New research reveals that taxing carried interest at ordinary income rates will harm new venture capital (VC) fund formation in emerging technology regions in the United States. The study, by Professors Yael Hochberg and John Barrios (of Rice University and Washington University in St. Louis, respectively), finds that taxing carried interest as ordinary income would make starting a new fund less economical and instead make steady employment at incumbent companies by comparison far more attractive than forming or participating in venture capital.
In particular, the lower potential earnings due to additional tax burdens could significantly reduce the number of VC funds in areas with less mature startup ecosystems, reduce diversity in the startup ecosystem, and limit the effectiveness of several programs in the Build Back Better agenda. The success of several significant priorities under consideration by policymakers today—such as the U.S. Innovation and Competition Act, the Infrastructure and Jobs Act, and the Democratic reconciliation bill—rely to great extent on the availability of funding to support the creation and growth of new innovative entrepreneurial ventures.
- Carried interest tax changes “have the potential to have far-reaching effects on the creation and growth of innovation-driven entrepreneurial ventures in precisely the locations where policymakers are often seeking to increase entrepreneurial activity and growth.”
- VCs under a tax regime taxing carried interest at ordinary income rates face a wage equivalent approximately 20-25% lower than under the current tax regime, a substantial income hit.
- Over the life span of a venture capital fund (which averages about 12 years), the pre-tax wage that would be economically equivalent to the compensation a General Partner receives from running a representatively successful fund of $10 million is approximately $71,000 under the current tax regime. Under a regime that taxes carried interest at ordinary income rates, this pre-tax wage equivalent falls to $52,000.
- Significant new taxes on carried interest “may risk a reversal in the gains that are being made towards increasing diversity among the investor community, and as a result, in the progress towards increasing the diversity of the entrepreneur community.”
- In 2020, 63% of woman and minority-owned firms in the market were raising first-time funds, with many featuring investment strategies that aimed to address social injustice, including investing in underrepresented entrepreneurs.
- States with startup ecosystems that stand to lose the most from this tax change include Pennsylvania, Arizona, Wisconsin, Montana, Michigan, Ohio, Nevada, New Hampshire, Colorado, and Indiana—all of which would lose out on the creation of high-quality jobs should funding to startups dry up due to less local VC financing available.
Why It Matters
Carried interest is often offered up in political discussions in the mistaken belief that it is a pain-free tax increase on the annual income of hedge fund managers. But the reality is that taxing carried interest as ordinary income would have its most significant impact on VC partnerships. These partnerships are financing the economic transition of the U.S. economy, backing technology-focused startups from concept through scaling phase by providing multiple rounds of equity capital as well as strategic counsel and mentorship to company founders. VC partnerships would be disproportionately impacted by increased taxes on carried interest because of the particularly long-time horizons that company building requires, the higher-risk nature of startup investing, and the primary reliance on capital gains as the economic incentive for participation.
The research by Professors Hochberg and Barrios shows that, far from being painless, a significant new tax increase on carried interest will particularly hurt regions and communities with nascent technology ecosystems. This tax increase will limit early-stage venture capital investment, reduce job creation and economic growth in these areas, and ultimately leave them further behind regions with mature technology ecosystems in and outside the United States. Further, a tax increase focused on the VC model will hurt startup activity in virtually all areas of the country and all industry verticals, including climate technology, cybersecurity, semiconductors, and medical technology, dampening our nation’s global competitiveness at a time when the U.S. is fiercely competing for leadership in the next generation of technologies.
A recent survey of VC-backed companies by NVCA showed that “four out of five respondents spent at least 70 percent of their budgets on two activities, wages and compensation and research and development.” The survey also found that nearly one in five VC-backed companies spend at least 85 percent of their budget on R&D. It’s no surprise then that this industry is responsible for over half of companies that go public each year (including 40 percent of climate technology companies), around half of new FDA-approved cures, and are causally responsible for the rise of one-fifth of the current largest 300 US public companies. What is surprising is that, at a time when we as a nation are seeking to accelerate economic growth and access to opportunity, a tax increase this targeted on the most productive investment financing model in the U.S. economy is under such significant consideration. We hope that this study will help inform policymakers as they continue to debate a consequential policy agenda that seeks to improve the long-term economic prospects of our country.