Rangelnomics
Head Taxwurst Maker Charles Rangel has put out the outlines of his plan to pay for Alternative Minimum Tax Relief on the backs of folks like me (video here if you can stand it).
This is terrible policy and it will have severe unintended consequences. Let's just begin to look at what the implications might be using a simplified hedge fund example, with two parties and one investment. You, the Limited Partner, give me, the General Partner, $1 million to invest at the beginning of the year. I setup 'Fund I' and I go out and purchase 20,000 shares of XYZ stock at $50 a share. Now imagine that XYZ's share price doubles (by virtue of my intense lobbying of XYZ's CEO to adopt a new, brilliant business strategy) by the end of the year. I have earned you $1 million on top of your original investment and thus, you owe me 20% of that amount in incentive fees, or $200,000. But I don't get that in cash. I get 20% of our little fund's "interests" assigned over to me from you. So now you own 80% of Fund I and I own 20%, which, based on the underlying assets of 20,000 shares of XYZ priced at $100 a share, means you own 18,000 shares and I own 2,000. My 2,000 shares have a cost basis of $100,000 and I am sitting on $100,000 of unrealized capital gains. The way it works now is that I am not taxed on that unrealized gain until I sell the stock and realize the gain. After all, the stock could tank just as readily as it rose and my gains could evaporate. Not just the gain could evaporate, but the stock could go to zero and my $100,000 cost basis could vanish too. According to Rangelnomics, however, I am exploiting a loophole by avoiding a tax - I've earned $200,000 and am keeping from the government what it is owed, which would be 37.9%, or $75,800. I don't have that kinda cash lying around, so I have to sell some stock to pay the tax, but let's ignore that for now. So I pay my Rangelnomics tax, but now if that stock goes down, my effective tax rate zooms higher. If the stock declines to $75 a share, I've paid a tax rate of 51% ($75,800 on assets now worth $150,000). If the stock goes back to $50, where I bought it, my tax rate is 76% ($75,800 paid on assets now worth $100,000). If the stock does a Worldcom and goes to zero, my tax rate is, well, infinite. So what the hell do you think I am gonna do? I'm not insane, I'm going to sell my damn 2,000 shares, which I actually can't do; technically I have to liquidate my interests in Fund I, which completely severes the link between your interests and my interests. You, as my investor, probably want me to have skin in the game, to eat my own cooking, so that our interests are completely aligned so I'll do a better job for you. Well, under Rangelnomics I have to expose myself to exorbitant, even infinite, rates of taxation to maintain that alignment of interests. I might not go for it in which case you might not want to invest with me. One of us has to take a big risk, either you accepting a degraded investment vehicle, without that tight link between your interests and my interests, or me having to except exposure to exorbitant tax rates. Now multiply this example by hundreds of billions of dollars and thousands of mes and yous. Barring a clever workaround, which will come at the price of enormous legal bills, a highly popular and effective asset management arrangement will be all but destroyed. In addition, many talented managers will simply leave the business and manage their own personal wealth. If you've got $10 or $50 or $500 million you don't need to work, you especially don't need to work in order to potentially give Charlie Rangel 75% of the fruits of your toil. The impact is going to be enormous. Capital markets' efficiency will decline by orders of magnitude. In the annals of dumb tax policy moves, Rangelnomics could just take the prize of dumbest.
This is terrible policy and it will have severe unintended consequences. Let's just begin to look at what the implications might be using a simplified hedge fund example, with two parties and one investment. You, the Limited Partner, give me, the General Partner, $1 million to invest at the beginning of the year. I setup 'Fund I' and I go out and purchase 20,000 shares of XYZ stock at $50 a share. Now imagine that XYZ's share price doubles (by virtue of my intense lobbying of XYZ's CEO to adopt a new, brilliant business strategy) by the end of the year. I have earned you $1 million on top of your original investment and thus, you owe me 20% of that amount in incentive fees, or $200,000. But I don't get that in cash. I get 20% of our little fund's "interests" assigned over to me from you. So now you own 80% of Fund I and I own 20%, which, based on the underlying assets of 20,000 shares of XYZ priced at $100 a share, means you own 18,000 shares and I own 2,000. My 2,000 shares have a cost basis of $100,000 and I am sitting on $100,000 of unrealized capital gains. The way it works now is that I am not taxed on that unrealized gain until I sell the stock and realize the gain. After all, the stock could tank just as readily as it rose and my gains could evaporate. Not just the gain could evaporate, but the stock could go to zero and my $100,000 cost basis could vanish too. According to Rangelnomics, however, I am exploiting a loophole by avoiding a tax - I've earned $200,000 and am keeping from the government what it is owed, which would be 37.9%, or $75,800. I don't have that kinda cash lying around, so I have to sell some stock to pay the tax, but let's ignore that for now. So I pay my Rangelnomics tax, but now if that stock goes down, my effective tax rate zooms higher. If the stock declines to $75 a share, I've paid a tax rate of 51% ($75,800 on assets now worth $150,000). If the stock goes back to $50, where I bought it, my tax rate is 76% ($75,800 paid on assets now worth $100,000). If the stock does a Worldcom and goes to zero, my tax rate is, well, infinite. So what the hell do you think I am gonna do? I'm not insane, I'm going to sell my damn 2,000 shares, which I actually can't do; technically I have to liquidate my interests in Fund I, which completely severes the link between your interests and my interests. You, as my investor, probably want me to have skin in the game, to eat my own cooking, so that our interests are completely aligned so I'll do a better job for you. Well, under Rangelnomics I have to expose myself to exorbitant, even infinite, rates of taxation to maintain that alignment of interests. I might not go for it in which case you might not want to invest with me. One of us has to take a big risk, either you accepting a degraded investment vehicle, without that tight link between your interests and my interests, or me having to except exposure to exorbitant tax rates. Now multiply this example by hundreds of billions of dollars and thousands of mes and yous. Barring a clever workaround, which will come at the price of enormous legal bills, a highly popular and effective asset management arrangement will be all but destroyed. In addition, many talented managers will simply leave the business and manage their own personal wealth. If you've got $10 or $50 or $500 million you don't need to work, you especially don't need to work in order to potentially give Charlie Rangel 75% of the fruits of your toil. The impact is going to be enormous. Capital markets' efficiency will decline by orders of magnitude. In the annals of dumb tax policy moves, Rangelnomics could just take the prize of dumbest.
posted by Donny Baseball at 11:16 AM
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