June 30, 1985
"Silicon Valley Doesn't Need a Capital Gains Crutch"
San Jose Mercury News
By Timothy Taylor
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IT is a prevailing orthodoxy in Silicon Valley, verging on holy writ, that the capital gains tax cuts of 1978 and 1981 are the prime cause of the venture capital boom of the early 1980s, which in turn has been the lifeblood of Silicon Valley.

Presently, 60 percent of a capital gain is excluded from federal income tax, so a taxpayer in the 50 percent bracket pays at a 20 percent rate.

But evidence is mounting that while the capital gains tax cut probably helped the growth of venture capital, many other factors were at least as important. And the hallowed venture capital explosion itself has not been all gain, no pain for Silicon Valley.

The casual analysis behind the faith in the capital gains tax cut runs this way. From 1969 to 1978, the maximum tax rate on capital gains was nearly the same as the 50 percent top bracket for earned income. Total new venture capital was only $600 million in 1978.

The top tax rate on capital gains was cut to 28 percent in 1978 and to 20 percent in 1981. Rep. Ed Zschau, R-Los Altos, helped lead the charge, along with the American Electronics Association, the National Association of Manufacturers, the Chamber of Commerce, the American Business Conference and many other business groups. New venture capital commitments rose to $4 billion in 1984, an increase of nearly 700 percent in six years. The Silicon Valley boomed. Case closed?

Not really. Of course the tax cut helped venture capital, somewhat. But the world is considerably more complicated than this simple cause-and-effect story. If the main purpose of the capital gains tax break is to encourage venture capital, it has been a hacksaw for a surgeon's job.

The cost of the capital gains exclusion in lost tax revenue went from $7.6 billion in 1978 to $19 billion in 1984, according to Treasury estimates. If the main purpose of the capital gains tax break is to stimulate venture capital, the country is spending $11.4 billion more in tax breaks to encourage $3.4 billion in venture capital. Incidentally, 82 percent of the capital gains tax break goes to the wealthiest 5 percent of all taxpayers.

But even that $3.4 billion increase in venture capital can't all be attributed to the capital gains tax cut. Pension funds have been the biggest source of new venture capital since 1980, providing about one-third of the total, according to data from Venture Economics Inc. But pension fund investments aren't taxed; they have increased because the Department of Labor rewrote the "prudent man" guidelines so pension investors could put money into venture capital.

Another fifth of new venture capital funds comes from foundations and endowments and foreign investors, who weren't encouraged by the capital gains tax cut because they aren't subject to federal income tax. Banks and insurance companies that pay only about a 5 percent tax rate contribute another quarter of new venture capital money, but their low tax rate means that the capital gains break matters little to them.

Only about 15 percent of the new venture capital money comes from individual investors. Of course, broader definitions of venture capital that include backing from family and friends or small investment houses provide different figures, but the general point remains unchallenged: The capital gains tax doesn't make much difference to a major proportion of venture capital investors.

In fact, the capital gains tax break doesn't provide any special incentive for investors to put their money in risky new startups or small companies, because the same capital gains rate applies to investments in IBM and commercial real estate and rare coins and certain tax shelters. The tax code is rewarding every commercial real estate dealer and stockplayer to encourage a few venture capital investors, which is neither sensible nor efficient.

In one way, the capital gains break probably causes less investment in venture capital. The low tax rate encourages investors to buy and sell and shuffle their money, but venture capitalists want "patient money" that waits for a new company to mature.

Investors have chosen venture capital investments over others not because of a tax break that applies to all investments, but because of the extraordinary returns on investment coming from the venture capital industry these past few years. The 30 percent returns of the past few years are attractive with or without a tax break.

Just as venture capital reflected the boom in the electronics industry, now it is reflecting the industry's hard times. Mercury News Business Writer Jonathan Greer summed up the change in his survey of the venture capital industry last Monday: "Venture capital was booming. It peaked in the first quarter of 1984 and has been sliding since. Now, venture capitalists say, the industry is returning to 'normal,' a state most define as before the boom of the early 1980s."

If venture capital is ebbing and flowing with the electronics industry, it's logical that the health of the industry is the prime mover, not tax breaks.

Also, a lot more than the change in capital gains taxes was happening around 1978. The technology of computing had reached a stage where it could be broadly applied, and the nature of the new machines gave small independent companies an ideal opportunity to exploit those profitable applications. Venture capital and the Silicon Valley rode that broad, swift technological current.

The entire economy is still going through a fundamental transformation to computers and the information age. Tax changes have some effect, but they could no more have created the information age than a chimpanzee could fingerpaint the Mona Lisa.

In fact, a rough consensus seems to have developed that the venture capital industry grew too far too fast. Andrew Pollack reported in The New York Times: "Another thing that may take years is the industry's recovery from a shakeout caused by overinvestment in the early 1980s. The amount of money invested in young enterprises, including many computer companies, through venture capital or in stock offerings... went into companies that did not advance technology but merely offered variations of other companies products."

"In the age of the entrepreneur," Pollack continues, "many people think the computer industry is suffering from the ill effects of entrepreneurialism run amok."

Too many new firms means that prices are driven too low by competition for any to make money. Eventually, the weakest firms go out of business, but the whole industry suffers in the meantime.

A cover story in Inc. magazine last fall explained, "Why smart companies are saying NO to venture capital." The explosion in venture capital has meant a shortage of experienced venture capitalists. Instead of acting in their traditional role of providing a background and expertise that helped new firms grow, overstretched venture capitalists have too often been rushing firms to go public before they were ready to cope with outside pressures.

So what is the bottom line? Much if not most of the venture capital money would have been invested without the capital gains tax cut. Although the bulk of the venture capital expansion has been extremely productive, many of the industry's current troubles are because a healthy expansion became an overflow. The capital gains tax break should be kept in some form, if for no other reason than investors and market prices have incorporated it into their planning. But the first Treasury tax reform proposal suggested a sensible reform last November: Index capital gains for inflation and then tax them as ordinary income at a top rate of 35 percent, rather than keeping the arbitrary 60 percent exclusion.

With 4 percent inflation, any investor making 5 1/3 percent real return or less -- that is 9 1/3 overall nominal return -- on an investment would be better off with indexing rather than with the exclusion. The average investor over the last two decades would have been better off with indexing than with the exclusion.

This swap wouldn't much change the amount collected by the capital gains tax, but it would change the incentives.

Investors would seek out the most productive inflation- adjusted deals, and they would be protected against a resurgence of inflation. They would have to pay higher taxes on firms that do extremely well, but lower taxes on firms that do badly, which would tend to reduce the risk of losses.

Indexing would also shift the benefits of the capital gains exclusion from the very wealthy to the moderately well-to-do, as discovered by a 1978 study co-authored by the former chairman of the Council of Economic Advisers Martin Feldstein. That's partly because indexing makes successful investors pay more, and partly because while the very wealthy can better inflation-proof their investments right now, indexing would extend that power to everyone.

Noel J. Fenton, the head of the Capital Formation Committee of the American Electronics Association, wrote in these pages last December that the capital gains exclusion is the "lifeblood of entrepreneurship." The Silicon Valley has practically become a Valhalla of entrepreneurs, as much legend as reality, and the capital gains tax break is part of the myth.

But a Wall Street Journal survey of entrepreneurs in their special business section last month found them to be driven people who break rules, sacrifice family, fail repeatedly, try again, and work 100-hour weeks. They are not the sort of people who sit around waiting for tax breaks; expanded incentive stock options are more their style.

Taking the argument of Fenton and the AEA to its logical conclusion implies that the electronics and computer industries have little more productive economic merit than windmills or solar energy or other businesses that need special tax breaks to survive.

If the stem and root of the Silicon Valley is a truly a tax break -- a thought which grates on my nerves and judgment -- then the whole notion of the hardy independent entrepreneur deserves radical reshaping. It makes more sense to see the technological and industrial marvel that has been created here as a remarkable confluence of people, education, and resources that grew as a result of a fundamental economic opportunity.

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