Analyzing the Venture Capital Tax Debate: Fairness, Impact, and Consequences

July 23, 2012 by

President Obama’s 2013 budget once again contains a provision for raising taxes on the profits venture capitalists earn on their investments.

The thinking behind the provision goes like this: Venture capitalists make a lot of money, so it’s only fair that they should pay more in taxes. And because they dedicate their time to investing in, working with, and ultimately realizing the value of their portfolio companies, their income should be taxed at the same rates as wages, rather than capital gains.

It’s a simple argument that, on the surface, seems to make sense. The problem is that the logic is incomplete. Until we fully understand the implications of the current venture capital tax proposals, we risk unleashing some unintended and, frankly, undesirable consequences for everyone.

This is not a commentary on the appropriate levels of government spending or overall tax policy. It’s a simple request that, before implementing any tax policy changes, we analyze the potential impacts should such a policy be put in place. Would the results be better for society than the ones our current tax policy generates?

Widespread economic benefits

Venture capitalists invest equity into companies to help them create new technologies, products, and services; employ and train people; and grow the economy. The capital can be used to hire staff and outside professional services firms, lease real estate, or purchase furniture and equipment. These investments are usually quite risky for the venture capital funds that make them, but sometimes yield considerable financial returns and frequently lead to significant advances in innovation and competitiveness.

Compared to the “shovel-ready” capital investments that the government tends to make, venture capital is far more effective at stimulating the economy. Venture capital investments don’t cost the government anything, yet still generate revenue for it.

Importantly, they help create permanent jobs and stimulate economic growth over the long term, rather than simply creating a short-term spike. For example, according to a 2011 report by the National Venture Capital Association, in 2010, venture capital-backed companies accounted for 11 percent of private sector employment (nearly 12 million people). The report also found that every dollar of venture capital invested between 1970 and 2010 helped to generate $6.27 in revenue in 2010.

Questioning the Logic

Before we change policies, let’s be sure that we thoroughly understand how the current proposals will ripple through the venture capital and entrepreneurial sectors, and what their actual long-term impact will be on tax revenues.

Here are some of the fundamental questions that should be answered before making any changes, as well as some insights I’ve gathered throughout my 12 years as a venture capitalist:

How important is investing in growth companies for the economy and for tax revenue?

I’ve learned a few things about the benefits of private equity investments, and job creation is one of the great examples. Approximately 60 to 70 percent of the money venture capitalists pump into companies is used to hire and train employees, typically for positions that pay significantly more than the average job. These workers generate payroll taxes as well as non-discretionary and discretionary spending (think new homes and cars, or just more meals out). Employers also pay taxes on their companies’ overall income and capital gains. Altogether, we’re talking about a significant source of long-term economic stimulus.

Successful companies also bring innovation and competitiveness to our economy. You don’t have to look any further than Facebook, Google, or Apple for examples of venture capital-backed companies that have helped reshape the face of our economy.

Will lower net compensation for venture capitalists lead to less venture capital activity or reduced quality?

Anyone who has sat through freshman economics knows that financial incentives change behavior. Earning a lower net income could push some venture capitalists to retire, change careers, or worse, never enter the sector in the first place. While most experienced venture capitalists love what they do, myself included, the movement of people in and out of the industry is relatively fluid. Change the tax policy and there almost certainly will be fewer venture capitalists and less venture capital activity.

What effect would less venture capital activity have on the economy?

This is one of the most important questions to be studied because there would likely be significant downstream effects should venture capital activity diminish. Fewer venture capital investments would mean less funding for growth companies. That, in turn, would translate into fewer jobs, less innovation, and a decrease in our overall competitiveness — none of which bodes well for the economy.

Will taxing venture capitalists at a higher rate result in greater tax revenues?

It’s not likely. Venture capitalists currently receive a portion of the capital gains they help create through their venture capital funds. If they are treated as employees who are paid wages from those funds, we would effectively be increasing the capital gains tax on arguably one of the most important investment sectors in the economy.

In addition, less venture capital activity could lead to reduced start-up funding. That would mean fewer high-paying job opportunities and less business investment, which create taxes both directly and indirectly through their multiplier effect on the economy. The tax increase on venture capitalists would surely lead to lower tax revenues from the missed economic growth opportunities. Understanding this relationship is key to crafting the best tax policy.

Finally, if tax policy were to change, venture capitalists may choose to embrace other avenues that are more advantageous from a tax perspective, further eroding tax revenue.

The road ahead?

There’s no doubt that venture capitalists are well compensated and can generally afford to pay higher taxes. But what happens to our economy if we decide to tax venture capitalists more? Do we end up with higher total tax revenues? Will we impede innovation, competitiveness, and job growth in the process? Is there a different tax policy, perhaps a counterintuitive one, that would be better for the economy overall?

Forward-thinking national, state, and local governments recognize the value that venture capitalists bring to their economies. Some of them, such as Israel, Russia, Pennsylvania, and others even offer incentives to attract entrepreneurial activity to their geographies. The tax policies currently under consideration, by contrast, would act as a disincentive. Maybe the policies are optimal, but shouldn’t we at least take the time to analyze their implications before implementing them?

The bottom line is that venture capital activity grows our economy. We should be maximizing that growth, not hampering it through tax policy.

Weekly Email Newsletter OpenView Blog RSS Feed

Subscribe with RSS or Email to get the best new ideas for
building great technology companies delivered to you.

Tagged in

Discussion

  • John

    Where goes
    the border between corporat
    tax planning     and tax fraud, or is it constantly moving as laws are
    changing?

  • BillyJackLives

    This commentary reflects no understanding — or, worse, a deliberate misrepresentation — of how the utterly ridiculous carried interest tax loophole actually works. Venture capitalists are free to invest their own money into ventures — that is the money that, rightly or wrongly, the government has long seen fit to tax at a lower rate, to encourage investment. But when you invest someone else’s money for a living — as a fund manager (hedge fund, venture fund, private equity, as the case may be) then your DAY JOB is to simply get a commission on investing _other people’s_ money.

    This commentary fails to reveal that this is why almost the entire country, except the 1% (and including much of them, like most senators and congressmen, even!), find the carried interest loophole to be completely ludicrous. No other trade or profession has this exception. Not sales people, not wait staff working for tips. The only people who get taxed at a lower rate for their commission are fund managers, and that’s patently improper.

    Then we see this: “Earning a lower net income could push some venture capitalists to retire, change careers, or worse, never enter the sector in the first place.” Why is losing those solely motivated by money a bad thing? I think most good investors and VCs would admit that this would be a GOOD thing. It doesn’t reduce the pool of money available necessarily at all — despite conflations in this commentary, we’re only talking about dissuading fund _managers_, not investors. And if a fund manager is only in the venture world for the money (or the investment world, since this will impact parallel fund types as well), they’re likely among the worst of the lot in terms of adding quality to the venture community. Good VCs do it because they love it. If you’d rather get rich another way, you should just go do that, and good riddance.

    Then a scare tactic for the likely readers of this blog (entrepreneurs). “In addition, less venture capital activity could lead to reduced start-up funding.” Scary, right? We’re expected to believe that this would chase away important, skilled fund managers who were only in it for the marginal take over what they could have gotten as, I don’t know, pop stars or pro basketball players.

    Think about it, entrepreneurs… would you rather work with an investor who is only in it to be super-duper rich and, if he could only get super rich, would throw in the towel? Or are you more interested in working with the guys who could barely care less about tax rates, are more interested in contributing to the common good with their excess riches and in working with entrepreneurs because they’re driven to support innovation and progress? Maybe some of the worse ideas that are currently getting funded would not, if there were suddenly a shortage of bad VCs. That doesn’t sound terrible to me, though.

    Now, it’s possible, I admit, that the worst VCs are often the best fundraisers. So for every Brad Feld or Mark Andreeson there are 3 or 10 guys who suck at investing but have great connections to big LP pools, and they happen to be doing VC funds because they can make that much more than as a singer, but now they’ll go back to cranking out platinum albums as their day job. Maybe.