The Carried Interest Tax Debate

The NY Times came out today on the side of taxing carried interest as ordinary income instead of capital gains. I’ll be the first one to admit that the preferential treatment of carried interest as capital gains is a great boon to the general partners who run private equity and venture capital firms. And being a progressive who is in favor of more equity in our tax code, I would gladly pay more taxes. But I am not sure this is the best way for the federal government to get more money from me.

First, I think there are a couple things the NY Times got wrong.

Here’s a quote from the Times’ opinion piece:

The deeper question in all this is whether capital gains — which are
currently taxed at less than half the top rate of ordinary income —
should continue to be so lavishly advantaged. The answer there is no.

I think the Times is dead wrong on this one. Entrepreneurs and investors who risk their capital in an attempt to create new businesses that employ people, make our lives better, our businesses more efficient, etc should be rewarded for doing so. I don’t think a long term risky investment that pays off should be taxed the same way that interest on a corporate bond is. We need a tax code that creates some incentives to take risk or wealthy people will be less inclined to do so. This is a competitiveness issue and the Times clearly doesn’t get that.

Second, private equity and venture capital are different animals. An early stage venture firm that is making $1mm investments in hopes of a 10x gain over five to seven years is just a different animal than a buyout firm that invests $5bn in equity to make a $5bn gain in two to four years. The amounts are different, the risks are different, the incentives are different, and the gains are different (all by orders of magnitude).

But to my mind the biggest issue with changing the way VC carried interest is taxed is the unintended consequences. If angel investors who put up their own dollars at risk continue to get capital gains treatment (as they should) and venture capitalists who are investing institutional money lose capital gains treatment, the best venture investors will simply choose to invest their own capital instead of others. It’s already happening. The capital bases of the very best venture capital firms are increasingly made of of the general partners’ own capital. They continue to invest third party capital as well. If the economics of managing third party capital gets much worse, I bet we’ll see the best firms move to investing only their own capital.

#VC & Technology