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Why Barack Obama’s Hedge Fund Tax Hike Won’t Work

CNBC: Barack Obama’s plans to reduce the budget deficit by raising taxes on hedge fund managers show that he’s more interested in political theater than responsibly dealing with the budget.

When Obama says he wants to end the “tax break” for hedge funds, what he presumably means is he would tax what’s known as carried interest as ordinary income. Currently, it is taxed at the lower capital gains rate.

But the only comprehensive study to look at proposals to tax carried interest as ordinary income found the change would generate very, very little revenue. In fact, because hedge fund managers would change the way they get paid it would likely generate almost no revenue at all.

Before you get all outraged about this, it’s important to understand why it is so easy for hedge fund managers to avoid having carried interest taxed as ordinary income. The reason is this: Carried interest isn’t ordinary income. It’s a capital gain.

Let’s use an example to illustrate this point. Suppose NetNet staffer Cadie Thompson decides she’s learned enough about markets to become an investment advisor. She tells me that she will invest $1 million of my money for a low 2 percent management fee.

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