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Hedge Fund Tax Cheats?

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A few months ago we had the chance to ask one of our friends who works on Capitol Hill why lawmakers were so focused on hedge funds. For a group representing such a tiny segment of the economy, hedge funds certainly seem to be garnering outsized attention from senators and congressmen. How many hearings were held in the Capitol building last year about hedge funds? Why are lawmakers so fixated on rich guys in Greenwich?
“Because that’s where the money is,” the Capitol Hill staffer told us. Lawmakers understand that threatening to investigate or regulate hedge funds is an effective way to shake campaign donations out of hedge fund managers. Lobbyists understand this too. In fact, there’s an entire industry in our nation’s capital devoted to finding untapped markets of unpoliticized wealth and attempting to get the taps flowing by threatening them with politics. We’ve always believed that this activity of the politicos should be called “rent-seeking” but for some reason economists insist on using this term to describe something else altogether.
Today’s New York Times introduces another chapter in the history of political rent-seeking from hedge funds—threatening to end tax-deferral of hedge fund compensation.

A lot of the hedge fund managers earning the astronomical paychecks making headlines these days are able to postpone paying taxes on much of that income for 10 years or more.
The key to the hedge fund tax boon is that many managers of these lightly regulated private pools of capital have the ability to earn the bulk of their compensation offshore and invest it in their funds, where it grows tax-free.
“If you could compound your compensation tax-free, why wouldn’t you?” asked Stewart Massey, founding partner of Massey & Quick, a consulting firm.
Few people know the power of compounding better than hedge fund managers. Consider the following calculation done by Financial Engines, a financial advisory and portfolio management firm: A hedge fund manager makes $10 million in fees and defers it for five years, earning a return of 10 percent a year. When he pays taxes at the end, he walks away with $10.5 million. Another manager who makes the same $10 million pays his taxes immediately. He still earns 10 percent on what’s left, but over the same period he accumulates just $8.9 million.

And just in case you miss the message, Jenny Anderson drives it home. “This tax advantage is now coming under scrutiny in Washington, where Congress is looking for ways to reduce the budget deficit, to pay for the Iraq war and to help cover the exploding retirement and health care costs of aging baby boomers,” Anderson writes.
Got that? If you want to continue tax deferrals for hedge fund managers you must love budget deficits, hate our troops in Iraq and want to snuff out the old and the sick.
Managers Use Hedge Funds as Big I.R.A.’s [New York Times]