The Social Function of Corporate Takeovers

Posted: Aug 04, 2007 12:00 AM

One of the latest gripes against “evil” corporations and big business concerns the tax rate applied to general partners of private equity and hedge funds. In a campaign statement, Hillary Clinton opined:

It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income…As president I will reform our tax code to ensure that the carried interest earned by some multimillionaire Wall Street managers is recognized for what it is: ordinary income that should be taxed at ordinary income tax rates. Clinton’s statement raises both an interesting philosophical question, and a far more important economic one. First the philosophical question: Is the “carried interest” on a private equity (or hedge fund) deal a capital gain or regular income? It turns out that this question (like many deep philosophical ones) may not have a good answer. So-called carried interest refers to the percentage (generally around 20-25%) of net profit that the general partners retain from a fund’s earnings. For example, if a hedge fund’s investment in a project yields a net $100 million, the general partners might retain $20 million in carried interest and distribute the other $80 million to the limited partners.

So, the general partners are definitely $20 million richer, at least before taxes. Now the question is whether this increase in wealth is a capital gain or income for services. If the former, it will be taxed at 15%. If the latter, it will be taxed at the highest bracket, currently 35%. Obviously this apparently philosophical issue has serious ramifications, and provides a great opportunity for Democratic class warfare rhetoric.

As I hinted above, there really isn’t a crisp answer to this question, for the simple reason that in a market economy, successful speculators buy low and sell high (i.e. earn a capital gain), and in so doing provide a real service. Consequently, we can’t say whether the income of hedge fund or private equity partners is “really” a capital gain or “really” normal income. It’s both, and the tax code’s arbitrary attempt to distinguish between the two doesn’t mesh with economic reality. For an analogy, the classical economists of the early 1800s used to think that rent was a special type of income earned by landowners, whereas modern economics understands that rent is a much broader concept, as any tuxedo shop owner can attest.

How exactly do financial speculators provide a service, not only to their investors but the general public? To understand, we must first realize that market prices serve a definite purpose. It really means something that (as of this writing) an ounce of gold is $677 while an ounce of silver is only $13. Because of the relative supplies and desires of human beings for their possible applications, it just so happens that gold is much scarcer and so commands a far higher price in the market. If market participants couldn’t rely on the “signals” provided by commodity and other prices, the economy wouldn’t function nearly as smoothly as it does. Gold would be channeled into uses that were far too unimportant (given its scarcity) while silver might be needlessly hoarded.

Yet a similar principle holds for the price of a company, or the price of a share of publicly traded stock. Contrary to the views of socialists, the frenzied trading in New York, London, and other financial centers every day really accomplishes something. Those speculators are trying to anticipate the future, as reflected in the earnings and other performance characteristics of firms. Successful hedge funds and private equity firms are precisely those that notice mistakes in the appraisement of other experts—and that’s why they swoop in to buy up the “cheap” companies and resell them later at a significant gain.

In a market economy, we don’t have government “experts” planning our various industries, making investment, production, and personnel decisions. No, we have a decentralized system where anyone with the requisite savings (or financial backers) can start a business and try to please customers better than the competition. But the system only works if the numbers behind it—i.e. the market prices—are the right ones.

Private equity and hedge funds contribute to the success of the economy by correcting mistakes in the prices of major companies. However we want to define their earnings (i.e. the philosophical question), the economic issue is clear: If we raise the effective tax rates on these funds, it will only discourage their socially beneficial behavior. If the status quo is considered “unfair,” then by all means let’s cut income tax rates down to 15%!