Here’s a simple criterion to determine whether managers are earning income or investment returns: If you own an asset (and are eligible to pay cap gains taxes on it), you must have symmetrical exposure to the downside and the upside. If hedge fundies want to take that risk they can do so–they are, in that circumstance, providing the socially valuable service of risk-taking and investment, and we encourage that with a lower tax rate. If your management contract only says you get X% of investment gains, though, that’s ordinary income and you get to pay the full tax rate on it.
It seems like the issue should be more complicated than this. Am I missing something, or is this a reasonable framework?
Note: If you insure against losses, I’m inclined to think that insurance payment ought to be taxed as ordinary income. That might end up being incredibly hard to do in practice, though, and I’m really not certain how to deal with risk mitigation in general.