Pulling the plug on venture capital

Nation's Business, July, 1986

Pulling The Plug On Venture Capital

Venture capitalists who help finance and manage high-risk new ventures are in shell shock because the Senate version of proposed tax reform legislation eliminates the preferential tax treatment of capital gains.

Passage of the Senate version as it stands would raise the maximum federal levy on such income from 20 percent to 27 percent--or even 32 percent (see chart, page 12).

Echoing a sentiment expressed by many venture capitalists, James R. Swartz, a managing director of Accel Partners, a venture capital company with offices in Princeton, N.J., and San Francisco, says of the Senate bill:

"It is a long-run disaster for emerging companies and the whole process of new business creation. It sends a strong signal to risk takers that there is no longer any incentive in risk taking. Would-be entrepreneurs just are not going to get pointed in that direction, and it will be extremely difficult to get senior corporate executives to work for little companies.'

Adds David Gladstone, president of Allied Capital Corporation, a Washington-based venture firm: "Parity in the taxation of capital gains and ordinary income is a travesty and very detrimental to small business.'

Christopher Brody, a managing director of the New York venture firm of E.M. Pincus Warburg & Company, says eliminating the differential between the tax on ordinary income and capital gains would raise the cost of equity capital for high-risk companies.

Such a change would, he says, make the United States one of the few industrial nations that do not give a tax preference to capital gains.

Swartz, president-elect of the National Venture Capital Association, a Washington trade group, says, however, that slashing the corporate tax rate to 33 percent on incomes over $75,000 (the rate would be 15 percent up to $50,000 and 25 percent to $75,000) would generally benefit existing companies.

And, he notes, reducing the top personal tax rate to 27 percent would benefit entrepreneurs who have already cashed out of start-ups and now want salary income.

The Senate action is all the more surprising, Swartz says, because what venture capitalists in 1978 predicted would happen did happen, after Congress lowered the maximum tax on long-term capital gains from 49 percent to 28 percent. That cut, and a further lowering of the capital gains tax rate in 1981, he says, led to a burst of entrepreneurial activity, ample risk capital for new ventures and millions of new jobs in high-growth industries.

The Senate Finance Committee justifies its move to abolish the special treatment of capital gains on the grounds that abolition would bring in an additional $220 billion in tax revenues over five years.

De Seve Economics Associates, a Washington consulting firm, disagrees. It says raising the capital gains tax rate would add just $1.9 billion to revenues in that period.

Internal Revenue Service figures show that revenues from capital gains taxes went up after such taxes were cut in 1978 and again in 1981.

A study by Congress' General Accounting Office shows that it may be short-sighted to discourage entrepreneurs' risk taking. The GAO projects that $1.4 billion invested in 1,322 start-up firms from 1970 to 1979 led to creation of companies that are expected to have sales of $88.8 billion and 1.9 million employees in 1989.

A recent study by Lawrence Lindsey of the National Bureau of Economic Research, in Cambridge, Mass., says that government would maximize its revenues, in the long run, with a maximum capital gains tax of 18.5 percent.

Industry lobbyists say they will try to get changes made in the final version of tax reform legislation when congressional conferees meet this month to iron out differences between the Senate measure and a tax reform bill passed earlier by the House of Representatives.