Boston Business Journal editorial…

President, Congress Out of Step on Job Creation

By Michael Greeley and Paul Maeder

Making and delivering on campaign promises is a delicate dance, but President Obama took a step this week toward fulfilling one of his most important pre-election pledges.  We are referring to the President’s proposal to help small businesses by eliminating taxes on their capital gains.  While the details still have to be worked through, the spirit in which this measure was put forth is one of the most important tenets relating to ongoing U.S. leadership – as important as economic recovery, healthcare reform, or a clean-energy policy.

That’s because small companies – with their proven track records for innovation and job creation – must play central roles in each of those initiatives. They are the companies we’re counting on to develop new and more efficient medical treatments to reduce healthcare care costs, or develop new technologies to harness renewable energy sources and combat climate change. When healthy, their collective hiring power is at least equal to that of big corporations.  They also represent the necessary pipeline of future blue chip companies.

In this way, the President’s plan is bold and insightful. But apparently, many in the House of Representatives either disagree or didn’t get the memo.

This past week, the U.S. House passed a bill (HR 4213) that would permanently more than double the tax burden on the venture capitalists who provide funding and guidance to America’s most innovative and promising young companies – just when we need this investment the most. This provision, which was hastily included to pay for year-end tax extensions, works at cross purposes to the President’s strategy for stimulating job growth.

Unless you’re a finance major or C-SPAN junkie, the change in tax status may seem minor – even arcane.  Basically, the bill reclassifies the returns (or “carried interest”) that venture capitalists earn when they build successful companies from capital gains (which are taxed at a lower rate) to ordinary income (which is taxed at a higher rate).  Fiscal responsibility is important, but this is the wrong tank from which to siphon fuel.

Due to the extraordinarily high risks and long time horizons involved in building companies from scratch, venture capital remains one of the only sources of funding for America’s most ingenious entrepreneurs and innovative start-up companies. Even for venture capitalists, the risks are extreme – which is why Congress for decades has provided the incentive of taxing carried interest as capital gains.  In order to take the risk of building early stage companies, the reward needs to be commensurate.

With this carefully calibrated ratio of risk to reward, the venture capital industry has powered America’s economic growth for decades.  Today, companies with venture capital roots employ more than 12 million Americans and generate revenues equal to 21 percent of U.S. GDP.

The current tax structure has clearly worked for Massachusetts, motivating venture firms to partner with the best and the brightest entrepreneurs from Cambridge to Pittsfield to build companies over the long term.  Here in the Bay State, venture capitalists have invested more than $50 billion dollars into thousands of companies in the last four decades, employing well over half a million citizens.  We are second only to California in terms of venture capital investment and job creation.  The Massachusetts venture capital ecosystem has also contributed greatly to significant advances in life sciences, information technology and clean technology industries.

These are precisely the types of growth industries the President is counting on to foster economic recovery and ongoing U.S. competitiveness.  But by discouraging investment in the companies that comprise these sectors, Congress risks not only letting these opportunities die on the vine, but also draining the pipeline from which future stalwart companies spring. 

That’s why President Obama and Congress must huddle up with regard to job creation – so that the tactics work with the strategy, not against it.  Our region’s continued growth and our country’s economic recovery is dependent on venture capital activity to remain strong.  HR 4213 has put this investment in serious jeopardy over the long term.  It is up to Senators Kerry and Kirk to protect a system that has worked for decades and remove the carried interest provision from the House tax extender bill.

When voters handed the Democrats control of the White House and Congress, it was with the expectation that they’d move together to turn the economy around. The President is leading, but Congress must fall in step quickly or risk tripping up our fragile recovery.

2 Comments

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2 responses to “Boston Business Journal editorial…

  1. just.a.guy

    Your argument that venture capital carried interest should be treated as capital gains and not income is entirely predicated on a set of social goals, rather than the substance of the matter.

    Let’s focus on this bit of substance: returns to venture capital investing have been miserable for going on ten years now, and most funds have not seen carried interest distributions in a decade. I would submit that this is due to an oversupply of capital in the asset class, which has kept returns dismal for all but the loftiest heights of VC investors (i.e. Sequoia).

    As a result, Limited Partners are staying away in droves and the number of firms plying the trade has been on the decline for 5 or more years, matching the general downtrend in first-time investments and deployed capital.

    Yet you seem to think Venture Capital is supply constrained and will be moreso if carried interest is taxed as income? Please.

  2. “Even for venture capitalists, the risks are extreme – which is why Congress for decades has provided the incentive of taxing carried interest as capital gains. In order to take the risk of building early stage companies, the reward needs to be commensurate.”

    So your argument is that VC’s should pay the capital gains rate on their carry because of the extreme risk they bear? Either you are being intentionally misleading or you don’t understand how it really works.

    The VC risks 1% of the capital, the LP’s risk 99% of the capital. If you win, and only if you win, part of the gain is shifted to the VC (20-30%–“carry”). Then and only then do the VC’s put in the capital relating to that gain to “pay back” for the capital they never had to put in in the first place. This is a risk-free arrangement on that carry.

    VC’s will still receive capital gain treatment on the amount they truly put at risk, the original 1% they actually had to risk under the proposed tax rules.

    Perhaps you should try another argument . . .

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