Monday, August 15, 2011

What HFT Hedge Funds Tell Us About Carried Interest

Warren Buffett's recent New York Times op-ed calling for higher taxes on the super-rich has brought the issue of carried interest back into relief.  For the uninitiated, carried interest is the tax loophole that lets private partnerships -- venture capitalists along with private equity, hedge fund and real estate managers -- get taxed at the long-term capital gains rate rather than at the ordinary income rate. That is why a billionaire fund manager like Buffett recently had a tax bill that amounted to only 17.4% of his income.

Carried interest is actually a bit more complicated. Members of private partnerships are typically compensated along a 2/20 model: they earn a management fee equal to 2% of the size of their fund, and receive a performance fee of 20% of any profits. The 2% management fee is taxed at the ordinary income rate -- i.e., 35% -- but the 20% of profits are taxed at the capital gains rate of 15%, despite the fact that fund managers ordinarily do not risk much of their own capital. There's a final wrinkle. Managers must hold on to a position for a year to qualify for the long-term capitals gain rate of 15%; if they do not, profits are taxed as ordinary income.

Megan McArdle considers these facts and lays out her strongest counter-argument for maintaining the carried interest exemption:
The arguments for the carried interest are farily compelling: without it, the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets. This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture?
Short answer: because the returns on these "untried ventures" are the most lucrative in our society. It's difficult to imagine someone choosing not to work at a private equity fund because carried interest was eliminated, given that it would be nearly impossible to find an equally well-paying job (none of which would enjoy tax subsidies either). Indeed, McArdle herself reaches the same conclusion -- albeit, rather tentatively.

But this is less a hypothetical question than an empirical one. Consider the case of high-frequency trading (HFT) hedge funds. As previously mentioned, a fund must hold a position for one year to qualify for the 15% capital gains rate. Venture capital, private equity and real estate trusts make multi-year investments, so this does not affect them. But many hedge funds, particularly the automated HFT crowd, hold very short-term positions. Consequently, those hedge funds have their entire income taxed at the ordinary rate. This has not seemed to much affect their staffing. Indeed, if there have been stories about HFT hedge funds having trouble hiring due to prospective employees worrying about their tax statuses, I have certainly missed them.

The proliferation of HFT funds the past few years shows that the marginal supply of hedge funders is relatively inelastic to the carried interest loophole, due to the inability to substitute a higher-paying job. Pretending otherwise is simply searching for a justification for an unjustifiable policy.

9 comments:

  1. HFT also use derivatives and futures. If I'm not mistaken, this also qualifies them for tax favored treatment on their trading profits. Something like 60/40 breakdown of income taxed at ST/LT rates.

    ReplyDelete
  2. Let me make your life easier: Think of McArdle as one of those smart people with simply awful judgement. Larry Summers and others are in this group

    ReplyDelete
  3. "Let me make your life easier: Think of McArdle as one of those smart people with simply awful judgement. Larry Summers and others are in this group." Ritholtz


    I am not worthy. Jesse

    ReplyDelete
  4. "This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture?"

    God she is f*cking stupid. It's a services business - tax it like any other services business. Remember, if McArdle likes it, it is most likely wrong.

    ReplyDelete
  5. You're conclusion is specious.

    Private Equity managers and HFT fund managers are not interchangable, recruit from different career backgrounds, cannot readily switch from one job to the other, etc., etc. Citing an ready ability to staff HFT funds as the reason why the Carried Interest loophole is not a disincentive is ridiculous on its face. If tomorrow we doubled the tax rate of professional basketball players while holding the tax rate of professional baseball players constant, we'd still have no problem finding players for the NBA.

    Also, I strongly suspect this loophole has nothing to do with why Warren Buffet's self-reported effective tax rate is 17.4% (notwithstanding his large ownership of Berkshire equity, which accrues for income taxes at 35%).

    Lastly, our tax code taxes the "character of income" not the recipient of that income. The character of the income for private partnerships like PE funds is capital gains and not wage income. Imagine I wanted to start a book store and you had capital to provide start-up equity, of which we split equally. Your basis is X and mine is zero. In 5 years, if we sell the business at 10x, you pay capital gains on 4x and I pay capital gains on 5x.

    Now imagine there's a third party who for a fee of 20% equity introduces me to you. Your basis is still X, the third party's is zero, as is mine. When we sell the business at 10x, you get 4x, paying capital gains on 3x, I get 4x paying capital gains on all 4 and our third party gets 2x paying capital gains on 2. The character of the income is the same regardless of the presence of this third party - as is the government revenues.

    ReplyDelete
  6. They did not invent the game. Most hedge fund and private equity deals are mostly judgement calls. The private equity guys do manage (mostly by firing people, cost cutting, and piling on debt on target companies to extract dividends taxed a lower rates!)

    That they would stop doing this is like saying an NFL quarter back will not play because he too has ideas about what to do with the ball, unless his taxes are cut. Even though the QB did not invent the NFL!

    What, "carried interest" guys will quit working, sell their homes, move into apartments and deliver pizzas if the cant make hundred of millions and pay less tax on it, in addition to regular fees they get paid for their work?

    Give me a break.

    ReplyDelete
  7. "the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets."

    This the case for everyone who earns ordinary income rather then capital gains income. I wonder why McCardle doesn't consider it unfair that a teacher or a carpenter who earns his income from his "talent" is taxed at a higher rate than someone who earns his income from "financial assets"?
    The unconsious class bias here is astounding.

    ReplyDelete
  8. Hunh. Nobody seems to wonder what huge economic advantage is conferred on our Society by capital income (gains) that it deserves a preferential tax rate to encourage the wealthy to invest.

    Perhaps somebody can show me that our hugely leveraged society is actually badly short of private capital to invest in Groupon, Facebook et al. To these eyes, it seems like we desperately over-invest in private business, while desperately under-investing in social goods such as schools, transportation and civic institutions available to all.

    Problem solved! Let the aspiring young people contemplate putting a quarter million into an advanced medical or engineering or business degree, as an equal income opportunity to putting it as a down payment on an apartment building.

    And let the people WITHOUT a quarter million from their parents see that they get the same treatment for their labors as the silver-spoon set gets for their contributions/rewards.

    ReplyDelete