Capital Gains Tax Rates and Entrepreneurs

My friend Lance Weatherby over at Force of Good has a post about the effects of capital gains tax rates on startups and equity investing - saying he won't vote for anyone who wants to raise the capital gains tax rate.. My main source of income for the last 10 years has been capital gains and it doesn't look like that is going to change any time soon, unfortunately. So I am certainly fond of lower capital gains rates. However, I think capital gains rates are too low and that many arguments against raising the rates are spurious at best.

Some quotes:

First and foremost having a low capital gains tax encourages risk taking and investment.

This may or may not be true and it may or may not be good. It also doesn't account for the potential for fraud. Here's a quote from Alan Blinder in a NY Times OpEd:

As the tax debate unfolds, you may find it difficult to follow the mind-numbing complexities. Who doesn’t? So just remember one simple principle: If we tax Activity A at 15 percent and Activity B at 38 percent, a free-market economy will give us more A and less B. Some of this shifting will represent genuine movements of resources out of B and into A — including those bad investments I just mentioned. The rest will be paper manipulations devised to avoid taxes.

Does anyone remember the "Synthetic Fuel" tax loophole that resulted in companies spraying coal dust with pine tar?

I would also argue that 1. There is still plenty of upside in equity investing and 2. Even if the tax rates are the same for income and gains, capital gains are still better.

Equity investing has proven to be higher risk/higher reward consistently through time under numerous tax structures, so I don't think I need to go into that. Most entrepreneurs forgo current income for a bigger capital gain. We reinvest capital into the company to grow it. This results in a deferred tax payment, which is worth more. Even without the growth, consider two 5 year scenarios: $500,000 per year or $2,500,000 in year 5. If the WACC is 10% and the tax on both is 28%, the NPV are $1,364,683.24 and $1,636,363.64 respectively. If the cap gains rate is 15%, the latter's NPV is $1,931,818.18.

For entrepreneurs, angels and VCs, there is the added benefit of the 1045 Qualified Small Business Rollover rule which allows continued deferral of capital gains. Indeed the ability to control when you take a loss or a gain significantly increases the value of capital gains. Even if the rates are the same, they are not equal.

Lance also points out:

Beyond that, at the macro level, there is no guarantee that an increase in capital tax rates will actually produce an increase in tax revenues.

True, but it is more likely that raising the capital gains rates will produce an increase in tax revenue, particularly in the short time. There is also no guarantee that lowering the tax rates increased revenues or increased economic activity (see this article). I take the view that lowering taxes on lower incomes increases economic activity as the money is more likely to be spent. "Equalizing" the rates is also discussed on Marginal Revolution:

One reason why the Clinton tax hikes weren't so bad for capital formation is because capital gains taxes can be avoided in various ways. The Bush defenders should recognize that and admit that K gains tax hikes are not always a disaster. On the other hand, the notion of equalizing income and capital gains rates is a myth, and always will be. There simply isn't a single capital rate that ends up applied to everyone, no matter what it says on paper.

I'm an entrepreneur because I love it. If the capital gains tax rate changes from 15% to 28% I won't go out and get a real job (since I'm no longer hire-able). I bet that most entrepreneurs would say the same thing. The tax code is mind-boggling, its impact on the economy barely fathomable to Nobel prize laureates. Is this the "one issue" that will drive your voting decision? I think that would be a mistake.

.