Speaking up More about VC Carried Interest Taxation and the Destruction of U.S. Innovation

The debate about taxing carried interest reminds me of the following poem by  Martin Niemöller in 1946:

"In Germany, they came first for the Communists, And I didn’t speak up because I wasn’t a Communist;

And then they came for the trade unionists, And I didn’t speak up because I wasn’t a trade unionist;

And then they came for the Jews, And I didn’t speak up because I wasn’t a Jew;

And then . . . they came for me . . . And by that time there was no one left to speak up."

So I am going to speak up once more about this subject on raising taxes on venture capitalists and I believe, on entrepreneurs and the people that join startups.

One of the commentors, Stephen Larson, to my prior post, mentions that this VC carried interest treatment as capital gains is a "loophole"; I appreciate the comment deeply, but I very respectfully disagree and give him credit for sparking my thinking on this.  This idea of loopholes and fairness of  a low current carried interest taxation policy is a common misperception among politicians and the press and I want to talk a bit about that.

I think it's the heart of the issue.  Many VCs themselves think of the carried interest taxed at capital gains as a "loophole" and don't want to speak up, as they are embarrassed a bit about their success-- or worse pilloried in the press as an example of a rich fat cat that doesn't want to pay higher taxes.

Taxing "carried interest" at a capital gains rate is not a "loophole".  In their infinite wisdom, historically, the IRS regulators, and tacitly, by the Congress, have agreed that "carried interest" should be treated as if it's a long term asset that a VC owns, and doesn't earn like income over time.  The Congress is having second thoughts about that which is why this debate is happening now.

Try the following thought experiment:

Suppose a entrepreneur starts a corporation, and invests $50,000 in it.  Then they raise $100,000,000 by selling 80% of it in preferred stock;  preferred stock means the investors get paid first, and is quite typical structure with startups.  Then the entrepreneur sells the corporation for $300,000,000 after 5 years.  Should the entrepreneur who continues to own the 20% piece that he owns, pay capital gains tax of 15% or ordinary income tax of 35%?

Today the law is 15%, as these are long term capital gains. 

Now change the word "entrepreneur" to "VC".   

Is that OK in your book if a VC creates such a company, and generates capital gains this way? 

Because if you are ok with that, then that's exactly what VCs will do.  Right now, VCs use the structure of "carried interest" instead of creating this other type of partnership, but they can easily change that structure, and investors will be happy to comply.   The IRS historically agreed that this is a long term held asset that a VC owns -- a VC isn't paid a fee, he owns the carried interest, just like a minority interest in a company that an entrepreneur owns.

So if Congress changes the law and says if you get "carried interest" we will tax this higher, VCs will simply change the structure to be more like a typical entrepreneurial company structure.  VCs will dissolve their structures, and get LPs to agree to a new structure so that VCs get treated like entrepreneurs.  So perhaps, this point is mute, but I am sure Congress will turn around and try to tax that "loophole", but this time they capture entrepreneurs in that "loophole" as well, taxing them at higher tax rates-- entrepreneurs didn't really own the stock, they got a "bonus" that they "earned" when they sold and it should be treated as "ordinary income".  Sound familiar?

Taxes destroy or reduce whatever gets taxes.  Higher taxation of anything, means you will get less of it.  That's just an economic fact of life.  It's unfair.  There has never been an instance where higher taxes creates a boom in the activity that is taxed, and in fact the opposite ALWAYS happens.    Reduce taxes on SUVs and guess what?  People buy more SUVs, even if it destroys the planet. Increase taxes on SUVs, and I can let you guess what happens to SUV sales.

Stephen concedes in his comment that this might be the case; there will be less VC capital if carried interest is taxed higher whatever the form.  He mentions that if taxes are raises on a VC's capital gains then the "vacuum" left by departing VCs will be filled by something else.  Perhaps, he means that angel investors or entrepreneurial sweat equity will fill the void.

Those dollars that used to flow into VC,  will go into more mature companies and debt instruments, and fewer Americans will be employed by VC firms.   Angels will not fill the vacuum, and sweat equity only goes so far.  There will be less enterpreneurial activity in this country; those dollars will go elsewhere, and those people will work elsewhere is lower paying and slowing growing economic opportunities.   It also means that money will flow to other parts of the world where high risk capital and high end entrepreneurial talent are treated better.  It's no accident that Europe has virtually no venture capital industry, given the crushing taxes on wealth and especially on capital investment in technology.

And ironically, as I also mention in my prior post, this is not really about fairness in the sense that this policy means less taxes to the government.  Ironically, a lower tax on startup investing net generates MORE taxes to the government, given the massive creation of higher paying jobs.  It's a bit counter intuitive but the tax base that VCs and entrepreneurs create hugely benefits the economy, and pay significantly more amounts of taxes ultimately than what would happen if there was no or less VC activity. 

This is about politicians finding a political football with great sound bites, with words like "loopholes for fatcats" or "nurses and firemen pay less tax than fat cat private equity investors".   It sounds great on TV, and it might make you more popular, but it's stupid economic policy to tax at a higher rate this entrepreneurial activity.  No politician will every say "Let's tax entrepreneurs more".  It's easier for a politician to say, "Let's tax those rich private equity guys more", not realizing that indirectly this will include all VCs and a good percentage of entrepreneurs.  In the end, entrepreneurs will bear this burden, and the millions of "unborn" companies that never get funded in this "vacuum" of VC money and talent.  We will all bear this burden.

What blows me away, is that politicians (like Charles Rangle of New York, Charles Schumer of New York, Hillary Clinton of New York, Barney Frank of Massachusetts, and Nancy Pelosi of California) that represent New York, California and Boston, where 90% of these pools of venture capital and private equity exist, want to tax their own constituents more.   

Any other politician would defend their region, or at least bring resources to their region and support their local industries.  Texas politicians would never suggest a higher tax on those "rich fat cat" oil developers in Texas; Florida politicians would never suggest a higher tax on retirees.  Detroit politicans would never suggest that a higher tax on car producers is a good idea.   Personally, I am an independent that supports pro-growth politicians that defend their regions interests.   Lets elect politicians, Republican or Democrat, that supports their regions economy and their nation's long term interest. 

Taxing venture capital and entrepreneurship in America at a higher rate is about the stupidest thing, outside the destruction of the SBIC program and the invasion of Iraq, that this country has ever done.  Ironically, a veto of this legislation, would be probably be one of the shiniest moment of the Bush administration with the most lasting impact on this country.

It takes a bit a bravery to take this stance, but it needs to be said, for our future, and our childrens future.   Those that are too old in the industry, don't really care that much; those in the VC industry that already have built wealth, at best are trying to do something, but at worst, fits their political bent toward higher taxation of all kinds, or kind of like the idea of raising taxes on the profession as this will diminish competition and incentives for new VCs to emerge. 

Some entrepreneurs, if they consider this issue, see this whole carried interest tax as more of an us vs them type of thing, when in reality its very much and us vs us thing.    There are efforts out there by the NVCA, but it needs to be said louder by all of us, both VCs and entrepreneurs and those people who care about our future economic prosperity.  There are lot of stupid things this country can do.  Innovation is the one thing that gets us out of all the other stupid things we do.  So if we kill innovation, through taxing VCs and entrepreneurs more, I fear for our future far more than short term stumbles on other economic and policy fronts.

You might recall the T-shirt "God, please give us just one more bubble" that was popular in Silicon Valley during the last recession.  I pray that we don't cripple our abilities to innovate for generations to come (not just this generation), and in our infinite wisdom, we tell our elected officials to back off on this one.  It sounds like that message is getting heard, but I hope we don't blow this one, as the blowback will be felt for a very long time.  I know this might sound over the top, but I think the economic leadership of the U.S. itself is at stake.  That's how important this debate over taxation of VCs and entrepreneurs really is. 

So, if you can make an impact, now is the time to do so, and speak out, before it's too late.