As a presidential candidate, Donald Trump lambasted hedge-fund managers for paying too little in taxes.
GOP lawmakers have suggested that reducing taxes on exports would help Americans in industries that sell goods overseas, such as farmers growing soybeans in the Midwest or workers building airplanes in Seattle.
Hedge funds happen to be one of America's major export industries. Many clients of U.S. hedge funds are wealthy investors from overseas, who pay fees to the Americans managing their money. In essence, those hedge-fund managers are exporting their services to foreign clients.
Trump has not said whether he will endorse the Republican lawmakers' proposal.
Barclay Hedge, a private research firm in Fairfield, Iowa, estimates that foreigners have roughly $1 trillion invested in U.S. hedge funds. That is about a third of the money managed by the sector.
Under the GOP plan, the fees those foreigners pay their managers would be exempt from taxation. Steven M. Rosenthal, an attorney at the nonpartisan Tax Policy Center in Washington, called the proposal “a windfall” for hedge-fund managers.
“That would be a better deal than they have today,” he said.
Indeed, hedge-fund managers are already getting a great deal. In the current system, most of them receive a flat fee equivalent to 2 percent of all the funds they are managing, plus 20 percent of any profits they earn for their clients. That 20 percent, known as “carried interest,” is taxed at the reduced rate for capital gains, which applies to earnings on investments.
During the campaign, Trump said he would put an end to this practice.
“One thing I'd do is get rid of carried interest,” Trump said in a debate with former Democratic presidential nominee Hillary Clinton in October.
The GOP tax plan, on the other hand, would offer hedge-fund managers more tax relief. Under that proposal, rather than paying the reduced capital-gains tax on their carried interest, they would not pay any taxes on their income from foreign clients. Instead, they could claim all of their income from foreign customers as fees, making their services tax-free exports, Rosenthal said.
Republicans might argue that it would be fair for hedge-fund managers not to pay any taxes on services rendered to foreign clients. Under the GOP plan, other Americans who sell products or services abroad will not pay taxes, either.
“If your product or service is consumed in the United States, it is taxed equally,” Rep. Kevin Brady (R-Tex.), the chairman of the Ways and Means Committee in the House, told the U.S. Chamber of Commerce last week in explaining his colleagues' plan.
“In tandem, if your product, service, or intellectual property is developed here and sold abroad, then your made-in-America export will no longer be subject to U.S. tax,” Brady continued. He did not discuss hedge funds specifically.
Opponents argue that this system would let exporters off the hook.
Reuven Avi-Yonah, a legal scholar at the University of Michigan, points out that hedge-fund managers send their children to American schools, take American trains to work every day and rely on U.S. courts to enforce their contracts. In turn, he said, they should pay taxes to fund those public services.
He pointed out that under the plan, “you can be an individual making hundreds of millions of dollars by exporting your services,” without paying U.S. taxes on any of that income, if all of your clients live abroad.
It is also likely that fluctuations in global currency markets will eat up some, if not all, of the benefits Brady promised for hedge-fund managers and other exporters.
Along with the break for exports, the GOP plan includes a tax on imports. This combination is common in foreign countries.
When other countries have implemented similar policies in the past, those countries have often recorded rapid inflation, said Caroline Freund, an economist at the Peterson Institute for International Economics in Washington. Companies charged their customers more to account for the fact that goods from abroad became nominally more expensive due to the tax on imports.
If prices in the United States followed a similar pattern, those fees from foreign investors would be less valuable in real terms for the American managers receiving them. They would not pay taxes, but they would bear the burden of inflation.
Inflation might not cancel out the tax break entirely, though, and in any case, prices will not adjust right away.
“It's just going to take some time. I think that the adjustment period could be messier,” Freund said. Those hedge-fund guys will come out ahead in the meantime.