Should the US Congress end tax breaks for hedge funds?

No

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by Daniel Harper

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The prevailing attitude for some members in congress is that private-equity firms and hedge funds around the country are getting more than they deserve. They believe that these groups and partnerships are making unparalleled sums of money, resisting transparency and regulation, and taking part in questionable trading activities, all while at the same time getting preferential tax treatment. This is a complex financial issue, and can only be understood by looking at it from both sides. Currently, private equity groups and hedge funds pay a fifteen percent tax on "carried interest," which is a term for the cut of the profits received by the group's managers. These sums are taxed at the fifteen percent long-term capital gains rate, because the law treats the money more like investment income rather than regular wages. A current proposed house bill would deem these profits as ordinary income and tax them at rates as high as thirty-five percent, which is the current capital gains tax imposed on businesses. Many people, not only democratic Representatives and Senators, believe that this increased taxation is a leveling of the playing field, and good for our economy as well as the individual investor. The tax loophole has given private equity and hedge funds the ability to generate huge amounts of capital, which in turn generates large amounts of carried interest, and they are taxed twenty percent less than what others have to pay. This mainly has to do with the fact that these are partnerships, as opposed to corporations, and therefore they do not have to submit to the capital gains tax expected of legitimate businesses. Adding to this frustration is the issue that many of these private equity and hedge fund groups are, at the same time, over-leveraging themselves, losing investor's money, and taking part in questionable trading activities. Two highly publicized examples that have brought this debate to the forefront are, Amaranth, with the suspicion of their managers manipulating natural gas prices, and Bear Sterns, who have seen two of their hedge funds focused on the sub prime mortgage market become basically valueless. The methods and decisions of these groups and partnerships have come under intense scrutiny, especially from those who have lost a great deal of money because of these practices.
Although these seem like good reasons for congress to take action, the individuals currently in favor of the bill proposal need to make sure that they are acting in the best interest of our economy. After assessing the situation, it may be possible to see private equity and hedge funds in a better light. Not as greedy partnership looking out for self interest, but rather as an important reason behind the long term strength of U.S markets and overall economic growth. On the opposite end of the spectrum, many have stated that private equity and hedge funds help our overall economy and should not be taxed at the capital gains rate, considering their importance to the long term sustainability of the domestic markets. The first aspect that supporters of partnerships mention is that these groups provide an important function within the stock market by bringing increased liquidity. Through the large amounts of capital that they bring to the table, the market is able to better streamline the investment process, which allows the markets to grow.
But with liquidity brings the chance for possible volatility in the markets. Unfortunately, the common investor generally does not understand the complex methods that private equity and hedge funds implement, and therefore, is not able to keep up with the volatility that these groups bring to the stock market on a day to day basis. This speculation brings about resentment by those who are trying to make money in the short-term market. But more importantly, in the long-term, this increased liquidity adds to the overall growth of the market and an increased ability for individuals or institutions to invest. Anti-taxation advocates will also refer to the current state of our economy and the markets strength. They reason that the United States has, in general, done so well in the past can be due in part to our willingness to take risks. Venture capital firms, along with private equity and hedge funds, are much more prevalent in the United States than anywhere else in the world, which has helped strengthen the economy, i.e. in terms of innovation, as well as aiding in long term economic progress, and increasing the quality of American companies. A particular reasoning behind the belief that these groups help the economy can actually be found through the often criticized actions of short selling and private equity buyouts. Many believe that short selling ultimately leads to the weakening of the economy, because you are basically betting against the company and hoping that their stock price drops. This thought has led other countries, such as France, to ban short selling completely. Although short selling seems to the counterproductive, it is an important factor in the increase of economic and market strength. Hedge funds search for inherent flaws in companies and shed light on these weaknesses by shorting stock, publicizing the inefficient companies within the market. This is hard for investors of the company in the short term, but the usual outcome tends to be one of two things. Either the company reassesses its business and fixes its problems, or an outside party can propose a take over or buyout bid. Private equity groups buy out weak or underperforming companies, usually through leverage, in order to fix the flaws and attempt to develop them into a stronger business.
Those opposing the recent house bill paint it as a new "investment tax," with far reaching, negative implications for other industries, from real-estate and timber companies to oil and gas interests. The increased taxation will inevitably lead to a lower rate of return, which will affect many more people than just rich money managers. This belief that the proposed tax changes would reduce the value of investments by pension funds is worrying many who have a stake in these investments. Specific pension funds, such as the California Public Employees Retirement Systems and the California State Teachers Retirement System, have benefited, and would risk losing a large portion of return that they have grown accustomed to.
Even with the negative effects that private equity and hedge funds possess, such a large increase in taxation of carried interest income will lead to a decreased involvement in such ventures, which will hurt the economy that we are trying to strengthen. It is a common assumption that private equity and hedge funds seem to be functioning solely for their own personal gain, which is hard to deny in certain cases, but one needs to look at the bigger picture and see that these groups are performing an invaluable function within our economy, which needs to be respected. The only change that needs to come about from this issue is that partnerships may need to be monitored a bit closer, so as to make sure that nobody is partaking in fraudulent or illegal activities. But one needs to remember that the lack of transparency is a major reason why money managers are able to be so successful. This should be an evolutionary process, with stricter rules coming only if they are guaranteed to reduce questionable activities and help the markets grow stronger. If this thirty-five percent taxation is implemented, doing business in the United States will be less attractive, and our private equity and hedge fund groups will start moving their operations into places such as London, and will take a great deal of capital and liquidity with them. Leaving with the private equity and hedge funds will be the level of competition in the U.S market. If we lose the most complex and competitive aspects of our market system, we will not only lose the brightest financial minds that are currently heading these operations, but also will reduce the overall level of competitiveness that has been synonymous with the American markets. Without competition in all levels of investment, the overall strength and ability to move forward will fall dramatically. This will hurt our economy in the long term and reduce our dominance in an area of finance that is increasingly becoming more important as the world economy continues to grow.

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