Obama to Venture Capitalists: Drop Dead!

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

taxman

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. 

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  1. That last point may not be a negative to Obama. During the campaign he said something about raising capital gains taxes for “fairness,” even if it brought in less revenue.

    We are so screwed.

  2. Which is exactly argument for why all taxes should be consumption taxes ala the FairTax.

  3. 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.

    But the Community benefits more from the fairness effect of taxing capital. You just have to belieeeeve.

  4. Kun-Young Yun

    Try to say that 5 times fast

  5. As someone who has been involved in startups courting venture capital, and plans to again, this is awful. It can be hard enough to get the funding, and they want to make it harder? Yeah, let’s make it more difficult for the next Google to get off the ground.

  6. This will inhibit productivity; and productivity is what makes a nation’s population rich, not “fairness” in distribution. We want a bigger pie, not a more evenly divided pie.

  7. Investors are evil.

  8. Ahhh, the perfect storm. The whims of the most popular president in the history of the universe will be backed by the average voter’s ignorance based perception that the wealthy are a bunch of uber greedy mooger foogers. We have a culture of lazy, underachieving, dullards that have no interest in the real workings of the economy. Our eyes glaze over at any sign of details and we simply stick out our hands at the promise of free money from the rich. One hand to vote with and the other to sign the checks.
    I predict that if the republicans fight the gravy train, they will all be sent home in 2 years and the Obamachine will roll on unimpeded for the next 2 or 3 decades.
    The good news: after the complete destruction of america as we know it, the folks might be ready for a more libertarian government to assume control.
    May Joe Pesci have mercy on us all.

  9. In ObamAmerica, pie divides you.

  10. doom
    DoooM
    DOOOOM

  11. See, brotherben, this is why nihilism is your best bet. At least it’s an ethos.

  12. As someone who has been involved in startups courting venture capital, and plans to again, this is awful. It can be hard enough to get the funding, and they want to make it harder? Yeah, let’s make it more difficult for the next Google to get off the ground.

    I’m in a similar situation – was hoping to start a rapid prototyping shop for microfludics/quantitative biology next year when my contract is up. This sort of thing is bad for me and potential customers. Well, hope there will be money left in singapore/switzerland/scandinavia, but a post-doc is more likely!

  13. Well, in these few short weeks, I’ve seen enough to know that I’ll be voting straight gridlock ticket come 2010.

  14. I can’t help but feel like I’m watching the beginning of the apocalypse sometimes. It’ll be interesting to watch this, helplessly, over the next several decades.

    Pat of me feels like just going out and spending all of my money in anticipation that it won’t be any good anymore, and the other part of me wants to hoard it.
    ARGGG

  15. Pat of me feels like just going out and spending all of my money in anticipation that it won’t be any good anymore

    Go out with a bang, moose.

    Charlie: If we were gonna kill ourselves, it would be awesome, right?

    Mac: Yeah. Yeah, if we were gonna kill ourselves, it would be with class, right? I mean, because if we-

    Charlie: Of course it would be with class! What do you think, I’m not gonna die with class?

    Mac: Maybe some type of explosion?

    Charlie: Of course there’s gonna be an explosion! You think I’m not gonna explode?

    Mac: I’m thinking, Charlie, it would be some kind of blaze of glory.

    Charlie: Of course it’s gonna be a blaze of glory! I’m going down right now. (squirts lighter fluid on his arm)

  16. “We are so screwed.”

    Now I know some people think this, but what they don’t see is that ultimately, when all of my plans come together, we will be living in what could rightly be called the “Utopian States of America (USA). But it’s going to take time. A long, long time. Because it took a long, long time to get to where we are today.

    So today, I am sending legislation to Congress proposing that we repeal the 22nd Ammendment, which will enable me to shepherd this nation for as long as is needed.

  17. If OECD is correct, that means we should eliminate all capital and corporate income taxes, in favor of more efficient sales taxes. Which is fine, if you want a completely regressive tax policy.

  18. I am your shepherd,
    You shall not want.

  19. I can’t believe that Reason, of all places, is pushing this bullshit that taxing income as, would you believe it, income instead of the capital gains it obviously isn’t is some kind of travesty. What happened to your principles?

  20. Sales tax isnt necessary regressive.

    If a poor person saves 10% of their money and a rich person spends 100% of their money (or, quite often, 125%), then the tax is progressive.

    Your savings rate determines your tax rate.

  21. “Which is fine, if you want a completely regressive tax policy.”

    There are ways around that and you know it.

  22. Well, hope there will be money left in singapore/switzerland/scandinavia, but a post-doc is more likely!

    Doing exactly what the incentives have been perverted to make you do is no way to live.

    When life gives you lemons, stuff your bra with them and become a tranny hooker.

    If OECD is correct, that means we should eliminate all capital and corporate income taxes, in favor of more efficient sales taxes. Which is fine, if you want a completely regressive tax policy.

    It already is. If you have a job, your tax rate is higher than any billionaire’s, because above a certain minimum, his tax exposure is up to him. A no-exceptions sales tax, in the absence of all others, would put everyone in the same position. That’s why it won’t happen.

  23. There are ways around that and you know it.

    The obvious being what KY (and other states) do. Dont tax unprepared food. Groceries are sales tax free. Since poor people spend a larger % of their income on groceries, it gets rid of the regressivity.

  24. While I can begin to grasp how the motivations promoted by certain taxes lead to different efficiencies, I can’t grasp how taxing hundreds of thousand of entities on their annual bottom lines (corporate taxes) doesn’t cost, in terms of labor and oversight, monumentally less than taxing hundreds of millions of entities on their annual bottom lines (income taxes) or hundreds of millions on tens of billions of overall transactions per year (sales taxes).

    No agenda here, just curious.

  25. Obama don’t need no sound economic logic.

  26. robc, here in Alabama, the legislature has been foghting over a bill to do away with sales tax on groceries. You stated the argument of it benefitting the poor. The rub is this. The bill makes up for lost tax revenue by removing a state tax exemption for federal taxes paid. There would be a net gain in revenue, all from higher wage earners, (above EITC level,) so it is poo-pooed as a tax increase. What makes it so interesting is that the Obama campaign resulted in a lot more poor people voting. That changes the pressures on lawmakers in Montgomery.

  27. Uh, oh. Normally start-ups are one of the drivers that help pull us out of recessions. Maybe I was wrong yesterday when I chastised Warren for being too pessimistic.

    Ron, are you still happy you helped “punish” the Republicans?

  28. NY doesn’t have taxes on groceries, but they’re looking at adding it for hair cuts

  29. brotherben,

    KY has the advantage of “always”* having had the grocery exemption. No need to offset anything.

    *As long as I can remember, so 30+ years now. In my lifetime, they changed the sales tax from 4 to 5 then to 6 percent and the grocery bit was already in place.

  30. and everyone knows poor people never get hair cuts or grooming services
    good god

  31. KY doesnt have sales tax on booze (due to an 11% excise tax), but it goes into effect April 1st (the excise tax isnt going away). Yeah for regressive taxes!!!

  32. I heard a headline on the radio that Wa. state is trying to pass a huge tax on porn. I haven’t bothered to look into it yet.

  33. stuartl: Yes. The Congressional Republicans have (at least rhetorically) remembered that they are supposed to be against big government. The really really sad part is that they are 8 years too late.

  34. One of the biggest criticisms of taxation is that it distorts investments. This is also seen as a positive of flat taxes. So why is it bad to tax their income the same as other people’s income?

    Besides, this doesn’t effect taxes on investments, but rather taxes on compensation for VC execs. The vast majority of investment capital in VCs come from the limited partners, not the VC execs. So it’s not going to effect the investments made by LPs. This effects the salaries of the executives, not the returns of the investors.

  35. Your point doesn’t make much sense. The whole argument about carried interest is whether it should be characterized as normal or capital income. Since it is being earned primarily from working, it seems to be a lot closer to wages than investment income.

  36. I agree with Adam @2:26

    It had always seemed to me that the ‘carried interest’ that hedge fund managers (as opposed to investors) were receiving was a lot closer to management fees (i.e. earned income) than capital gains. At the very least, closer to dividends.

    They were being very shady over the last few years with the tax treament of hedge fund earnings and imo the closing of this loophole will do more good than harm.

  37. I think the conceptual problem people have with taxes on capital gains is that they don’t understand that capital gain isn’t a sure thing like wages or salaries. They don’t understand that each investment is risk that could easily end up loosing money. Since they don’t see investing as risky, they can’t understand why lowering the rate of return will make people less likely to invest. After all, if you raise taxes on a wage earner, they don’t work appreciably less so they see no reason why an investor would not continue to invest at the same rate as taxes go up.

    Unfortunately, they forget that good investments pay for bad investments. The cutting edge investments that create real economic breakthroughs e.g. personal computers in circa 1980, are all very risky. Investors have to be able to make a good rate of return on the experimental investments that work in order to pay for the ones that don’t. That 15% off the top of successful investments is 15% that can pay for an experimental investment.

  38. Tax efficiency? Someone posits that taxes are enacted in this country on efficiency grounds?

    I might believe this, if, instead of being run by an elected government, our country were actually run by a 12-year-old playing a better-executed version of Hearts of Iron II.

  39. Shannon,

    You show that straw man who’s boss. For fuck’s sake, who the hell argues that capital gains is guaranteed? Is income guaranteed? Output from labor isn’t guaranteed either. Because there are a few hundred thousand laid off employees that beg to differ on that. If you want a guaranteed return, you invest in treasuries. That’s why their RoR is called the “risk free rate”. You take more risk, you get a higher reward.

    People are investments too Shannon. People designed those personal computers and internet applications. The guys that develop pharmaceuticals get paid and taxed under income. Human capital is just as vital as investment capital for advancing out economy. In your world, where do these investments come from, piles of money?

    The distortion caused by taxing investments differently than capital is the effects on the production function. Let’s assume a simple Cobb-Douglas. Without taxes it’s Y=A*L^a*K^b. So the amount of investment in either is based on output elasticities. However, if you tax capital gains at 15% and income at 35%, then Y=A*.65L^a*.85K^b. So investment in capital vs. labor will be the most efficient output based on taxes combined with output elasticity. Ideally, the inputs into labor and capital should be based on where it’s best deployed, not where the taxes push you to.

  40. will discourage the long-term investments the economy needs

    It will only discourage private investment. Government investment will step up to fill the void. For Obama this is a feature, not a bug.

  41. Let’s be fair…and tax every type of gain the same rate.

  42. Hedge fund managers give a lot of money to congress, and so get to keep their favorable tax treatment. I don’t see anything more complicated than that going on here.

  43. Seward @ February 27, 2009, 12:10pm: We want a bigger pie, not a more evenly divided pie.

    For people who believe that economies are zero-sum, then the big can not grow. Then “earning” money is really stealing money, because an imbalance of nominal value creates an imbalance of wealth, which is abhorrent in a system where the finite wealth should be evenly distributed.

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