Fund Tax Break Needs to Go: Harold Bradley and Paul Kedrosky

Innovation is precious in any modern economy. It creates jobs and economic growth, and can help ameliorate or even eliminate intractable social problems.

But a flawed and misleading connection is being made in the U.S. between innovation and favorable tax treatment of certain investment partnerships, including venture capitalists, as well as hedge funds and real-estate investment funds.

Partners in these funds are paid “two and 20.” They receive income of roughly 2 percent (a management fee) of their financial assets under management, plus 20 percent (called carried interest) of any eventual gains once their investors have been paid back their original capital. The management fee is intended to cover base salaries and the cost of business, while the carried interest is a bonus for performance.

At present, partners’ management fees are taxed as ordinary income, or as much as 35 percent, while any gains on carried interest are taxed at a lower capital-gains rate of 15 percent. Some have proposed that this loophole be closed.

This proposed change has run into loud opposition, and pending legislation is awaiting a Senate vote. Opponents, whose self-interest is obvious, make two types of argument:

Narrow: What venture capitalists do is similar to what others do who receive such favorable treatment.

Broad: We will see less venture capital, which will harm innovation.

Favored Treatment

A principle of tax policy is that people who do similar work should be treated similarly for tax purposes. Now, the fact that many of the people whose work most resembles that of venture capitalists -- mutual-fund managers, for example --don’t get favored tax treatment is a problem for this argument.

A version of the broad argument was recently made by a venture capitalist in the New York Times. He suggested that partnerships’ investments in private companies using other investors’ money resemble the transactions of consumers buying homes with borrowed capital, in which, upon sale, any gains are taxed as capital gains with no relation to the capital loaned.

This is a specious argument. First, the U.S. government has decided for policy reasons to favor home ownership, a tax distortion with many consequences that helped incubate the economic pain we still endure.

Second, homeowners don’t earn a management fee from lenders, while venture-fund general partners do. General partners serve in a fiduciary role for their own investors. This relationship illustrates that carried interest is a bonus and not a share in partnership profits based on capital contributions.

Loss of Capital

Finally, a homeowner’s equity may be reduced or eliminated by declining prices, while poor investments made by venture- capital general partners cause loss of capital only to the investors and usually not to the managers of the fund’s investments.

Let’s now turn to the innovation argument: that changing carried-interest tax treatment will make less venture capital available, thus damaging innovation and economic growth. There are multiple arguments embedded here, so we need to unpack them.

It is true that venture capital is important in catalyzing some kinds of innovations. No serious person argues that new drug development would happen on credit cards; then again, it is worth pointing out that less than 1 percent of all startups ever receive venture capital.

PR Exercises

Yes, groups such as the National Venture Capital Association make much grander claims for the total employment, wealth and economic activity created by venture-backed firms, but these are largely indefensible public-relations exercises. It is simply wrong to say all the jobs at a huge company such as Cisco Systems Inc. are attributable to a long-ago cash infusion from a venture capitalist. One might as well make the same claim for PG&E Corp., Cisco’s provider of alternating current.

As for the latter arguments: Will we see a tax-driven venture-capital contraction? Almost certainly not.

First, the investors who provide the capital -- pension funds, endowments, high-net-worth individuals -- will continue to receive favorable tax treatment.

Second, arguing that many of the best and brightest will leave venture capital runs counter to recent experience. Most venture capitalists received zero carried interest over the last decade, and that hasn’t materially shrunk the industry, so a higher income-tax rate will hardly send it into collapse.

No Exception

Similarly, treating bonuses as ordinary income has done nothing to slow the flow of people into other areas of money management, so it is difficult to imagine why venture capital would be an exception.

Finally, even if some of these people are dissuaded from entering this business, it wouldn’t be entirely a bad thing, as the industry’s negative 10-year results show that it must shrink in order to produce competitive returns.

Won’t all of this hurt innovation? Don’t we want more entrepreneurs being funded? Of course, and in a utopian world it might be nice if every entrepreneur who needed money got it.

But we don’t live in that world. Venture capital is a financial asset whose providers have choices and require investments that produce competitive returns. We all want more innovation and more entrepreneurs, and venture capital can play a part. But we shouldn’t exaggerate venture capital’s role in innovation, nor should we persist in tax policies that encourage an overgrown and uncompetitive industry to remain so.

(Harold Bradley is chief investment officer at the Ewing Marion Kauffman Foundation. Paul Kedrosky is a senior fellow at the foundation. The opinions expressed are their own.)

To contact the writers of this column: Harold Bradley at hbradley@kauffman.org Paul Kedrosky at paulk@kauffman.org

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