Welfare Loss from Taxing Carry

A tax on financiers will affect the price and quantity of capital supplied, the question is how much and who bears the burden of this loss?

The market for private equity dollars has a strongly price elastic supply curve and a normally elastic demand curve. When the government imposes a supply-side shock in the form of a carry tax, entrepreneurs lose.

Capital is a highly liquid asset that can be easily transferred to whatever opportunities yield the greatest return. In other words, the supply of private equity capital is seriously price elastic. The government imposes a tax on capital suppliers and they will pursue other opportunities and other forms of investment that don’t have such a heavy tax burden.

The demand for private equity is neither particularly price elastic nor inelastic. Entrepreneurs, the consumers of venture capital dollars, have options when it comes to financing a company. They can bootstrap their companies, or go with angel investors, VCs or venture debt firms. Despite the plethora of funding options, entrepreneurs may not be price sensitive if they feel VCs offer value beyond the valuation terms.

So when the supply of capital takes a supply shock, the greatest loss comes from the consumer surplus. Entrepreneurs get hosed because financiers look for other less-taxed investment opportunities.

Check out my cool hand-drawn graph. It’ll make you feel like you’re in economics 101 again.

Of course taxing carry doesn’t mean that all innovation will be killed in the cradle. Jim commented on an earlier post: “To argue that Apple and Intel etc. would not have been created if Art Rock had his carried interest taxed as capital gains is preposterous – and an insult to Bob Noyce, Gordon Moore, Steve Wozniak, and Steve Jobs etc. who were the ones who actually built great companies.”

He’s right. Hard-core entrepreneurs will change the world with or without VC dollars and the best VCs will make money with or without a tax on carry.