House Increases Taxes On Venture Capital At A Time When More Investment In Innovation Is Needed

from the bad-thinking dept

For a little while now, we’ve noted various plans among politicians to change tax laws for private equity fund managers — which is supposed to close some loopholes that allowed some bad investment decision making to happen. But one of the serious problems with those efforts are that they lump together all types of private equity, including hedge funds (which do have some issues) and venture capital, which functions entirely differently. Despite numerous warnings about this, it looks like the House has still gone forward with passing a bill that will greatly increase the taxes on venture capital partners, taxing part of the money they make as profits from investments as traditional income, rather than as capital gains (which is taxed at a much lower rate).

While I don’t think this change will be as devastating as some have made it out to be, it could chill some aspects of investment. And, while I also don’t believe that venture capital is the only way to build an innovative business these days, I do think it has an important place in the ecosystem, and is quite helpful for many companies. Taking away some of the incentives for venture investments, right at a time when we need greater innovation seems like a fundamentally short-sighted move. I understand the argument on the other side, that the partners are investing other people’s money, and thus it’s not “their” investment from which to earn capital gains, but to some extent that’s misleading. The setup of most venture funds with carried interest (i.e., the profit share for venture partners) is to effectively trade their time and effort in the investment for a part of the investment. So it might not be their cash, but they do invest in other ways, and for that they get a share of the profits.

There are certainly lots of problems with our financial system today, and many questions about the private equity space. But lumping in venture capitalists who do long-term, high risk investments in private companies to help them grow, with hedge funds that do short-term, highly speculative gambling-type investments without much focus on the underlying business or prospects, is a dangerous move. There are problems with the venture capital model, but for the most part it works quite well in funding all sorts of innovative companies. Putting this kind of speed bump into the market won’t stop venture capital investments, but it could have some pretty serious consequences, especially in terms of the type of companies VCs are willing to invest in. The Senate still needs to vote on this issue, and hopefully they recognize that this is not the time to punish venture capitalists.

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Comments on “House Increases Taxes On Venture Capital At A Time When More Investment In Innovation Is Needed”

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12 Comments
Shadow Six (profile) says:

Re: Re: Re:

I think he stumbles more in the “away” part. But, he will find out eventually that he’s doing far more damage to his industry than pirates or freetards or boogymen or whatever they call them today. The saddest part has nothing to do with these fools. The real problem is the exploits left in the already failing legal system that I worry about.

Shadow Six (profile) says:

Re: Re: Re:

I think he stumbles more in the “away” part. But, he will find out eventually that he’s doing far more damage to his industry than pirates or freetards or boogymen or whatever they call them today. The saddest part has nothing to do with these fools. The real problem is the exploits left in the already failing legal system that I worry about.

Lawrence D'Oliveiro says:

Tautology Rules OK

Mike wrote:

But lumping in venture capitalists who do long-term, high risk investments in private companies to help them grow, with hedge funds that do short-term, highly speculative gambling-type investments without much focus on the underlying business or prospects, is a dangerous move.

How do you tell the difference, except in hindsight? Gambles can indeed pay off, and even supposedly safe investments can fail. I’ve explained before about the purpose of regulation: the market is a dynamical system, mathematically isormorphic to something like a car’s suspension system, while regulation is like the shock absorbers. Its job is to reduce the efficiency of response to stimuli, thereby dampening down the instabilities. But there is no a priori way to tell good stimuli from bad stimuli; you have to damp them all down.

Gene Cavanaugh (profile) says:

Taxing earnings as income

Boy, did you miss the point!
What you are saying is that if I take a high-risk (of layoffs,
etc.) job, I should be taxed on ordinary income, but if a venture capitalist does the same, it should be capital gains? Why? Because they are rich, and I am not?
Talk about Welfare for the Wealthy! Seems to be the “American way” – there should be a few very wealthy people and everyone else should be pushed toward poverty.

David Feldman (profile) says:

No capital at risk = no capital gains treatment

I’m a big fan of VC investment, but this taxation issue is pure rent-seeking by the VC industry.

Perform the following thought experiment: if the VC industry didn’t receive cap gains treatment for carry, would there be a strong policy case to create an exception? I really doubt it. And even if there were a public policy case to be made to subsidize VC, would we choose to do it in the area of partner compensation? I doubt that even more.

The principle involved is pretty simple: to receive cap gains treatment, you must have capital at risk. To the extent that VCs are investing and profiting on the upside of investments made with other people’s money, they don’t have capital at risk. Income treatment is appropriate, just like it is for everybody else in the economy who receives a bonus contingent on business outcomes.

VC will work just as well when partners are taxed fairly. Have no fear. Fairness in the tax code is a justifiable end in itself.

Fred Lu (profile) says:

Where are the links to the other side?

Here is link to a very popular VC’s blog arguing FOR income tax on carried interest.

http://www.avc.com/a_vc/2007/06/the-carried-int.html

It makes a very good point. When its not your own money at risk, you shouldn’t get the benefits. Seems like a very simple idea to get behind. The investors in VC’s will still get the capital gains bonus, its just the VC’s who are profiting off money from others that shouldn’t.

Boraxo (profile) says:

Exactly how does this stifle investment?

Do I work less because I pay income tax? Uh, no. Do I save less because interest is taxed? No.
And for a venture firm, where most investments go nowhere, but a few make spectacular returns, there is even less disincentive from taxing returns. So I make a two thousand percent return instead of a three thousand percent return, on the one investment out of a dozen that hit. Do I take my money and say, well, gee, never going to do that again.
Puhleeze.
Somebody has to pay taxes. If you don’t tax venture capital returns, your tax code in effect is transferring wealth from the middle class and working poor to the rich – since the latter two are paying the taxes you’re not putting on the former. Income inequality is growing in this country, tis reached Gilded Age proportions, and in a consumer-driven economy that’s very bad news. And I’m supposed to worry that a VC guy will only reap five million instead of seven, that this will somehow stifle innovation?
Here’s a clue: VC managers are not the source of innovation.

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