The ‘Buffett Rule’ is bad news for tech start-ups

September 21, 2011

Jackson is the CEO of CapLinked, an online platform for private investing. He previously ran the marketing team at PayPal, and is the author of the award-winning book The PayPal Wars.

President Obama announced a new tax proposal that sets a minimum tax rate for households with annual income above $1 million on Sept. 19. The proposal is called the “Buffett Rule” for billionaire investor Warren Buffet, who in an editorial in August bemoaned that he pays a lower federal tax rate than his middle-class employees. While time will tell if this new tax proposal makes for good politics, it is bad news for technology start-ups.

First, we need to be clear when we describe what Buffett is talking about. Income for the rich generally doesn’t come from a paycheck but from capital gains, namely dividends -- or profit made from the sale of an asset, such as stock. The federal, long-term capital gains tax rate was lowered from 28 percent to 20 percent by then-president Bill Clinton, and then again to 15 percent by then-president George W. Bush.

Buffett’s argument is that it’s unfair that a rich businessman with $1 million in capital gains would pay a 15 percent federal tax on those gains while a secretary earning $50,000 a year would be in the 25 percent income tax bracket. However, income tax rates are marginal, and there are many credits and deductions that lower the effective rate, so it’s not precisely apples-to-apples.

There are multiple reasons why capital gains tax rates are different than income tax rates. For one thing, corporate income is already taxed before shareholders can recognize capital gains, and the combined federal and state tax on corporate income of 40 percent is the highest in the world. The capital gains rate also applies to investments held at least a year; short-term gains are taxed at the same rate as income.

Capital gains are how technology investors make money. Experienced investors in early stage companies—often called “angels”—make extremely risky investments with the hope of having some companies in their portfolio generate extraordinarily high returns. They know that many of their portfolio companies could fail, but the potential payoff from the winners justifies this high risk, high reward strategy. Its investments from these kinds of individuals that have been the seed money for popular technology companies such as Facebook, PayPal, YouTube, Yelp, and many others. This is how I funded my Web start-up. In short, tech start-ups depend on angel investing to exist.

The “Buffett Rule” is effectively an increase in the capital gains tax rate that early stage tech investors would pay when one of their investments hits it big. And this is bad news for tech start-ups for several reasons:

·It guarantees that investors will have a lower rate of return. A capital gains tax increase automatically lowers how much an investor can hope to make from the handful of winners in their portfolio. Given how risky tech investments are already, this makes the asset class relatively less attractive.

·It decreases the pool of capital available for early-stage investments. If Uncle Sam is taking a larger share when an investor’s portfolio company is acquired or goes public, then, by definition. fewer funds will be available for future investments.

·It lessens the comparative advantage of US entrepreneurs compared to their foreign counterparts. While Silicon Valley is still the envy of the world, entrepreneurs outside the US are following in our technological footsteps. Technology is one of the few bright areas of our moribund economy. Why lessen this advantage with taxes that chip away at start-up capital?

If the “Buffett Rule” is passed, it’s possible that little will change overnight, or even by the next election. But, over time, the higher effective capital gains will begin to eat away at the development of new technology as the pool of capital shrinks and seasoned investors fund fewer risky projects.

While Warren Buffett is legendary for his value approach to investing, his endorsement of President Obama’s proposal indicates he’s overlooking this unintended consequence. Maybe this shouldn’t be a surprise. Buffett has said that he doesn’t invest in tech companies because he doesn’t understand them; he favors old economy industries like construction, railroads, and food. GEICO and Dairy Queen don’t have a lot in common with Airbnb and Square. People will still buy auto insurance and ice cream if this new tax goes into effect.

The “Buffett Rule” isn’t going to do much damage to the Buffett portfolio. The same can’t be said for tech start-ups.

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