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The Corner

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Re: Let’s Give Wall Street a 70 Percent Pay Raise



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Over at Exchequer, Kevin has a great post on the myth of the Buffett Rule. In particular, he discusses the possible effects of one of its more popular forms: removing the “carried interest” loophole which allows financial managers to pay capital gains taxes on much of their income, rather than ordinary income taxes. Money managers across many types of asset classes collect carried interest fees, but they are nothing compared to the share of their income, or the absolute dollar amount, that carried interest generates for hedge funds, private equity, and venture capital, the industries this law would primarily affect.

Kevin points out that, if such a law were passed, Wall Street fund managers would demand higher incomes to compensate for higher taxes, and “with skills that are in high demand, [they] can command that price in the marketplace.” So a tax increase on Wall Street would probably result in a pay increase, sapping money out of the rest of the economy (including, say, public pension funds) and sending it to Wall Street and Capitol Hill.

Assuming this would happen, the effects would be quite significant. If managers demanded higher incomes, this would come in the form of higher fees charged to their investors, in the form of management fees (most commonly 2 percent, of the invested assets) and carried interest (a significant slice, usually 20 percent, of the fund’s profits in a given year).

These fees are significantly more onerous, already, than those required in other asset classes. Some funds do charge even higher rates — Renaissance, an exceptionally profitable firm historically, supposedly charges an astonishing 5 percent of assets and 36 percent of profits. But questions already exist, especially prompted by performances over the last few years, about whether the current fee structures are fair — and whether the average hedge fund generates a return so superior to the markets or other assets that the client comes out ahead after fees.

If fees creep even higher, many institutions and high-net-worth individuals would likely shift money out of these asset classes, into others. Investors would not find equivalent absolute returns in other asset classes, but their net returns from hedge funds and PE would no longer be worthwhile either — so basically, good luck to CalPERS on getting that 8 percent annual return.

The final point is an alternate scenario: When the tax is enacted, managers do accept substantially lower net salaries, instead of sending capital fleeing from higher fees (as Kevin noted, from, say, $850,000 to $520,000). The top traders and bankers now flow unabatedly from investment banks to hedge funds and private equity (the Elysian “buy-side”), largely because one can make spectacular amounts of carried interest in a few bull years, and pay barely any taxes. If this tax treatment changes dramatically, at the margin, these top managers would then be substantially less interested in going to work for these firms, relative to other segments of the industry. Finally, especially after the financial crisis, those who do stay at large banks and rise to be executives make the vast majority of their salaries in stock options — so their largest gains, even though they are practically salary, would continue to be taxed as capital gains.

Neither of these effects would necessarily be a bad thing; some may argue they are good — but the fact remains that eliminating the carried-interest loophole, like any other government intervention in the economy, is not just free and easy revenue-raising. It would substantially alter the current financial order, and not necessarily improve or stabilize it.



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