Editor’s note: David Gardner, founder of Cofounders Capital in Cary, is a regular contributor to WRAL TechWire.
CARY – Taxes are not just a way to pay for all of the stuff governments provide, they are also a powerful tool used to influence how citizens are incentivized to invest, save, support charities, etc.
As Congress struggles to find ways to pay for trillions of dollars of new spending, almost every tax break incentive seems to be on the potential chopping block. In its frenzy to raise taxes, close loopholes and reduce incentive tax breaks, it is important for lawmakers to pause and consider why some of these tax incentives were put in place originally.
Saving tens of millions of dollars by eliminating an incentive may sound pretty good right now until you find out that doing so will actually cost the government hundreds of millions in lost revenue down the road, in effect, exacerbating the very problem being targeted.
Such is the case with some of the proposed incentive cuts such as reducing the 1202 exemption for investing in early stage companies which I have written previous articles about. Since 2010 multiple Republican and Democratic administrations have supported the 1202 exemption. It has been used effectively to encourage investors to direct their dollars towards early stage ventures in the US. It helps offset the risk of investing in startups by offering investors a zero Federal tax rate on gains if the investor meets the criteria such as holding the investment for at least five years. Unfortunately, the current proposed Biden plan would cut this rate in half. Other proposed cuts will make it more difficult for investors to invest in early stage ventures out of their IRA accounts or even to qualify as accredited investors to invest. Such changes add up to a big disincentive to invest in early stage ventures in the US.
Why is this the wrong area to cut incentives?
Over the last several years, investors have gravitated towards increasingly larger venture funds where both risk and returns are typically lower. This trend is well documented in numerous reports and my own previous publications.
Large funds have to write large checks so they do not make early stage investments. This has created an increasing lack of early stage capital which is a particular problem because startup companies are not only where most of our innovation occurs in the US but also where almost all later stage companies come from. The entire innovation ecosystem begins to break down if money for early stage ventures dries up for too long.
The proposed change will discourage entrepreneurs from starting companies and early stage ventures from investing in. Many investors will simply move their portfolios to international markets or other US sectors such as real estate where tax incentives continue to abound. This would be particularly punctuated in North Carolina where our tax code follows the Fed’s creating an even bigger disincentive.
With all of the focus on corporations let’s not forget that 75% of business taxes are paid by small businesses not major corporations. If those dollars dry up then many of those businesses won’t get started and that could create an even bigger tax shortfall in the future. Yes, we need more tax revenue now but we also need to avoid any knee-jerk legislation that could make our fields even more fallow in the years to come.