More On the Carried Interest Taxation Debate

Last week I wrote briefly about my position in the carried interest taxation debate.  Since then the debate has gotten a bit more heated with opposing posts by Chris Dixon and James Robinson.  Chris argued that this is a matter of basic tax fairness and Jim provided two (new) arguments for how increasing the tax rate on VCs might result in fewer dollars for startups. 

Jim’s first argument is what economists call “tax incidence."  When you tax someone they will lay off part of the tax on their customers, which in this case would be the Limited Partners.  While correct in principle, I don’t think it carries much weight here because tax incidence depends on the relative slopes of the demand and supply curves (in this case for capital).  After years of fairly abysmal returns, I doubt most VCs are in a position to change the pricing vis-a-vis LPs.  The funds are essentially facing flat supply curves which places the entire tax on the GPs. 

Jim’s second argument, which are potentially negative structural changes to how funds are set up and/or make investments in startups is more interesting.  I pointed this out as one of my two worries with this legislation.  But the structural side effects argument is also one of the strongest argument against treating VCs differently from other money managers, in particular everyone’s favorite: hedge funds.   That would create a huge incentive for hedge funds to be classified as VC funds.  Given the capital available to many hedge funds it would be possible for them to make as many or more investments in startups than most VCs, which I doubt is in anyone’s interest.

Which brings me to the most important point.  If somebody is concerned that taxing VCs more will reduce investment in startups, then the proper solution is not to somehow treat VCs differently, but to directly go after the problem.  And that could be done easily by dropping the capital gains tax for investment in startups.  In fact, Jim proposes 10% for long term capital gains in startups towards the end of his post.  The administration has a proposal for eliminating the cap gains tax for investments in startups (unfortunately, the requirement to be a qualified small business is onerous).  If we get a usable reduction in long-term cap gains for investing in startups that will more than offset any possible reduction resulting from taxing VC’s carried interest as income.