We investigate a game of delegated portfolio management such as hedge funds
featuring risk-neutrality, hidden types, and hidden actions. We show that capital gain tax
plays the decisive role in solving the incentive problem. We characterize the constrained
optimal fee scheme and capital gain tax rate; the fee after taxation must be linear and
affected by gains and losses in a low-powered and symmetric manner. We argue that
high income tax incentivizes managers to select this scheme voluntarily. The equity
stake suppresses the distortion caused by solvency. |