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August 10, 2007

the ethics of taxing hedge funds

The debate about taxes for hedge fund managers is an opportunity to consider the rationale for taxing various kinds of income at different rates. The narrow issue is that hedge fund managers pay capital gains taxes instead of income taxes on their earnings, even though their livelihood comes from managing other people's investments. The broader issue is that we tax income, capital gains, consumption, property, and various imports at different rates. I'm inclined to say:

1. The degree to which we deserve the money we make and spend varies enormously, depending on risk, effort, and especially the public impact of what we do. You can work hard producing a product that is bad for other people's security or health (or for nature), and in that case, I hardly think you "deserve" your income--in the moral sense of desert. Or you can sit back and accrue interest on your trust fund, in which case I am unmoved by your claim to deserve what you have. However ...

2. It's problematic for the government to tax at different rates depending on the moral value of people's work. I don't deny that moral distinctions can be made, but can we trust the legislature to make them? Can Congress manage to make distinctions across the whole of a modern economy, without lumping behavior into crude categories? And do we want the government to collect all the information it would need to make really wise judgments?

At best, Congress would have to review all kinds of private behavior and readjust taxation constantly. In fact, that's what it does, and the result is a tax code that hardly fits in one bookcase and that shifts every year. As Hamilton wrote in Federalist 62, "a mutable policy ... poisons the blessing of liberty itself. It will be of little avail to the people, that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man, who knows what the law is to-day, can guess what it will be to-morrow. Law is defined to be a rule of action; but how can that be a rule, which is little known, and less fixed?" Hamilton understood the kind of "liberty" that Friedrich von Hayek championed--the ability to plan without having to guess what some other power will do. For Hayek, the rate of taxation was not as important as its stability and transparency--and he had a point.

3. But the government needs money. In fact, it needs more money than it collects. It's a terrible waste to borrow almost $9 trillion, on which we must pay $400 billion in annual interest. It is immoral to pass that debt to our kids. No one really argues that we can cut federal spending deeply enough to close the annual deficit, let alone pay off the debt. And society would work better if the government actually picked up an additional expense (paid by our taxes): universal health insurance. Even if you disagree with the last point, you pretty much have to concede that the government needs somewhere in the neighborhood of $2.5 trillion per year to operate.

3. If the government needs money, it ought to take it from the people who will miss it least. Losing one dollar matters a lot more to someone who lives on the minimum wage than it does to a hedge fund manager.

Thus I'm for raising taxes on hedge fund managers. There's an argument that we ought to "incentivize" risk-taking, but I suspect that managing a hedge-fund would be adequately rewarding even if the effective tax rate were 15 percentage points higher. As for the argument that risk-taking is virtuous, I think that's quite beside the point. Any urban public school teacher exhibits a lot more courage than a hedge fund manager, but we don't and can't tax income in proportion to personal virtue.

A better system would actually tax wealth (not annual income) at one smoothly graduated rate, regardless of the source. That's the fairest way to raise funds, given the declining marginal utility of money. But I'm not sure how we could measure accumulated wealth well enough to tax it.

August 10, 2007 12:50 PM | category: none


You make several good points, but I think that you've only touched on the multifaceted discussion of ethics of taxes. For example, fairness: people who have similar situations should be taxed similary. Similarly, you've over-simplified the trust fund issue by ignoring the property rights of the parents.

But the bigger issue you've overlooked is incentives. In other words, rewarding certain kinds of investments grows the economy without necessarily harming others (and in fact, perhaps helping others).

In the final analysis, I share your conclusion that fees from hedge funds should be taxed as ordinary income. But my opinion is based on a simpler analyses of the law: you should only be able to claim capital gains when you have your own actual capital at risk.

A last note: I can't remember where I saw it, but many funds will be able to restructure themselves to avoid any legal efforts to close the loophole with derivatives.


August 10, 2007 6:00 PM | Comments (3) | posted by Michael Weiksner

If you can cut someone's taxes without harming anyone else, it sounds like you should do it. That's a "Pareto improvement." In fact, I'd settle for something less than a Pareto improvement: any big tax cut that reduces the government's revenue by only a little sounds wise. It's also be a good deal for society whenever a tax cut efficiently enhances a public good, such as clean energy.

This, however, is the problem. A Congress that can tinker with the tax code to create incentives for specific economic behavior can also tinker with the tax code to benefit well organized special interests. Or it can act with good intentions but bad information, especially bad information about the future. Meanwhile, the very fact that Congress tinkers makes it harder for everyone to plan, which is surely bad for market efficiency as well as personal liberty. Thus I think we should bind Congress to impose very simple taxes and let the market create all the incentives. This may not be the most efficient tax code, but I think it's the most efficient possible code.

August 10, 2007 6:25 PM | Comments (3) | posted by Peter Levine

In other words, rewarding certain kinds of investments grows the economy without necessarily harming others (and in fact, perhaps helping others).

Hedge funds take many forms, but it's not clear that they are the sorts of businesses whose transactions really benefit the economy as a whole. Their only common denominator is their leveraging behavior and their freedom from oversight, which is a combination that has not served US financial markets well in the past. Since they operate in secret and attempt to manipulate markets, there is good reason to believe that much of their profit is derived in a way that often directly expropriates funds in a manner analogous to insider trading or fraud. Following the LTCM debacle, it's clear that they pose significant systemic risks, yet it remains to be seen whether they offer a comparable improvement in the efficiency of markets.

Risk-seeking may not be the wisest mood for funds managing such large accumulations of capital, because they swing the market too far out of true in search of a repricing advantage. In Peter's terms, they may be reducing both Kaldor-Hicks and Pareto optimality.

August 11, 2007 10:40 AM | Comments (3) | posted by anotherpanacea

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