Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation

37 Pages Posted: 15 Jan 2008 Last revised: 25 Nov 2008

Karl Okamoto

Drexel University College of Law

Thomas J. Brennan

Harvard Law School

Date Written: February 26, 2008

Abstract

A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Keywords: private equity, hedge funds, carried interest, carry, performance fee, equity-based compensation, tax, taxation, deferral

JEL Classification: H2, H25, D2, D3, D6

Suggested Citation

Okamoto, Karl and Brennan, Thomas J., Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation (February 26, 2008). Drexel College of Law Research Paper No. 2008-W-01. Available at SSRN: https://ssrn.com/abstract=1082943 or http://dx.doi.org/10.2139/ssrn.1082943

Karl Okamoto (Contact Author)

Drexel University College of Law ( email )

Thomas J. Brennan

Harvard Law School ( email )

1557 Massachusetts Ave
6 Ever
Cambridge, MA 02138
United States
617-495-3141 (Phone)

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