The Agenda

Thoughts on the Financial Sector and Inequality

I’m a fan of Sebastian Mallaby. Matt Yglesias has poked fun at his writing on hedge funds, which I’ve found enormously instructive and entertaining:

Sebastian Mallaby continues to show he’s the smartest man in journalism through his consistent focus on defending the interests of the richest people on earth.

And in another post Matt writes:

If reducing high-end inequality means implementing regulations that make the very richest hedge fund managers less rich to the benefit of lesser managers of financial assets then that doesn’t seem like a particularly important goal. By contrast, if what’s happening is that finance types are getting rich off a badly flawed regulatory scheme that leaves the world economy vulnerable to catastrophic crashes and panics then that’s a problem all on its own completely apart from the impact on inequality. Last, taxes. These hedge fund and private equity guys are paying a lower marginal tax rate on their income than you or me or a teacher—that’s outrageous.

Let’s break this up into pieces:

(1) I agree with Matt on the first sentence.

(2) And as for the second sentence, it is important to note that hedge funds appear to be part of the solution rather than part of the problem, as Mallaby has explained in More Money Than God. There’s more, but here’s part of the story:

“When [bank] traders take enormous risks, they earn fortunes if the bets pay off. But if the bets go wrong, they don’t endure symmetrical punishment—the performance fees and bonuses dry up, but they do not go negative….Hedge funds [on the other hand] tend to have ‘high-water marks’: If they lose money one year, they take reduced or even no performance fees until they earn back their losses.” Additionally, most hedge fund managers invest in their own funds—a powerful incentive to avoid losses. By contrast, while bank traders often own company stock, they do not risk their personal savings in the pools of money they manage. Mallaby concludes that consequently the typical hedge fund is more cautious in its use of leverage: the average hedge fund borrows only one or two times its investors’ capital, and those that are considered highly leveraged generally borrow less than ten times, while broker-dealers such as Goldman Sachs or Lehman Brothers were leveraged thirty to one before the crisis, and banks like Citi were even higher by some measures.

(3) The carried interest issue is complicated, as Jim Manzi explained to me back in 2007. 

 

“Sweat equity” is basically any ownership that I am granted in the business over and above what I get in return for my pro rata contribution of tangible capital because of my contribution to creating and/or building the business. This sweat equity can be provided in multiple formats, for example Founder’s Equity or options in a C-Corp. “Carried Interest” in a hedge fund has a very similar economic structure to options in a corporation. Similar corporation or partnership structures are used for pretty much every small business and professional partnership in the US. They all have investors and have the ability to sell the ownership of the business for more than was invested, thereby creating a profit to the owners that will be taxed at some rate.

Unless I’m missing something, all I have to do is re-label my “hedge fund” as something else and I force the government to either convert the tax treatment from capital gains to ordinary income for anybody with sweat equity in this kind of vehicle, or let me get capital gains tax treatment on my “carried interest”, which has now simply been re-labeled as Founder’s Equity, option value or something else. At that point, how would you distinguish between a hedge fund and any business?

And outlawing sweat equity would have enormous consequences for many people who don’t run hedge funds:

 

The net effect of such a law would therefore not be to take a bite out of hedge fund managers, but either be: (i) to make the same guys doing pretty much the same activities pay a little more money to lawyers and adopt less efficient vehicles for investments, or, ultimately, (ii) to treat all equity gains not linked pro rata to a cash investment as ordinary income – that is, to outlaw sweat equity.

Now, you might say “great, I consider all of this payment for labor, so it should be taxed at the same rate”, but if so recognize that you wouldn’t just be reducing the income of a few hundred billionaires – you’d be substantially reducing the profit available to the owners upon sale of any business.I suspect that the impact this would have on the owner of pretty much every dry cleaner, deli, car dealership, McDonald’s franchise and professional partnership in America might account for reluctance of Republicans to take this on.

 

This seems like a serious objection. 

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