrast this to the present state of affairs in our country. We have not been saving– we have been borrowing. Citizens have mortgaged their future by consuming continuously, while investing nothing. We are turning into a country where people will begin to wonder why they should invest, if it’s just going to be taken away from them in the long run by those who do not.
In order to get the middle class back on track, we must focus our efforts and rhetoric on reminding ourselves that this country was built upon those who were willing to invest their time and money to become great. It is the true source of upward mobility – and those that do not do their fair share will be left behind by those who do. Investment is what made our country thrive and it is the only thing that will properly sustain our country’s financial future.
