The U.S. House of Representatives recently passed a bill to close the carried interest "loophole" for private equity investors. Currently, these investors pay capital gains tax rather than income tax on the upside they receive if their investments do well. Most private equity investors don't favor the new legislation, as it severely increases the tax they will pay on their profits.
The legislation will affect both buy-out investors and venture capitalists. (Many people, including many in the press, misuse the term "private equity" to refer only to buy-out investing, but strictly speaking, it applies to both.) Venture capitalists buy minority positions in young companies they think will grow quickly; buy-out investors buy most or all of companies they think can be turned around by fixing a few basic things.
The new bill concerns carried interest -- i.e., the share of the fund's profits paid to fund managers, typically 20%. Under current law, carried interest is taxed as capital gains at a rate of 15%. The new bill will tax 75% of this carried interest as ordinary income (at a rate up to 35%), treating only 25% as capital gains.
No surprise, then, that investors don't like this idea. Venture capitalists in particular are up in arms. They've launched a massive lobbying campaign, the main thrust of which ultimately reduces to something like the following: "Hey Uncle Sam! Tax the buy-out guys all you like; they're just financial engineers. But we VCs are funding innovation, creating new companies and jobs that will drive the future of the American economy." They've got a point: As Thomas Freidman pointed out, virtually every net new job created since 1980 was created by a startup.
However, two prominent investors, Chris Dixon and Union Square Venture's Fred Wilson (both friends of mine), argue the opposite -- that taxing VCs on the basis of ordinary income rather than capital gains is the way to go.
Fred says that now the best managers will be more inclined to invest their own money rather than other people's, since personal investment gains are still taxed at the capital gains rate. He also makes a general argument on the basis of tax code fairness and another on the basis of debt reduction. (Exempting VCs from this bill would have virtually no effect on debt reduction.) Chris makes a strong fairness argument--these investors make more money than, say, firemen, so why should they pay 15% tax when firemen pay 35%?
Since Fred and Chris appear to be arguing against their own self-interest, their position seems high-minded and objective. NYC Internet guru Jonathan Glick -- who was formerly a Gerson Lehrman Group honcho and is currently the founder of T-Lists (disclosure: I'm a T-Lists investor) -- tweeted in jest that Dixon was a "class traitor."
But perhaps what's driving Fred and Chris is not a deep philosophical desire to rationalize the federal tax code. Perhaps, instead, they're motivated by the belief that there's too much money in the venture industry, competing for and winning good deals and creating upward pricing pressure on all deals. It's popular among top VCs to denigrate this capital as "dumb money" and to whine about it when they miss out on hot companies. So some top venture investors would like to see the total amount of capital in the industry decline. Some, perhaps, would even be willing to pay more taxes to see that happen. After all, VC is a binary business. It doesn't matter if you pay less in taxes on your bad deals (that are going to go bankrupt anyway); what matters is getting into the good deals, which less competition would tend to facilitate.
So I'm with the VC industry on this issue. It is intellectually dishonest to lump venture investors with hedge fund and buy-out investors. The law is flexible enough to carve out an exemption for VCs. Buy-out investing is all well and good -- it's better for the economy than hedge fund investing--but it's not nearly as long term GDP-accretive as is venture capital. And venture capital is a distinct American competitive advantage, the envy of Europe and Asia.
Fred and Chris are top-flight investors, but I don't care about the top venture capitalists; they can take care of themselves. I care about all the other VCs out there, even the mediocre VCs. Chris Dixon's argument is entirely correct on the basis of fairness, but so what? Policy shouldn't be based on primarily on fairness. It should be based primarily on what creates the most value, especially if that value is somewhat evenly distributed. Venture capitalists, certainly, create value for themselves, but they also singularly create value for the rest of the world. Witness: Google, Microsoft, eBay, Amazon, and on and on and on.
So, if anything, we should make it easier and more lucrative to be a venture investor. Go ahead and increase taxes on buy-out funds, but leave venture capitalists alone. In fact, I'd go even further and grant additional tax breaks and subsidies to the VC industry. Even mediocre VCs help build great companies, albeit fewer of them.
Venture capital today is clustered in just a few locations -- Silicon Valley, New York, Boston, and D.C. It's far from efficiently distributed and accessible. Given its importance to our future economic development, shouldn't we be encouraging it as much as possible?
Imagine if the NFL only had four teams: San Francisco, New York, Boston, and D.C. Sure, increasing the size of the league to 32 teams would dilute talent. So? The game is so popular, it ought to be more widespread -- even if that reduces talent level, to the chagrin of some of old-timers. Same with VC: it's too important.
We are a country driven by innovation, and now, with globalization sending an increasing number of low-end manufacturing industries overseas, it is essential that we create new companies and new industries. Instead, this bill will likely do permanent structural damage to the U.S. venture capital industry.
As Representative Lee Terry of Nebraska points out, raising taxes on investments in business is, directly or indirectly, "a sure way to kill jobs." And I don't care what side you're on--nobody wants that.