PJ Media

Tax Venture Capitalists, Ventures Go Unfunded — Does Reich Understand Incentives?

Robert Reich is advocating a rise in the tax on “carried interest” — the money that venture capitalists (VC) and private equity (PE) partners make after all their investors have been paid. Reich would like to see the tax on carried interest go from its current rate of 15% to the top rate of 35%. Of course, next year, the top rate will be 39.5%, and even higher for higher earners.

In Reich’s world, virtually every investment that a VC or PE firm makes has the Midas touch. They never lose. However, in the real world they do lose, often.

VC and PE partners raise money for their funds. They receive a management fee and a percentage of the funds raised. They are taxed for this effort, as they should be, since they have zero risk associated with this activity. No matter what happens with their investments, they still get paid. Hence, they pay the highest rate of tax, whatever it is.

But once the money is raised, they become bankers and investors. In VC, they make investments in up-and-coming companies on the cutting edge of new industry. Billions of dollars of capital have been invested in Silicon Valley tech firms, biomedical firms, green energy firms, and anywhere there is innovation in the world. If the firms they invest in are successful, the VC makes money by selling them, or taking them to an initial public offering (IPO) on a public exchange.

The investors in the fund are then paid off from the proceeds of the sale. The VC keeps the rest and is taxed at 15% on those gains.

However, nine out of ten of these ventures end in failure. VC is a risky business fraught with danger.

The PE world is much different. They raise funds, just like the VC. Then they invest the funds by purchasing existing, operating companies. They internalize the companies and float a large amount of debt on that company.

The next step is to restructure the company so that it runs more efficiently and can grow quickly — quick growth is necessary to pay off the debt load. As the debt begins to be paid off, the PE firm either sells the company or takes it to an exchange for an IPO. They are taxed at 15% on those gains.

If the firm doesn’t grow, the debt load eats the PE firm alive. It either has to wait longer for a return on investment, or lose. Leverage causes huge profit when the firm is right, but cuts mercilessly when wrong.

Both PE and VC firms create thousands of jobs via their investments. If the U.S. raises taxes significantly on them, they will have zero incentive to invest. Innovation has already been kicked in the teeth with the passage of ObamaCare: recall the 10% increase in taxes on medical devices? Tax increases of this sort dig the economy’s grave, bury the corpse, and fill the hole with dirt.

Reich lives in a fantasy world where incentives don’t matter. He fails to follow real-life statistics — when capital gains taxes were cut in 2000 from 20% to 15%, government revenue actually increased significantly. Why? Because unproductive capital sitting in unproductive assets was repatriated into productive assets.

Reich also fails to understand the difference between accounting and economics. In accounting analysis, one plugs in numbers and monkeys with percentages to get output. It is static, one-dimensional. Economic analysis takes into consideration the change in behavior given different inputs and incentives. Sometimes, it’s counterintuitive — lowering taxes can actually lead to greater government revenues.

Instead of continuing the tax-and-spend path our government is currently pursuing, they ought to consider cutting both taxes and spending. The multiplier effect of a government spent dollar is zero, or very close to zero. Yet a 1% drop in taxes creates a significant amount of economic activity.

A different tax standard might indeed be appropriate for VC and PE. However, the new standard ought to be thoughtfully considered using sophisticated statistical economic analysis. Incentives matter. We shouldn’t use the random, pie-in-the-sky analysis Mr. Reich has applied to the problem.