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Increased Taxes on VC Profits – Catastrophe in the Making?

Washington is talking again about increasing taxes on private equity firms, including VC firms, and this could easily be a catastrophe in the making. Such a policy may be OK for hedge funds, but not for VC funds, which are already struggling and which, more importantly, might close shop if they had to fork over a big piece of their diminishing profits to the government. As it is, investment profits at most firms have been mighty lean for a decade.

The biggest issue is not what a big tax hike would do to venture firms themselves but to the US. economy. Historically, venture-backed startups have generated a disproportionately large share of good American jobs, especially if these startups ultimately go public, because they help create or expand important industries. This is no time to undermine that trend.

The only way for the U.S. to avoid following Greece (and we already are right behind them) is to create new leading-edge industries with highly differentiated and high-paying jobs. This is the key not only to re-invigorating the sagging U.S. standard of living but also tackling the sticky issues related to our massive national debt. These jobs are the output of the venture ecosystem. U.S. tax and other economic policies should be focused on stimulating as much innovation as possible in America. Venture capital is a crucial element of this process, and tax rates have a significant impact on the risk/reward appetite of the venture capital industry.

Some say venture capital firms should pay markedly higher taxes on their profits, or carried interest, because it is a matter of “fairness.” This misses the point entirely. Our tax code has always been primarily a tool to achieve economic and social objectives. I would put high -paying job growth at or near the top of the priority list, especially given America’s lingering economic woes.

For the small minority who think that venture capitalists are being singled out for special treatment, consider a few rhetorical questions:

  • Why is interest on home loans deductible when rent is not?
  • Why do we have a long history of tax breaks for investment in research and development or for purchases of capital equipment?
  • Why are donations to non-profit organizations tax-deductible?

Our tax favors these activities because they are deemed to be beneficial to our economy and our society. Isn’t this also true for American job creation in America, especially the higher paying jobs that sprout from the venture ecosystem?

Bear in mind, too, that venture capitalists are already investing more of their capital off-shore in countries such as India and China, where tax treatment is more favorable. And it’s not just about taxes. The capital is also following the foreign-born entrepreneurial talent that once dreamed of building lives in America. These entrepreneurs are still coming to America to be educated, but they are then returning to their homelands because good opportunities there are growing briskly. This includes startup creation, and these startups are creating jobs that do not employ Americans or pay US taxes.

Everybody who has a stake in this issue should write their congressman and lobby hard to take the possibility of venture capital tax increase off the table. If Washington policy makers don’t wake up, all Americans — not just venture capitalists and startup entrepreneurs — will pay a terrible price. Our already faltering innovation engine, if not resurrected, will turn America into a second-rate economy with second-rate jobs and reduced standard of living for all.

Bob Ackerman is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto, California. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a startup executive. Read his past peHUB posts here