That’s the argument being put forth by University of Colorado professor Victor Fleischer, who several years ago wrote a paper that nearly prompted Congress to change the way that private equity and hedge fund managers are taxed on their investment profits (or “carried interest”). The new paper is called “Taxing Founders’ Stock,” and is expected to be submitted to law journals in March. A draft version can be found here.
I was a very vocal supporter of Fleischer’s earlier campaign, belieivng that carried interest is a fee for services to people who do not put their own capital at risk. This time around, however, I’ve been much more ambivalent:
The issue here is whether changing this tax break would significantly dissuade potential entrepreneurs from hanging their own shingles. My gut feeling is that it would, and perhaps in great numbers. There are many factors that contribute to the creation of an entrepreneur — including passion for the product and a desire to be one’s own boss — but the prospect of future riches is right up there. Given how few entrepreneurs actually succeed, it would seem counterproductive to lighten the pot of gold.
Fleischer was on vacation when I first wrote about his new paper, but today we spoke via telephone. Here is an edited transcript:
Fortune: There are a lot of similarities between your carried interest and founder’s stock arguments. Is the latter just a continuation of the former?
Fleischer: Distributive justice is one of the key points of the paper. Founders obviously tend to be a much more sympathetic bunch than private equity firms, and venture capital is somewhere in the middle. People are more likely to respond favorably toward Mark Zuckerberg than to Steve Schwarzman.
But if you look at the Forbes 400, most guys are on there because they started companies, or because someone in their family started a company. Not only do they get to pay taxes at a lower rate than most other people, but so do those who inherit stock at a step-up in basis.
Imagine Bill Gates passes on Microsoft (MSFT) stock to his nephew. And let’s say that Gates originally paid $1 per share, and it’s now worth $100 per share. All of the gains attributable to Gates’ labor disappears and is never taxed. That’s one reason why you have so many Waltons on the Forbes 100 –nobody has ever paid income taxes on those gains. It’s possible that some of that ultimately gets caught up by the estate tax, but there are ways to plan for that.
Ok, but how much weight do you give to the argument that a lower tax rate for company founders spurs entrepreneurship, which almost everyone agrees is an economic boon?
Yes, there is a much stronger case for some form of economic subsidy for founders, because entrepreneurship is so important.
So I examined the economic research out there on entrepreneurs, and found that there is no empirical evidence that subsidy is effective. Of all the things entrepreneurs think about, tax is low enough on the list that it doesn’t appear to have an impact. The fact that you may pay 35% compared to 15% 10 years from now doesn’t seem to significantly factor into someone’s decision to leave Google (GOOG) or Intel (INTC) to launch a new company.
Entrepreneurs are so aware of the risk that they aren’t really counting on anything. If the idea is good and it works out, they’ll get paid. If not, they’ll do something else. Plus, the capital gains rates were higher in the late 1980s and 1990s, and it does not appear that entrepreneurship suffered.
But founders, unlike private equity investors, are indeed risking something in exchange for founders stock. Many of them take shares in lieu of all, or part, of their salaries.
It’s not any different than a commission in real estate. There is contingent pay in all sorts of arenas that is taxed as ordinary income. To get at that as a policy matter, you’d need to show me evidence that a lower tax rate would cause more people to leave Intel to start new companies, and I can’t find it.
I’m not anti-entrepreneurship. I simply think there are better ways to stimulate it than by this tax subsidy. Increase funding for basic research, improve immigration policy so that talented engineers came come and found or work for startups, or do a variety of other things that would be more effective.
What would be your opinion of some sort of hybrid taxation structure for founder stock? Something whereby the first million dollars or so is taxed as capital gains, and then anything above that as ordinary income.
That would be fine. We actually have a version of that under Qualified Small Business Stock, or Section 1202.
Where I actually come out in the paper is that I don’t think we can fix this under our current tax scheme. First, it’s administratively difficult to differentiate between founder stock and investor stock. Plus, if carried interest couldn’t get through…
The point of the paper is not to get a bill into Congress, but to get policymakers to think about this as part of a broader tax reform.
