Tax Policy: A Tool for Good or a Weapon of Mass Destruction?

President Obama, Congress and much of the public have torches in their hands, storming the fortress that is alternative assets – venture capital, private equity and hedge funds. The issue: taxation of earnings. What is the character of the earnings, ordinary income or capital gains? Unfortunately they’re missing the point. How about creating an environment where there are more earnings – which generate even higher taxes, employment, new business creation and innovation? And consider the larger issue of the capital gains tax rate itself. President Obama wants to raise it, to at least 20% and perhaps beyond. The disgruntled public and PR-happy Congresspeople are excited at the prospect of raising taxes on these constituencies, and getting to raise the pelt over their heads with the message “We just generated billions of dollars, took from the rich and gave to you, the middle class.” The fact is, nothing could be further from the truth. This short-sighted publicity stunt will do nothing but hamper the US economic recovery, create disincentives for investment and cast a pall over an industry that has been a key source of competitive advantage for the US over the past 30 years.

Congress would have you believe that venture capitalists and investors in emerging businesses are a bunch of selfish, money-grubbing capitalists. And they’d generally be right. But consider that success is inextricably bound to making good investment decisions, the kinds of decisions that help promising companies get launched and funded for growth. These companies develop new technologies, employ people in growing industries, pay taxes and spawn a new crop of entrepreneurs who can do it all over again. Venture investors play an essential role in the business formation and job creation process, and why anybody in their right mind would raise taxes on this constituency at any time – much less a time like this – boggles the mind. We should be doing everything in our power to encourage investment, which I’d prefer to see via simplification of the tax code rather than creating additional complexity for one-off programs. How about slashing the tax rate on investment in small businesses to spur investment and risk-taking? Wouldn’t this make more sense than trying to close a trillion-dollar deficit with punitive tax increases?

Also, the sentiment of “soak the corporation” is wrong-headed and illogical as well. Corporate cash flow is used to do many good things: pay employees; invest in the business; and pay dividends. After-tax earnings is the primary generator of this cash flow. So when Congress in its populist zeal beats the war drums about low effective corporate tax rates, just how exactly do they think jacking up taxes on corporations is going to help the employees, the working people of this country? Keep corporate taxes low, have fiduciaries (Board members, powerful investors such as pensions and endowments, etc.) do their jobs and compensate and incentivize senior executives intelligently (as opposed to egregiously) and let companies re-invest in their businesses or dividend cash out to shareholders. And by all means, simplify the corporate tax code so there is greater transparency between book tax and cash tax liabilities. Investors should be able to look at an income statement and have a sense of the taxes a corporation is paying. Unfortunately, this is anything but the case today.

If you really want a progressive tax regime that encourages investment and fosters economic growth, focus on taxing consumption instead of relying on earnings. This is clearly not a panacea, because if consumption is taxed too heavily then individuals won’t spend enough to support the economy, either. Striking the right balance between savings and investment is critical. But I can imagine a tax regime that discriminates between luxuries and necessities, and has a progressive character based on aggregate consumption. I think this is much easier to engineer and administer than an uber-complicated earnings-driven tax policy such as we have today.

Bottom line: tax policy should be used to help us grow out of our problems, not generate cash for bailing our way out of our problems. And the current budget proposals do not give me comfort that Obama & Co. have their heads or hearts in the right place.

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