June 30, 1985
"Silicon Valley Doesn't Need a Capital Gains Crutch"
San Jose Mercury News
By Timothy Taylor
<< Back to 1985 menu
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
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
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
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
<< Back to 1985 menu