Taxing Hedge Funds

Congress, tempting by Victor Fleischer's argument, is considering taxing the "carry" of hedge funds at ordinary income tax rates.  Hedge funds create investment pools and take 20% of the returns, if any, as compensation for their management duties.  Investors willing agree because their 80% return for a 100% investment still often shows a total return of 20% or more. 

The tax proposal is a mistake, of course, because it is not based on a general principle that makes economic sense.   There are numerous reasons to do it that do not make economic sense:  1) We should tax anyone who make large amounts of money fast at higher rates just because they are making boatloads of money or 2) We should threaten to tax those who make money and do not contribute to political campaigns to get political cover to induce them to ante up (ask Bill Gates about this).  Reason 1) is pure economic redistribution, a discretionary progressive tax system, and 2) is political extortion.

Partnerships in everything from local laundries to complex multi-national ventures have long had two types of investors, Moneybags (a passive investor who puts up the cash for a portion of the profits) and Operator (who invests labor and no cash and takes no salary but takes a portion of the profits).  Both Moneybags and Operator are taxed the same on the profits; if the profits are ordinary income both pay income tax -- if the profits are capital gains (long or short), both pay capital gains tax.  Fleischer would have the partners taxed differently on capital investments.  Operator would pay income tax and Moneybags would pay a capital gains tax. There is no theory to support this: Operator is investing foregone salary but the returns are not in any sense salary, they are speculative returns based on an investment of the foregone salary. The best one could do is tax the estimated foregone salary at ordinary income rates perhaps, and deduct it as return of capital before the capital gains rate is applied to the rest of the profits, but this is administratively difficult for little gain.  The investment return of the Operator is not salary in any traditional sense.