The political hysteria surrounding the small but complex issue of the tax treatment of carried interest reached new heights this past week as both Donald Trump and Hillary Clinton called for its demise.
Carried interest allows managers of some private investment funds (such as hedge funds, private equity and venture capital) to pay a lower rate on profits from investment gains than most individuals do on ordinary income.
While many different factors have converged over time to create America’s leadership in innovation, significant credit is due to our long-standing tax policy that supports the spirit of entrepreneurship. It’s alarming that each candidate would be so quick to throw something that motivates investors to pour money into start-ups onto the garbage heap. Given their populist-driven rhetoric to increase taxes on start-up investment, it seems appropriate to set the record straight and explain its fundamental role in the American entrepreneurial ecosystem.
Incorrectly perceived by many as an unfair loophole in the tax code, carried interest is actually the primary incentive for venture capital investors to create new venture funds that invest in start-ups, and is only realized if that investment is successful. The debate today is whether it is wise economic policy to double the tax rate on carried interest received by venture capitalists who were successful in helping to create new companies.
Venture capitalists create partnerships with institutional investors to combine the capital held by pension funds, endowments, foundations and others with their talent and expertise to make risky, long-term equity investments into innovative start-ups. These are generally partnerships that last 10 to 15 years, building investments far longer than any other asset class. Hopefully start-ups succeed against huge risks and grow into successful companies, but in over 50 percent of deals, they fail.
Carried interest, an important ingredient in the venture model, has historically been treated as a capital gain because carry is the venture capitalist’s share of the profits from a partnership that builds start-ups over the long-term. These profits are a result of years of value creation from an initial risky investment and a great deal of hard work from everyone involved. Carry is similar to stock awards received by start-up founders in that both venture capitalists and founders invest time, energy and creativity against huge risks in the hopes of creating long-term value. As a result, both currently receive capital gain tax treatment on their interests if they succeed.
Venture capital has had a tremendous impact on the American economy, funding the creation of household names such as Apple, Facebook, Genentech and SpaceX, and spurring the creation of entire new industries. A recent research paper by Stanford University found that 42 percent of all companies that have gone public since 1974 can trace their roots to venture capital. Those venture-backed companies account for an astounding 85 percent of all research-and-development spending by companies that have gone public since 1974. And, start-ups are an important source of job creation in the U.S. economy.
In addition to being appropriate tax policy, the role of carried interest in the entrepreneurial ecosystem is important economic policy. America is the global leader in innovation — a critical component in a globally competitive economy — in large part because of venture capital. And as we can see from the economies of other countries, if venture capital isn’t around to support an entrepreneurial ecosystem, no other investment class, nor government spending, can fill this gap.
Increasing taxes on carried interest earned by venture capitalists actually runs counter to urgings by many economists and policy makers on both sides of the aisle who maintain that patient, equity investment be rewarded over short-term bets and financial engineering. If they were to form partnerships on the same day, other asset classes that are held for shorter periods can see profits from multiple investment cycles in the time it takes venture capitalists to realize any potential gain from their first investment, with both inflation and opportunity cost eating away at the value of carried interest. The net result of this tax increase will be a shift away from riskier investments with greater promise for breakthrough innovation towards safer investment strategies that favor incremental progress. Additionally, raising taxes on carried interest would be particularly devastating to venture capital fund formation outside of the traditional regions because of the outsized reliance that smaller funds place on carry to make the economics work.
If you were whiteboarding the best public policy solutions to encourage new company creation, you would be hard-pressed to find a more perfect alignment of interests than the carried interest a venture capitalist receives from a successful start-up investment. Carry is long-term and perfectly aligned with the long-term success of a capital gain instrument. When things don’t work out for the start-up, the carry on a deal is zero. The benefit of carry is only achieved as a result of long-term, high-risk investments supporting bold ideas and will hopefully remain the reward for the investments that will create the next generation of American industries. Tax policy defined by a simple equation which holds that no benefit is extended unless and until our country receives the benefit of greater economic activity through company and job creation is a carried interest we should all care about.
So, instead of wasting time debating a complex tax policy that’s become a political football and would raise enough revenue to fund the government for about three hours, let’s discuss ideas for how to make tax policy work better for the entrepreneurial ecosystem so that it’s easier to build the great companies of tomorrow here in America today.