It’s obvious: “Reducing taxes on gains from the sale of financial assets and on dividends of ownership of financial assets received stimulates capital formation.”
This claim is a favorite among the financial industry cognoscenti, conservative politicians, some conservative, think-tank economists and, probably, a majority of voters. The logic is that if profits from asset sales are taxed at a lower rate when realized after holding them for at least one year, asset owners will respond positively to this incentive and hold those assets for at least a year before selling them. Somehow, this incentive transforms institutional and individual traders and investors into long-term investors. This transformation helps public and private corporations raise money in the money market for projects that will deliver long-term economic benefits to the company rather than projects that promise small, immediate returns that when annualized, have very high values. This focus on long-term investing creates more value over a longer holding period than would a focus on short-term profits.
Proponents usually state this case along these lines: American industry and its workforce have grown from modest beginnings as just another industrial economy in the world to the economic titan it is, today, as the result of technological innovation, abundant resources, geographic isolation from large-scale conflicts, exceptional entrepreneurship and its ability to gather money into large pools, which are then invested in large-scale projects that enable exceptional entrepreneurs to invent superior processes and products, marshal our abundant natural and human resources to achieve business-model scale expansion and consequent competitive advantages (cost, capacity, marketing, sales, liquidity, etc.) over competitors to whom such funding is unavailable. Investors don’t realized ash-on-cash returns on such investments for years; the project requires a startup period and a lengthy period during which no residuals are available to investors because the project consumes all the cash flow it generates as production and sales volumes grow. To encourage this long-term investment, this argument goes, the federal government should subsidize returns on such investment by taxing them at a lower rate than it taxes so-called ordinary income. By taxing such profits at lower rates, it encourages people with idle funds to invest in risky, long-term projects.
There are, at least, five fatal problems with this story and it’s logic. First, it’s a classic case of post hoc ergo propter hoc (after the fact, therefore, because of the fact) reasoning; favorable taxation of capital gains is irrelevant to encouraging sound, productive investment, despite the apparent coincidence of reduced tax rates on capital gains and astronomical growth in commitments to private equity and venture capital funds. Second, although some factors may have been necessary to achieve such post hoc outcomes, favorable tax treatment was not one of them. Third, no single factor is a sufficient condition for their achievement, particularly not this one. Fourth, no data or evidence supports this claim. Fifth, the current form of implementation is not only inconsistent with its intended financial outcomes it’s counterproductive. Six, it encourages rent-seeking behavior to the detriment encouraging of productive behavior.
There is an interesting case in recent history that illustrates this argument for favorable capital gains treatment and what’s wrong with it. Before 1978, that pillar of long-term investment, entrepreneurship, innovation and wealth creation, the venture capital industry, was tiny. “Venture capital” wasn’t even a term of use until the 1940s; the primary sources of startup and early stage capital were wealthy families and corporations. Such wealthy families the Whitney, Hillman, Vanderbilt and Rockefeller families and a few such corporations as Textron pooled the vast majority of money pooled for investment in early-stage and startup companies. The first “institutional” (funds that used other people’s money) venture fund was American Research & Development Corp., which was founded in 1946 by General George S. Doriot (founder of INSEAD and former Dean of Harvard Business School), Karl Compton (former president of MIT) and Ralph Flanders (former U. S. Senator from Vermont). Also founded in 1946 was J. H. Whitney & Co. For a good overview of the history of Venture Capital, follow this link, History of Venture Capital, Wikipedia.
Conservative politicians, funding sources and think-tank writers assert commonly that the venture capital and private equity/leveraged buyout boom in the 1980s was driven the enactment of the Reagan Economic Recovery Tax Act of 1981 (ERTA), one provision of which was to reduce the top tax rate on capital gains to 20% from 28%. This reduction, conservatives claim, was large enough to influence investors to change their investment strategies to create the private equity boom of the early 1980s. Unfortunately, this claim is false. If only stimulating this type of investment was that easy!
Here’s why that claim is false. First, most (at least 80%) of the growth of investor commitments to institutional VC and LBO funds (Private Equity funds were called Leveraged Buyout Funds in those days—before the collapse of their investments in the latter half of the 1980s) was the increase in commitments by college and university endowments and pension funds. Those institutions pay no taxes on their earnings or capital gains. Therefore, changes to tax rates on their income or capital gains affected neither their investment outcomes nor their investment behavior. Okay, so what did drive this boom?
In 1974, Congress passed the Employment Retirement Investment Securities Act (ERISA). One of the provisions, the “prudent man” rule, of this act was to restrict pension funds and endowments to investments in marketable securities traded on “public” exchanges. This provision excluded, therefore, real estate, private equity, venture capital, commodities futures and options, and options on the behavior of stocks or markets. In 1975, investments in PE/VC funds cratered to $10 million. In 1978, this restriction was relaxed to permit investment of up to 10% of total assets in so-called “alternative investments”. To get an idea of how small the VC/PE industry was in 1977, commitments to such funds totaled $39 million (vs. $20 Billion in VC alone for Q3, 2012)1. Commitments, after ERISA was amended in 1978, totaled $570 million, and increase of 1,500%. In the ensuing decade, annual commitments to PE (LBO in those days) funds grew from $2.4 Billion in 1980 to $21.9 Billion in 1989. Commitments to VC funds grew from $3 Billion in 1979 (up from $570 million in 1978) to $31 Billion in 1989. Changes in tax rates had no effect on this growth.
To gauge the effect of tax rate changes on this growth, just examine commitments to VC and PE funds during the period from 1981, when ERTA was enacted, to 1985. Capital commitments in 1980 to VC funds approximated $3 Billion and to PE Funds, $2.4 Billion. In 1985, total commitments to VC funds approximated $3.7 Billion, a hard-to-believe-because-it’s-so-large annual increase of 4.28%, unadjusted for inflation, which was 8-10% per year during that period. Total commitments to PE funds approximated $3.0 Billion, another amazing annual growth of 3%, unadjusted for inflation. Clearly, changes to tax rates may affect the behaviors of individual investors, but changes to tax rates do not affect institutional investors because they don’t pay taxes and institutions supply the vast majority of investment funds to private equity and venture capital funds!
What, then, did drive the post-70s boom in commitments to private equity and venture capital funds? I’ll discuss this topic in my next post.