The Fund Manager Tax Scam

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Dean Baker
International Business Times, July 18, 2007 

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There are some issues where there is not much room for debate, like beating puppies. There is only side; it is wrong to abuse puppies. In the same way, it is not possible to justify the special tax treatment of the earnings of managers of hedge funds and private equity funds. It’s just plain wrong.

The issue here is simple. There is no economic rationale for having a lower tax rate on the compensation of fund managers than on people who do other types of work. It is incredibly inefficient to have a tax code that applies different tax rates for different occupations, for example taxing school teachers at a lower rate than firefighters. In effect, a differential tax rate amounts to workers in the high tax rate occupation subsidizing workers in the low tax rate occupation.

This is exactly what we have done as a result of the fund manager tax break, except that it creates a situation in which both teachers and firefighters, along with workers in every other occupation, are subsidizing fund managers, some of the very highest paid workers in the country. And just to be clear, this is real money. Under current law, most fund managers are paying tax at just a 15 percent rate. By contrast, if they were subject to the same tax schedule as teachers and firefighters, they would be taxed at a 35 percent tax rate. 

Given the incredible salaries of fund managers, this 20 percentage point tax subsidy can be real money. Many fund managers earn over $100 million a year, which translates into a tax subsidy of more than $20 million. The most highly paid fund managers earn over $1 billion a year, which will get them more than $200 million in tax subsidies. This is enough to provide health care insurance for more than 60,000 kids.

Since the fund managers don’t have much of an argument they have tried to obscure the facts to protect their tax break. They argue that they are risk-takers who have played an important role in making the economy more productive. The extent to which hedge and equity funds benefit the economy can be debated (presumably Amaranth and the bankrupt funds that specialized in debt instruments backed by subprime mortgages did not benefit the economy), but no one is proposing that we eliminate these funds. The question is whether their managers deserve a special tax subsidy. If the removal of the tax subsidy causes some fund managers to pursue other lines of work or to retire early, the economy will surely be able to withstand the damage.

The other trick used by the fund managers is to try to imply that the issue is the tax rate that they pay on their investments. Of course this is not the issue. Fund managers pay the 15 percent capital gains tax rate on any money that they actually invest in the funds they manage. No one is proposing to raise this rate. The money in question is the money that the fund managers are paid to manage the funds, not money that they invest in the funds. Fund managers all know the distinction, they just hope that the public can be deceived.

Even though the fund managers don’t have much of an argument, the smart money in Washington says that they are likely to keep their tax break. The fund managers have something much more valuable in Washington politics than good arguments – they have the money to make big campaign contributions to politicians. As a result, hundreds of members of Congress, from both political parties, will stand up and argue the case for beating puppies. They will tell the public that they think it’s important to give a special tax break to some of the richest people in the country.

Here’s where the fund managers’ claim that they provide valuable services is really borne out. They have provided a foolproof method for identifying completely corrupt politicians. Who says that they don’t earn their pay?


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.