Earlier this month, Jeb Bush rolled out a $3.4 trillion tax cut plan that would bestow over 50 percent of its largess on the richest one percent of the population. And yet he got large segments of the press to cover it as a significant break with Republican orthodoxy or even a "populist" initiative through the cute gimmick of including a crackdown on a particular tax loophole beloved by hedge fund and private equity managers. Except when Matt O'Brien sat down to actually run the numbers, he found that most hedge fund managers would get a tax cut from Bush.
That's because Bush's plan, in the aggregate, is a very large tax cut and a very large share of the cuts go to rich people and most hedge fund managers are pretty rich. Consequently, if you're a rich hedge fund manager, Jeb's probably got your back. It's just that with a perfect Bushian twist, it's only a tax cut if you aren't very good at your job — which it turns out most hedge fund managers aren't.
The basic story is that hedge fund managers derive income through two different channels. Bush would raise taxes on one of those channels, but cut taxes on the other. Whether you benefit on net depends on the balance of the two channels in your particular income. And most hedgies come out ahead under Bush.
Yet he's earned headlines like:
- "Jeb Bush’s Populist Tack on Taxes Finds Echoes in Unlikely Sources" (New York Times)
- "Hedge fund tax hike: Jeb Bush, Donald Trump climb aboard" (NJ.com)
- "Jeb Bush, Donald Trump find common ground in taxing hedge fund managers" (CNN)
- "Jeb Bush Follows Trump On Ending Wall Street Tax Break" (Huffington Post)
Carried interest, explained
A standard private equity or hedge fund has a compensation structure governed by the principle of 2-and-20. You earn a management fee of 2 percent of the total value of the fund, and you also earn 20 percent of the investment profits. That management fee is taxes like regular income (at a current top rate of 39.6 percent) but the profit share is taxed at the capital gains rate (at a current top rate of 23 percent).
Back in the 16th Century, the profits of trading ventures to Asia were split between investors who earned a "capital interest" in the voyage and the captain and his key officers who earned a "carry interest" for doing the work. Through a little linguistic drift, the 20 percent profit share for fund managers has come to be known as carried interest based on analogy to the ship captains of yore. But this carried interest isn't just a fun a piece of nautical history, it's also a valuable loophole because it's taxed at the lower rate used for investment income rather than the higher rate earned for labor income.
The policy rationale for taxing investment income at a preferential rate is to encourage people to save a larger share of their income, thus boosting investment activity throughout the economy. But clearly taxing hedge fund managers at a preferential rate doesn't encourage any kind of savings. That's why there's fairly widespread policy agreement that it would be desirable to close this loophole, though of course there is interest group lobbying to keep it place and a lot of room for disagreement about what to do with the money you could raise.
Bush plans to close the loophole as part of a larger package of tax reform that, in the aggregate, would increase the deficit by $3.4 trillion.
Jeb Bush delivers a huge tax cut on the 2, while hiking taxes on the 20
So Bush, by closing the carried interest loophole, would raise taxes on profit sharing but cut taxes on the management fee.
That said, he's not talking about raising taxes on the profit share all the way up to the current top rate of 39.6 percent because he'd be cutting the top rate down to 28 percent.
By the same token, he'd also be slashing the tax rate paid on the management fee from the current top marginal rate of 39.6 percent down to 28 percent.
So whether a given hedge fund manager wins or loses under Jeb comes down to how valuable his management fee is versus how valuable is his profit share. In other words, it has to do with how high a rate of return you provide your investors. If your fund does great, Jeb is raising your taxes. But if your fund does not-so-great, Jeb is cutting your taxes. Specifically, O'Brien ran the numbers and finds that "if they had less than a 27.6 percent return, they would save more on their taxes on management fees than they would pay more on their taxes on performance fees."
So what return did the average hedge fund get last year? 7.4 percent, meaning the typical manager is in for a big tax cut.
The dirty secrets of the hedge fund industry are that most hedge funds don't hedge and most hedge funds provide worse returns than the stock market. For a handful of super-elite (or super-lucky) hedge fund managers, Bush is delivering a tax hike. But for the rich-but-totally-mediocre majority, Bush is providing a tax cut. The idea that people who are very rich but also not good at their jobs need a financial boost is a little bit strange, but anyone who's watched Jeb struggle to convert his family legacy, a massive fundraising advantage, and the lion's share of early endorsements into a viable presidential campaign can see why he might be sympathetic to the idea.