Entrepreneurs need an incentive to start new companies, angels need to fund provocative new ideas, venture capitalists need to build pioneering new businesses, and the public markets and large corporations need to be motivated to acquire emerging growth companies.
How can these demands be met? By lowering the capital gains rate. It is the most effective economic stimulus Washington could enact and would accomplish all of these objectives.
David Dreier (R-Calif.) has introduced a bill, H.R. 44, to create a two-year window in which assets purchased during that time will lock-in a reduced capital gains tax rate when they are sold. The act cuts the capital gains tax rate for investments purchased within the window and held for one year from 20% to 10% for individuals and from 35% to 20% for corporations.
This targeted bill is effectively crafted to avoid the usual criticisms of a capital gains cut. By making it prospective, there is no incentive to cash out of current investments. In fact, it’s just the opposite. It brings new money into play. In addition, unlike the dividend tax cut proposal, lowering the capital gains for corporate investments means that corporations have an incentive to buy portfolio companies with their cash rather than return the cash to shareholders.
Everyone knows that the No. 1 priority of emerging growth companies is and always has been sufficient and efficient access to capital. This access is enhanced most directly and effectively by lowering the cost of capital via reductions in the capital gains tax rate. Importantly, these are the companies that contribute significant job and productivity growth.
Congress took an important step in 1997 when it lowered the capital gains tax rate, but much more needs to be done in this area. U.S. investors-who now represent more than half of U.S. households-face capital gains tax rates on both short- and long-term gains that are among the highest in the industrial world, according to research conducted by the American Council for Capital Formation. While long-term gains for individuals are taxed at a top federal rate of 20% in the United States, the average tax rate in the other countries is only 14.5%. The disparity is even more dramatic when state taxes are included: The average rate for combined state and federal taxes is 24.6% in the United States.
The short-term capital gains rate differential between the United States and its competitors is even greater than the long-term rate: Individual U.S. investors face a top federal rate of 39.6%, in contrast to an average of just 18.4% overseas. Closing these differentials will significantly enhance the incentive within our country for individuals and corporations to buy, hold and sell equity instruments.
Capital gains taxation has a particularly powerful impact on entrepreneurs. These individuals are a major driving force for technological breakthroughs, startups and the creation of high-paying jobs. If the tax on potential capital gains is a higher rate, then the pool of qualified entrepreneurs will decline.
A study published in the Global Entrepreneurship Monitor found that among the world’s 10 leading economies the level of entrepreneurial activity accounted for roughly one-third of the difference in growth rates from country to country. In other words, the United States, which is growing faster than France, can attribute one-third of the difference in its growth rate to its relatively high level of entrepreneurship.
Finally, we all know that small businesses and entrepreneurs face higher capital costs than Fortune 500 companies. For them, a significant capital gains tax differential can make a big difference in decisions affecting jobs and growth.
It’s truly unfortunate that discussions about cutting the capital gains rate have become polarized and partisan. Helping America’s small, entrepreneurial firms, which have been the engines of our economy’s remarkable growth, shouldn’t be so difficult. By backing the most skilled and talented entrepreneurs, managers and technical experts and the most innovative ideas, the venture capital community has served as a catalyst to this growth. In order to sustain and build upon this record, the most important tool needed by entrepreneurs is capital. When considering tax policy, the wisest policies are those that lower the cost of this essential tool and that is why it so important for the U.S. Congress to pass H.R. 44.
Howard Cox is a General Partner with Greylock and Chairman of the National Venture Capital Association. He is a graduate of Princeton University, Columbia Law School and the Harvard Business School.