Small Business Tax Reform

Federal tax policies are a powerful factor in encouraging or impeding business investment, job creation, and international competitiveness. For small businesses and growth companies, capital gains taxation plays a particularly important role.

Reduced capital gains taxes can generate greater financing of young companies by angel investors and venture capitalists. Lower capital gains taxes can also encourage people to become entrepreneurs because the payoff from a successful start‐​up is improved compared to a wage job. Entrepreneurs put their own money into their ventures and want to maximize the financial returns from their hard work and sacrifice.

Investors in entrepreneurial ventures take big risks in the hope that their bets on unproven technologies and unproven markets pay off years down the road. Their reward for putting up “patient capital” is a possible capital gain on some of their investments, net of their losses on investments gone sour. The U.S. tax system is biased against such beneficial risk‐​taking because it taxes the gains but restricts the ability to use capital losses.

The higher the tax rate on capital gains, the fewer potential projects will get the green light from investors, who are looking for a certain level of after‐​tax return. Put another way, higher taxes increase the “hurdle rate” that prospective projects must earn to be viable.

Angel funding for young companies comes from the “personal pocketbooks” of high‐​earning individuals, who could alternately put their cash into safer investments, such as tax‐​free municipal bonds.¹ The capital gains tax rate thus directly affects the willingness of investors to place their funds into risky start‐​up and growth firms.

In the United States, there are roughly 300,000 or more angel investors, who are often entrepreneurs themselves.² Their role in funding waves of promising young companies is crucial because some of those firms will grow into major businesses. For example, Andy Bechtolsheim invested $100,000 in 1998 to help launch Google. He was also a co‐​founder of Sun Microsystems, which itself had been nurtured by venture capital in the early 1980s. Another well‐​know angel is Peter Thiel, who founded PayPal. His wealth from that venture has allowed him to fund many young companies, including investing $500,000 in 2004 to help launch Facebook.

When angel investors such as Thiel and Bechtolsheim have successes, they will eventually want to exit their investments and realize a capital gain. Then they will often use their after‐​tax returns to fund more young companies in an ongoing virtuous cycle. A low capital gains tax rate is crucial to this cycle of growth and innovation.

Nowhere has that virtuous cycle been move evident than California’s Silicon Valley, which roared to life after reductions in the top federal capital gains tax rate from 40 percent in 1978 to 20 percent in 1981.³ Many now‐​famous technology firms were nurtured on the flood of new risk capital available since the late 1970s, including Apple, Microsoft, Ebay, Cisco, and Amazon.

Today, higher capital gains tax rates risk killing off the new Apples and Amazons that we need to power America’s economy in the future. Congress should reconsider the recent legislative changes that raised the top federal tax rate on long‐​term capital gains from 15 percent to 23.8 percent. Capital gains are different than ordinary income, which is why most nations have top capital gains tax rates that are much lower than their top rates on ordinary income.

When state‐​level taxes are included, the average top U.S. tax rate on long‐​term capital gains is now 27.9 percent. That rate is much higher than the average rate of just 16.4 percent in the 34 nations of the Organization for Economic Cooperation and Development (OECD).⁴

Eleven OECD countries do not impose taxes on long‐​term capital gains, nor do some jurisdictions outside of the OECD, such as Hong Kong, Malaysia, and Thailand. The nontaxation of long‐​term gains used to be the norm in many countries because they properly viewed gains as not being “income.” Britain did not tax capital gains until 1965, Canada until 1972, and Australia until 1985. And only in the last few years have long‐​term gains been taxed in Austria, Germany, and Portugal.

In sum, long‐​term capital gains are widely recognized as being much different than ordinary income, and they should be subject to low or zero tax rates. Hopefully, federal policymakers will reconsider capital gains tax policy in coming months and reduce our tax rate to at least the average rate of our trading partners in the OECD. A lower capital gains tax rate would boost innovation, spur entrepreneurship, and help America regain its competitive edge.

Thank you for holding this important hearing.

Notes

¹ David Verrill, Angel Capital Association, testimony to the Senate Committee on Finance, September 20, 2012.
² Scott Shane, “The Importance of Angel Investing in Financing the Growth of Entrepreneurial Ventures,” Small Business Administration, September 2008.
³ In addition to capital gains tax cuts, rule changes for U.S. pension plans in 1978 helped boost the U.S. venture capital industry by allowing higher‐​risk investments.
⁴ Chris Edwards, “Advantages of Low Capital Gains Tax Rates,” Cato Institute Tax and Budget Bulletin no. 66, December 2012.