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How they are funded and how the tax system affects funding

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Reagan’s reform of 1986, tax loopholes and entrepreneurship

Thursday 16 June 2011, by Rose Blackburry

The impact of tax legislation on start-ups birth as well as the weight of tax loopholes is dramatically illustrated by the Reagan’s reforms of 1986.

U.S. investors are no more risk takers than others and react rationally to changes in tax legislation.

Investments in start-ups are extremely sensitive to tax incentives: as taxes have taken with time a larger share of expected gains, maintaining a sufficient rate of start-up creation requires the government to balance by reducing the risk-of-loss side, either by allowing a fraction of the investment to be deducted from income tax (“Avantage Madelin” in France, EIS in UK) or by having the government carrying part of the risk (Subchapter S in the US, which allows a shareholder to deduct his part of a company losses) but taxing capital gains on sale of securities at half the marginal rate of income tax. This difference between the marginal tax rate on income and taxes on capital gains, makes investment in a company the best tax avoidance method in the US and explains why Americans invest so much in start-ups. When this differential disappears, investment stops.

The U.S. fiscal history proves it through two episodes.

In 1977, capital gains were taxed at up to 30% and the highest rate of income tax was 75%, when President Carter, just elected, announced, during budget 78 preparation that capital gains will be taxed at 50% from thereon. This increase did not occur because a campaign led by an industrialist, Zschau, repealed Carter’s initiative. But the funds collected by the U.S. venture capital, which in 1977 reached hundreds of millions of dollars, were reduced in 1978 to ten million. After the announcement of abandonment of Carter’s initiative, venture capital invested jumped to 900 million in 1980, 4.1 billion in 1983.

Second episode in 1986, President Reagan reduced the maximum rate of income tax from about 50% to 28% but, to balance the budget compensation, deleted all the tax loopholes. He thought this would stimulate the economic activity and that firm creations would accelerate. Instead, it dropped as shown on the chart below.

What happened is that, in the great leveling and removal of all loopholes to reduce the income tax rate, this removed the differential between marginal income tax rate and capital gains tax rate, all set at 28%. The number of new companies that had been growing for over 15 years suddenly began to fall. Four years later, the deficit in entrepreneurship reached about 750,000 businesses, about a year’s creation. Unemployment rose to 7-8% and was responsible for George Bush non reelection.

The irony is that the winner, Bill Clinton, pushed up the marginal rate of income tax to 39% and lowered the tax rate on capital gains invested in small businesses to 14%. The differential was reestablished and company creations went up again.

The fact that these are not mere coincidences is demonstrated by written evidence of the time. Listen to what experts from venture capital, said during the preparation of the 1986 Reagan’s reform:

"The tax law will reduce the emergence of entrepreneurs as well as capital, said the venture capitalist in Boston, Craig Burr, summing up the feeling of a large segment of the venture capital community. Many contractors say that the encouragement by far the most important to start a new business is the difference in tax treatment between income and capital gains. This is true both for those who support them financially. The tax law [in preparation, N d R] eliminates this difference by taxing income and capital gains at a maximum rate of 27% [actually it was 28%, N d R]. Currently [May 1986, N d R], the maximum income is 50% while capital gains are taxed at the maximum rate of 20%.”

“Leaders leave well paid positions in corporations, for entrepreneurial adventures when the potential reward is higher, "said Mark Burton Murty, a venture capitalist in Menlo Park, California [Mecca of venture capital N d R].
A major reason why the potential rewards are higher is that entrepreneurs receive a large share of their profits in the form of shares or stock-options’, which gives them the chance to make gains that are favorably treated by the tax. If the rewards are reduced by the operation of higher tax rates, the number of entrepreneurs could be reduced"
 [1]

Footnotes

[1Wall Street Journal of 12 May 1986 : « Tax bill could discourage formation of new firms, venture capitalists say »

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