Obama budget calls for higher taxes on hedge funds

Did you notice that power shift in Washington? When your party has a sizable majority in the House, almost sixty votes in the Senate, and a popular president whose electoral base is expanding, that tends to translate to political capital.

If they haven't noticed it yet, the alternative investment community will notice it Tuesday when President Obama announces his proposed fiscal 2010 budget. In it, Obama calls for taxing investment income of hedge funds at ordinary tax rates, which are now as high as 39.6%, instead of the capital gains rate, which is 15% at most, The New York Times reports. The administration also plans to increase tax rates for private equity partners, as well.

Ending a loop hole?

Opponents argue that substantially increasing the tax for a business segment will serve to contract the U.S. economy further, and that what's needed now is constant or lower tax rates to facilitate commerce.

Backers of the tax argue that the roughly $2 trillion hedge fund sector has served as a legal loop hole for upper income citizens. They say an adept, properly structured fund results in officers and others paying tax rates of 15% or less on compensation totaling hundreds of thousands of dollars -- and in some cases millions of dollars -- annually, whereas typical, middle-class and working-class citizens are taxed rates of 25%, 28% and 33%.

The Obama administration also plans to let the Bush administrations' tax cut on income, dividends, and capital gains lapse after 2010 for people earning more than $250,000 per year, The Times reports. The top rate for income would increase to 39.6%; the top rate for capital gains and dividends would be 20%.

Economic Analysis: The Obama administration will likely face opposition on the tax increase for hedge funds from moderate Democrats and, of course, from most Republicans. It remains to be seen whether the administration can cultivate a majority for this measure, but the view from here argues they will be able to do so, but just barely. Majority sentiment currently not only argues that current hedge fund regulations enable members to skirt paying taxes on millions of dollars of compensation, but also that hedge fund activity, along with private equity firms, siphoned-off capital from the productive economy in financial entities whose primary benefit was the lower tax rate.

Controlled, multi-variable studies may later demonstrate that the above is not entirely true, but in an economic climate currently characterized by constrained credit, with hedge funds and other private financial institutions unwilling to deploy much needed capital to re-liquefy the financial system, Congress will not look favorably on the lower tax rate for these institutions.
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