Obama to Venture Capitalists: Drop Dead!

The Obama administration's new budget proposes changing the way that venture capital is taxed. As BusinessWeek reports:

In [the] search for funds, the Administration is also reigniting what promises to be another tough battle: It has reintroduced a proposal to tax the "carried interest" income earned by executives at hedge fund and private equity firms at the regular income tax rate rather than at the lower 15% capital gains rate they pay on such earnings today. 

The change would also apply to partnerships in real estate, energy, and other fields that use a similar legal structure, but the lion's share of the revenue targeted would come from financial industry players.

Administration officials estimate the carried interest change could bring in $7 billion in revenues in 2011 and 2012, but they won't get that kind of dough without a fight. Private equity, hedge fund, and venture capital firms argue that boosting the tax rates on carried interest—which encompasses the returns they make for managing investments in companies and other assets—will discourage the long-term investments the economy needs.

Carried interest generally means the shares or an option on shares taken by the venture capitalist in the company in which he or she is investing as part of the financing agreement. The stake taken is often 20 percent. 

Numerous economic studies have found that taxing capital is far less efficient way of raising revenues than taxing consumption or payroll. As a 2007 review study by the Fraser Insitute explains tax efficiency:

The costs associated with taxation extend far beyond the amount of tax collected. First, there are significant incentive-based costs, which are generally referred to as efficiency costs. These costs emerge because taxes alter relative prices and thus the incentives for productive behavior and affect a wide range of decisions regarding savings, investment, effort, and entrepreneurship. These costs vary widely by the type of tax.

One main method for quantifying these costs is referred to as the marginal efficiency cost (MEC). It calculates the cost of raising one additional dollar of tax revenue using different types of taxes. Estimates of the marginal efficiency costs of both American and Canadian taxes indicate that consumption and payroll (wage and salary) taxes are much less costly (and thus more efficient) than taxes on capital or the return to capital. For example, a study by the Department of Finance for the OECD (1997) concluded that corporate income taxes imposed a marginal cost of $1.55 (MEC) for one additional dollar of revenue compared to $0.17 for an additional dollar of revenue raised through consumption taxes.

Similarly, one of the most widely cited calculations of marginal efficiency costs (MEC) is that by Harvard Professor Dale Jorgensen and his colleague Kun-Young Yun (1991). Their estimates of the MEC of select US taxes indicate significant variation in the economic costs of different taxes and support the Canadian findings. Specifically, capital-based taxes (MEC = $0.92) and corporate income taxes (MEC = $0.84) were shown to impose much higher costs than other, more efficient types of taxes such as the sales tax (MEC = $0.26).

If the OECD calculation is correct, taxing capital means that it costs the economy more to raise an additional dollar of tax revenue than the government takes in. The feds may end up enacting that old joke about the stockbroker who keeps investing his clients' money until it's all gone.