Damaging the Entrepreneurial Ecosystem?

Filed in archive Law on September 10, 2007

With the Ways and Means holding Congressional hearings on how to simplify America's tax code, several members of the National Venture Capital Association (NVCA) have testified recently before Congress. The topic: a proposal to tax carried interest as ordinary personal income instead of capital gains. That could more than double the amount of taxes many fund managers and investors in the venture capital and private equity industries pay on earnings.




Those opposing the proposal to change the way carried interest is taxed included Jonathan Silver of Core Capital Partners, testified Thursday before the Congressional committee. Swifts arguments were typical: venture capitalists make a unique and valuable contribution to the American economy, the current tax situation on carried interest is both correct and necessary (which is to say that carried interest is in fact, at least as Silver sees it, capital gains and that taxing them at a higher rate would drive fund managers away from venture capital projects), and the current proposal, HR 2834, has the potential to "damage the entrepreneurial ecosystem in the United States - a system that has been at the heart of our country's economic leadership for decades."

Silver is by no means alone in his opposition to the tax change proposal: the U.S. Chamber of Commerce also opposes it. So does the Real Estate Roundtable, calling it a tax on "sweat equity." The venture capital and private equity industries are not alone in being impacted by the proposed tax change. "This proposal is a tax increase on those who take on entrepreneurial risk and devote sweat equity to create or own investment real estate," said Roundtable President and CEO Jeffrey D. DeBoer. "Eliminating capital gain treatment for real estate carried interests is bad for this crucial sector of the American economy."

While voices against changing the tax law were many and loud last week, testimony was far from unanimous. A coalition of some 300 separate organizations has lobbied in favor of the tax change.

The Huffington Post had a good opinion piece that recounted some of the testimony in favor of the change:

But Leo Hindery Jr., a former executive in the cable television industry who is now managing partner at a private equity fund, InterMedia Partners, disagreed, telling the committee that the industry had taken advantage of a "tax loophole the size of a Mack truck."

"Congress, starting with this committee, needs to tax money management income, what we call carried interest, as what it is, which is plain old ordinary income," Mr. Hindery said. He called the argument that the tax increases would hurt the economy "self-serving" and "complete poppycock."

He was joined by William D. Stanfill, a founding partner of TrailHead Ventures, a venture capital firm in Denver, who said that his compensation should be taxed the same as teachers, firefighters and movie stars. "I don't think it's fair for those teachers and firefighters to subsidize special tax breaks for me and other venture capitalists," Mr. Stanfill said. "Or for private equity and hedge fund managers."

It would be an understatement to say that the issue is emotional. Emotions aside, I think I personally agree, by and large, with the Huffington Post: "In plain language, this is utter (okay I probably can't print this word) and the true definition of audacious. These folks are so intent on making sure that they can keep buying yachts with helicopter pads and build mansions that would make the robber barons of the 19th and early 20th Century look like paupers that they seriously argue that somehow they will have less incentive to take the money of pensioners and invest it."

The Huffington Post goes on to report a moment during the testimony that it describes as "clarifying" - at least for the reporter:

A moment of comic relief came when one member of the House Ways and Means Committee pressed some of the panelists who work in the hedge fund industry to estimate the average pay among hedge fund managers.

After an awkward silence, and prodding by the congressman, one witness conceded "millions," and then $500 million. The top earner last year, according to Institutional Investor's Alpha magazine, earned $1.7 billion.

One last tidbit from Huffington - a quote from Warren Buffett: "It's an outrage that Americans who are paid millions or even billions for their labor can be subject to lower federal tax rates than their middle-income receptionists."

I wish the debate wasn't quite so emotional. But ultimately it is an issue of fairness. Fund managers who make into the millions are paying lower tax rates than the average worker in America. Personally, I think that's wrong. I think the argument that some of those involved in private equity investments might decide to find other work we raised thier taxes (and pay 35% somewhere else instead of paying 35% at their current jobs) is lame. But if that did happen, my guess is that someone would apply for the vacancy their departure created.

Silver would have us believe that "Literally thousands of companies would not exist today were it not for the venture capital support they received early on. Federal Express, Staples, Outback Steakhouse and Starbucks are well known examples of traditional companies that were launched with venture backing. Cisco, Google, EBay, Yahoo and countless other technology companies were all, at one time, just ideas that needed start-up capital and guidance." The idea that Federal Express (or something very like it) and Starbucks (or something very like it) only came into being because there was venture capital there - that strikes me as hyperbole, or perhaps fantasy.

Venture capital helps. But Google's founders would probably be offended at Silver's remarks. And China's Internet giants will be birthed into the world even if venture capital disappears.

I don't think there's much need to worry about that. The venture capital and private equity world may hope the new tax proposal is defeated, but if it passes they'll still keep making money.

Damaging the entrepreneurial ecosystem? I don't think so...