Startups fail fast and often, which is why incentives for investing in them need to be protected
House Republicans are fast-tracking tax reform and the newest iterations by the Chairman of the tax-writing Committee, Rep. Kevin Brady, (R-Texas) correctly protects the carried interest tax provision, an extremely important financial mechanism for supporting growth and innovation as well as long a boogeyman of left-wing redistributionists.
Mr. Brady has proposed the addition of a holding period of three years before partners and investment managers would qualify for taxation as a capital gain. This minor modification won’t please the Bernie Sanders’ of the world or the New York Times, but will thankfully continue to incentivize venture investment in early-stage companies and ensure tax-reform is oriented towards promoting economic growth and innovation.
For those unfamiliar, the carried interest provision is a provision in our tax code that treats certain kinds of profits from investments as capital gains rather than income. Often associated with private equity, venture capital, and other alternative investments, it is an essential part of our financial system that encourages investment in young and small companies that may otherwise have difficulty getting their initial funding.
According to reports, it looks like the White House is open to a compromise where the holding period for investments is extended to a minimum of three-years in order for it to be taxed at the capital gains rate, as opposed to the current 1-year minimum, with the stated goal of preventing short-term financial engineering.
Even Steve Bannon, perhaps the greatest proponent in the White House at the time for doing away entirely with the carried interest tax provision, has signed on to the compromise and believes a 3-year lock-in is sufficient for his populist goals and values.
In revamping our tax system, Congressional Republicans undoubtedly want to address some of its excesses and broken parts. While the carried interest provision is not perfect, it nonetheless has extremely impactful and wide-ranging economic effects that make it worth keeping.
By extending the carried interest provision’s holding-period to three-years instead of one-year, it would preserve the ability of investors to be compensated for taking risks that may lead to the next behemoth Internet company or another innovative and disruptive business that brings immense innovation and jobs.
The carried interest provision in recent years has often been mischaracterized as a tax break for the rich, but in fact it is a paltry reward for investors who take immense risks by investing in new companies that often end up creating immense wealth and benefit for the rest of society.
Many companies ranging from Apple to Twitter to Facebook have been started with venture capital, as have and are countless other startups driving incredible innovation and creating jobs in many different sectors.
A major reason why alternative investors are willing to risk their money in ventures, which according to a Harvard Business School study fail 75% of the time and result in the investors losing nearly everything, is that there is a significant reward if the company does succeed and the investor can cash out their original equity investment. By reducing that incentive, entrepreneurs who need early-stage equity investments would be severely hurt.
Furthermore, taxing such an essential financial function would hurt the entire economy in the long-term would, as there would be fewer new ventures that are funded and consequently a slowdown in innovation, jobs, and growth.
President Trump on the campaign trail spoke about how he believed the carried interest provision needed reform. The current compromise that is being discussed would allow President Trump to keep his promise to reform the carried interest provision while preserving its ability to properly reward risky but highly socially-beneficial investments in early-stage ventures.
By extending the holding time-period required from 1-year to 3-years, short-term equity investments will be de-incentivized while long-term investments, which are the kind that often support successful entrepreneurial companies, will still be protected and encouraged.
Tax reform has the potential to dramatically accelerate economic growth and innovation. However in order for tax reform to do so, it needs to avoid falling to rabble-rousing ideas that would do dramatic damage to our financial system.
By keeping the carried interest provision, even if in a modified form with the White House compromise, the Trump Administration and Congressional Republicans will be able to ensure tax reform actually supports opportunity, jobs, and growth for Americans.
As the Senate now also considers the tax reform bill, hopefully Senator Orrin Hatch, who Chairs the Senate Finance Committee, and other Senate Republicans will embrace and mimic Congressman Kevin Brady’s principled stand and support entrepreneurs, risk-taking, and innovation by protecting the carried interest tax provision.
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