The Carried Interest Taxation Debate

My partner Fred has come out in support of taxing carried interest as income instead of capital gains.  I agree with Fred’s position because I do not believe that this change will result in less investment in startups.

Taxes generally cause distortions and as a first approximation, taxing something at a higher rate tends to lead to less activity.  Sometimes that is the desired outcome.  For instance, if the US were to tax CO2 emissions we would expect to see companies attempt to reduce their emissions.  Sometimes that is a negative side effect.  For instance at higher income taxes people tend to work less.

But this basic principle is only a first approximation at best.  Many factors other than price influence behavior (taxes are essentially a way of changing the price of an activity).  Emotions play a critical role also.  For instance, passion often trumps cost considerations.  Jeff Bussgang in his book Mastering the VC Game (terrible title but great book) speaks eloquently of the passion that drives entrepreneurs and many VCs (which is why it is somewhat surprising that Jeff thinks the tax would matter for VC activity).

I can’t imagine anything else I would rather do than being in Venture Capital.  Tax considerations will have no influence on that.  Now one could still argue that VCs might shift towards investing their own capital (on which they will receive capital gains taxation) rather than that of Limited Partners.  While that is an option for some of the VCs who have been hugely successful already, I doubt that will make a meaningful dent in the pool of capital available for startups.  There is plenty of interest from younger partners who don’t have fortunes to invest and people who’d like to enter the VC business.

I only have two worries with this legislation.  First, that it winds up being circumventable with some structure that causes significant distortions (e.g. in the alignment of interest between GPs and LPs).  Second, that by mistake this will also affect the treatment of founders’ stock.  If founders’ stock were to be subject to income tax instead of capital gains, that might lead to a significant allocation away from startups.

Posted: 2nd June 2010Comments
Tags:  taxation policy carried interest

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