Governor David Paterson and the Democratic leaders of the New York State Legislature have agreed to impose $50 million in new taxes on non-resident partners in New York-based hedge funds.

Here’s how the provision is described in the memo accompanying the governor’s revenue bill:

Non-Resident Hedge Fund Manager Carried Interest
This bill would tax the income a partner (whether a corporation or an individual) receives for the performance of investment management services they provide to a partnership hedge fund, but not tax income earned on funds invested by the service partner. Therefore, it would equalize the tax treatment of income from such services whether the partner is a New York resident or nonresident.

The complete language of the new tax provision can be found on pp. 250-256 of the governor’s proposed bill. Matching language is in the Legislature’s version of the revenue bill.

In effect, this is New York’s answer to the ongoing congressional debate over taxation of carried interest. On the federal level, it’s a much bigger deal for affected funds, because carried interest is currently treated as a capital gain and taxed at a substantially lower rate than normal labor income.  New York taxes all income at the same rate; however, nonresidents who work in New York are taxed only on labor income they earn in the state, and not on capital gains.  Non-resident hedge fund partners don’t get off scot free, though: they still are taxed by their state of residence.

Our Manhattan Institute colleague Josh Barro observes:

Maybe I’m misinterpreting, but (the New York bill language) is essentially saying that carried interest payments are labor income, not investment income … So, a hedge fund manager who lives in CT and works in NY would pay NY tax on that income, just as an investment bank managing director who lives in CT and works in NY pays NY tax on his income.

I’m not sure this would even have significant economic effects, since most of these non-resident taxpayers likely reside in NJ and CT, where they are currently paying tax on this income. Our top rate is the same as NJ’s, so for NJ residents this is just a money grab from NJ coffers with no net impact on the taxpayer.  CT residents (subject to 6.5% state income tax) would pay about 2.47% more at the margin– though if (last year’s) NYS income tax increase actually sunsets, that gap would shrink to 0.35%.  And NY would also get a significant revenue grab from CT.

Hmm.  Who’s going to break this news to Governors Christie and Rell?