This article is written by Nibha Yadav, pursuing Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
The United States of America, the land of ‘Capitalists’ which proudly hosts the richest people of the world like Jeff Bezos, the Founder, and CEO of multinational company Amazon, worth $179 billion, followed by Bill Gates who is worth $111 billion, Mark Zuckerberg worth $ 85 billion, Warren Buffet worth $73.5 billion who are owners of multinational companies like Microsoft, Facebook, Berkshire Hathaway respectively. According to the Forbes 400 2020: The Richest People in America, America’s 400 richest are worth a record $ 3.2 trillion. But unfortunately, the lack of investment in the public policies and the loopholes in the tax system which allegedly favours the richest of America has unmasked the fragility of the healthcare system of the country and the overall quality of its infrastructure. Internal Revenue Services has revealed that audit rates on people making more than $1 million annually have fallen sharply by 80% between 2011 to 2018. Joe Biden’s government has undertaken the role of fixing this loophole by introducing the new tax policy which is colloquially known as the ‘high capital gains tax policy’. This new policy is believed to majorly impact the top 1% of rich Americans and for that reason, it has garnered a lot of criticism even before the legislation could be passed.
The Joe Biden government is firm on raising revenues for the socialist program “American Families Plan” by evading the preferential tax rate system and raising the rate as high as 43.4% by the end of the year 2022. However, the efficiency of the new tax policy has to be determined taking into consideration different factors like its impact on the entrepreneurial ecosystem and economic growth of the country. In this article we shall be comparatively analyzing the current and the new proposed tax policy, critically review the policy from the perspective of venture capitalists, investors and primarily determine whether it will impact venture funding in the country.
Current tax policy and its shortcomings
Currently under the tax policy of America capital gains i.e. profits raised from selling assets and stock dividends are subjected to personal income tax known as capital gains tax at a much lower rate than the other types of income. Capital gains taxes are applicable to wealthy individuals as their income is based on investment rather than ordinary income or salaried labour. The capital gains tax rate is only at 20% while the income tax bracket is as high as 37%. This is because the current policy fails to recognise the profits earned by capitalists as “income” but identifies them as a mere gain earned on selling assets and dividends. The wealthy people making millions of money are paying way lower taxes than the middle-income taxpayers. This has subjected the middle-income earners to a prolonged disparity. Most of the benefits of the preferential rates for capital gains and dividends go to the 1% richest of the country as a result of this very well off individuals pay a lower effective tax rate than individuals whose incomes are much smaller. In 2012 Warren Buffet famously said that he paid a lower effective tax rate than his secretary, this statement found its way in one of President Barack Obama’s State of Union speeches.
The Internal Revenue Service has estimated that the tax gap i.e. the difference between federal taxes owed to the state and paid was an average of $ 381 billion from 2011 to 2013. The tax gap today as estimated by the IRS could have risen nearly $ 600 billion and it could be as high as $ 1 trillion a year. About one-third of this tax gap is thought to be owed by the richest 1% of the country. This further proves that the current arrangement is fundamentally unfair to the lower earners as they are the ones shouldering the burden of the tax.
Biden’s new tax plan, if enacted, would affect less than 1% of taxpayers and would be confined almost exclusively to the richest 1% of Americans who draw returns essentially by selling securities like stocks, bonds and other assets held in taxable accounts for a gain. The revenue thus collected would be then allocated to American Families Plan to fund education, child care, paid leave, etc.
The proposed tax policy and its objective
President Joe Biden’s American Families Plan includes revenue-raising proposals that would certainly affect very high-income taxpayers by bringing the following changes: reinstating the original personal income tax rate of 39.6% against the current 37% and eliminating tax breaks related to capital gains for the rich. The new tax policy would increase income tax rates of the millionaires in the following manner:
i) Reinstate the original personal income tax rate
Democrats are in favour of restoring the personal income tax rate to 39.6% which was lowered to 37% by the Trump administration in 2017 which effectively raised the threshold for taxable income. The income tax rate of 39.6% will also apply to people earning more than $4,00,000 million a year. Joe Biden is calling for reinstating the tax rate for the top income tax bracket to as high as 39.6%
ii) Eliminate the special tax rate for capital gains and stock dividends
Capital gains on assets and dividends will now be treated as ‘income’ bringing it at par with the ordinary income or salary. Thus, under Biden’s plan income on capital gains and stock dividends exceeding $1 million in a year will be subjected to the same 39.6% rate that would apply to the other income. Two-thirds of this group would see their taxes go up by an average of $159,000 a year according to the analysis of the Institute on Taxation and Economic Policy.
iii) To end the exclusion of capital gains on assets left for heirs exceeding $1 million
The current tax code taxes only that part of the income when assets are sold and the increase in value of such assets becomes ‘realized’ capital gain. So under the current tax law, if a taxpayer dies and passes on his assets to his heirs, the ‘unrealized’ capital gains on such assets are not considered as part of income and hence, it is not taxed. In order to calculate a capital gain after selling an asset, the ‘basis’ is usually the price which the taxpayer has paid to purchase the asset, such ‘basis’ is subtracted from the sale price they received for such asset, this break is also known as the “stepped-up basis.” The Biden government wants to end this break on capital gains.
Let’s say if a wealthy couple bought a mansion worth $3 million and it values $6 million by the time they die then according to the current tax policy their heirs could exclude $3 million gain and pay taxes on the remaining $1.5 million of the original purchase price.
iv) End the carried interest loophole for millionaires
‘Carried interest’ is the money that fund managers earn for managing someone else’s investments, however, the money they earn is not considered as an income but as capital gains, thus, subjecting it to a lower tax rate of 20%. It would be wiser to remove this loophole from the tax code.
v) End the loophole regarding taxes paid by high-income earners for health care
As per the Affordable Care Act, people whose income is above $200,000 are liable to pay Medicare payroll tax of 3.8%. A comparable 3.8% tax is levied on investment income known as Net Investment Income Tax, it applies to whatever part of a taxpayer’s adjusted gross income is above $ 200,000. The objective was to levy a 3.8% healthcare tax on the rich regardless of the form of income. However, a loophole allows certain income from pass-through businesses to avoid being part of either Medicare payroll tax or investment tax. The Biden administration is aiming to close this loophole for incomes exceeding $ 400,000 annually. The Obama administration had estimated that closing this loophole would have raised around $ 272 billion over a period of 10 years.
Thus, the Biden administration is aiming to restore the top personal income tax rate at 39.6% for people earning more than $400,000 annually, subjecting capital gains to the same tax rate for people earning $1 million or more annually and ending the carried interest tax break among other things as a key method for compensation. Furthermore, the government would allocate additional resources to the Internal Revenue Services (IRS). This would provide the IRS with better tools to regulate and administer the income of the taxpayers. The tax increase on individuals from the policy on personal income tax and on capital gains together would raise $168 billion by 2022. However, the combined revenue impact could be as little as $88 billion because due to the rate increase on capital gains taxpayers would resort to different techniques to escape this raise. By raising the taxes of less than 1% rich Americans, the American Families Plan could raise $1.5 trillion over a decade. This amount could save nearly $15,000 a year of the Biden Government on child care, workers could get 12 weeks of paid family and medical leave, the administration could make free college tuitions a reality.
A critical review of the new tax policy from the perspective of Venture Capitalists and investors
The announcement of the new tax policy has garnered mixed reactions where few investors are welcoming of this decision while few spars over the government as they could sense danger on their personal income. Silicon Valley venture capitalists and other large investors have mobilized to protest against the President’s plan to raise taxes even before the legislation could be placed in Congress for approval. The National Venture Capital Association, the largest known lobbying group of America has publicly opposed the new proposed policy as they believe it could hamper investment in the longer run. Another venture capitalist David Stewart recently tweeted that the higher capital gains tax has the potential to neuter the entrepreneurial ecosystem of America. Tim Draper, a billionaire venture capitalist believes that higher taxes will rob the incentive to build long term startups and thus, kill the opportunity to create jobs.
However, capitalist Vinod Khosla believes otherwise. In his opinion sharing the benefits of capitalism is not terrible and lower taxes should not be criteria for ethical folks. Nihal Mehta, the founding general partner at Eniac Ventures, said that investment in human capital any day will outweigh the delta in the tax that we as citizens pay. U.S. Commerce Secretary Gina Raimondo defended the new proposed policy to raise capital gains tax, saying that the proposed change wouldn’t discourage investment which is the primary concern of many investors, irrespective of the changes venture capitalists are going to continue to invest in new businesses, potential entrepreneurs.
i) Does Joe Biden’s new tax policy fixes the inequities in the tax code or it worsens the condition for investors?
The capital gains tax increase will mark the biggest hike in the history of the USA as the tax rate will be almost doubled from a meagre 20% to almost 43.4%. But it is difficult to comprehend whether raising the tax rate will suddenly fix the inequities in the tax code from time immemorial. A report by the Tax Foundation estimates that the new hiked capital gains tax could result in $469.4 billion revenue over a decade, however, the forecasted revenue will be back-ended and negligible when compared to projected government consumption of $6.6 trillion in 2020 alone. Biden’s plan to tax people drawing a salary of $400,000 or more in a year at a rate of 39.6% would mean paying an additional 6.2% in tax on top of the 39.6% marginal rate. This would also mean that freelancers, small business owners, self-employed people after paying both employer and employee side of the tax they will have to pay an additional 12.4% in tax on top of the 39.6% marginal rate resulting in a total of 53 per cent marginal rate.
So even after raising the capital gains tax with an objective to tax the millionaires, there might be a possibility where small business owners will end up paying a higher marginal tax rate and a higher effective rate than the wealthy individuals, thus, nullifying the whole objective. This will likely result in a condition where investors will choose to hold onto assets far longer than required. Congressional Research Service published a paper explaining the behavioural responses to changes in capital tax rates as “lock-in effect” wherein such changes may encourage the investors to hold suboptimal portfolios. This basically means that investors will simply hold onto their assets to evade tax than selling them and investing in a better stock which will eventually lead to market inefficiencies. As per the analysis of Tax Foundation, low tax rates on capital gains encourages investment which is good for the economy in the long run while higher tax rates will lead to more consumption which is only good for the short term. Raising taxes on capital gains will result in creative attempts to sell off the assets for the purpose of evading taxes which will eventually do more harm to the economy than good.
ii) How the Wall Street Journal’s editorial under the column titled “The Dumbest Tax Increase” lacks evidence regarding the fundamentals of Venture Funding and Investments?
Wall Street Journal’s editorial titled “The Dumbest Tax Increase” argues that the proposed tax hike is driven by the ideology of the Biden administration and lacks the common sense to its effect. The new policy is fuelled by the propaganda of the government in power. The journal further accuses the government on accounts of both “unfairness” and economic illiteracy” and argues that it is only justified to levy lower taxes on capital gains than labour income. The editorial backs up this argument by stating that under the current tax code though all the gains are fully taxed all losses are not deductible. Also, the gains in asset values are not adjusted against inflation which means that the investor has to pay taxes, part of which are illusory and capital gains tax is a second tax on corporate income.
Thus, the income of the investors is subjected to “double taxation” which is unfair when all the income could be taxed once. But even if you don’t consider the argument against double taxation, how raising taxes on a tiny subset of individuals earning more than $1 million a year is unfair? It is unlikely that the increased capital gains tax rate would radically decrease the savings rate among the richest 0.3% of Americans. Also, how is it fair for the lower-salaried people or middle-income earners to pay more taxes than capitalists who get away by paying one set of taxes? The argument about fairness, thus, falls flat on the face when the capitalists are themselves the beneficiaries of such inequity in the system.
Further, the arguments proposed by WSJ like lower tax rates encourage saving and investment while higher tax rates would discourage investment; low investment would mean lower worker productivity and thus smaller to negligible income gains for the working people is plausible on its face. A report made by the Congressional Research Service in 2018 which was primarily considering the effect of changes to the capital gains rate for Americans with income in the six-figure bracket or more, is contrary to the claims raised. The report stated that although evidence on the effect of tax cuts on saving rates and its relevant impact on economic growth is difficult to obtain, most evidence does not indicate that an increase in savings would reflect in the form of increased investment too. The impact of low capital gains tax rate on economic growth is unclear and it has too little data to suggest otherwise. Even if the journal could prove that a higher capital gains tax rate would have a negative impact on a macroeconomic level in isolation without considering any other factors, that would still not establish that Biden’s policy would too. Even the argument that the proposed higher capital gains tax rate would not raise revenue but even cost the government money on their part is untrue as the reports suggest otherwise. A 2016 report of child care’s impact on the workforce suggests that a 10% decrease in the child care costs could lead to an increase in labour jobs between 0.25% to 1.25%. Federal Trade Commission carried out a research in 2020 which estimated that enabling college education tuition-free would increase enrollment by 26% among students and degree completions by 20% thus, increasing the human capital of the nation. In fact, multiple studies have suggested that extending the accessibility of public health care to lower-income families would improve long term health, thereby increasing life productivity. Thus, the evidence for the benefits of these policies is way more robust than the evidence highlighting the benefits of low capital gains taxes.
Conclusion
In my opinion, the answer to the question as to whether the proposed “high tax” policy would impact venture funding or investments in the US is No. There is little to no evidence to back up the claim that increased capital gains taxes would lead to a decrease in innovation capital while lower tax rates would result in increased capital investment in the long run as reported by the Congressional Research Service. In fact, Gina Raimondo US’s Commerce secretary said in an interview that entrepreneurs like to create businesses and venture capitalists like to invest in such businesses and they would continue to do so irrespective of the changes proposed to capital gains tax. The notion that higher capital gains tax rate would discourage investors to sell off their assets is because selling an asset is a discretionary decision of the investor when he realizes a gain or loss and it is independent of the changes to the capital gains rate. Those opposing the new tax policy lack empirical evidence to support their claims.
The anger, denial, and disagreement is coming from a place of unexamined class entitlement and personal loss, Biden’s tax policy if implemented could impact the personal income of millionaires. The argument as to what the ideal capital gains tax rate would be has been reduced to whether it is worth hiking the capital gains taxes to fund Biden’s social investments. One may argue that such socialist programs can be funded by Public Debt or any other means, this argument does hold some credibility as capital gains are an unreliable source of revenue for the government as the investors are the masters in such cases. They have the discretion to decide when to liquidate their assets. The government instead of taxing the value that wealthy investors accrue when they sell off their assets could simply tax any increase in the value of their assets in their portfolios. Reports suggest that the Democrats are actively considering this policy and are in favour of pursuing it. One may say that it is now time for the rich capitalists to make up for the years-long low paid taxes.
References
- Venture Capitalists spar over Biden’s plan to raise their taxes
- Raimondo sees U.S. Venture Capital tax withstanding Biden tax plans
- Income tax increases in President Biden’s American Families Plan
- Biden’s capital gains tax plan fixes nothing
- Biden wants to raise $1.5 trillion by taxing the Rich. Here’s How
- Biden’s proposed tax plans could hit private equity in the pocket
- Rich Investors make a poor case against Biden’s Tax Plan
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