CAPITAL GAINS TAX POLICY TOWARD **

JAMES M. POTERBA* HE need to subsidize risky new ven- gains on venture investments in context T tures is frequently cited as a reason and compares their total value with the for taxing gains at rates below value of all realized gains, illustrating the other types of income. This paper inves- large spill-overs associated with system- tigates the efficacy of lowering individual atic reductions in capital gains rates. The capital gains tax rates as a device for sub- third section discusses the difficulties sidizing such ventures, particularly those which arise in designing such a targeted which are funded through the organized subsidy, There is a brief conclusion and a process.' data appendix. The paper makes two central points. First, more than three quarters of the funds that are invested in start-up firms 1. Capital Gains Taxation and the are provided by investors who are not Supply of Venture Capital Funds subject to the individual capital gains tax. Funds committed by untaxed investors, The source of funds for start-up enter- notably pension funds, have expanded prises is a central issue in assessing the more rapidly than funds from taxable importance of capital gains tax changes. investors in the years since the 1978 cap- Start-up firms receive capital from many ital gains tax cut. A significant fraction sources. The corporate founder and other of the funds supplied to venture firms is employees usually contribute capital, much therefore unaffected by the individual of this in the form of equity that is ulti- capital gains tax. mately subject to individual capital gains Second, the overwhelming majority of taxation. Table 1 presents evidence from taxable capital gains results from invest- a somewhat dated study on the debt, eq- ments in activities other than start-up uity, and ownership structure of start-up firms. Less than one third of reported enterprises. In 1976, organized venture gains are the result of appreciation of cor- capitalists accounted for less than 15 per- porate equity, and only a small fraction cent of total funding. By comparison, eq- of the gains on equity are related to ven- uity from insiders and unaffiliated indi- ture capital investments. An across-the- viduals amounted to 24.9 percent of the board capital gains tax cut is therefore a initial capital for technology-based firms. relatively blunt device for encouraging Approximately 54 percent of the funds for venture investment. If policymakers wish these small firms was supplied as equity. to subsidize venture investments, some For non-technology firms, the equity share form of targeted capital gains reduction was 29.7 percent with insiders and other would be a more attra:ctive option. individuals supplying 20.7 percent of the The paper is divided into four sections. total capitalization. The first presents evidence on the source The importance of organized venture of funds to the venture capital industry capital has almost surely grown since.the and documents the relatively minor role 1976 survey. Nevertheless, the common played by individual investors. Changes view that start-up enterprises rely exclu- in corporate capital gains tax rates have sively on equity finance seems incorrect. a larger impact on the effective tax bu r- Although small firms appear to use rel- den on the organized venture capital in- atively more equity than their larger dustry than do changes in the individual counterparts, many start-ups rely heavily income tax. Section two places capital on debt finance. One recent stud@ com- missioned by the Small Business Admin- *Massachusetts Institute of Technology, Cam- istration (JACA, 1985) found that 57.8 bridge, MA 02139 and National Bureau for Economic percent of start-up businesses did not use Research, Cambridge, MA 02138. any of the founders' savings. Debt, either

375 376 NATIONAL TAX JOURNAL [Vol. XLII

Table 1: Capital Structure of Start-Up Enterprises

Share of Capital Structure

Capital Type & Source Technology-Based Firms Other Firms

Eguity 53.8% 29.7%

Insiders 13.6% 16.4%

unaffiliated 11.3% 4.3%

Individuals

Venture Capitalists 9.8% 5.1%

Other Investors 19.1% 3.9%

Debt 46.2% 70.3%

Insiders 2.2% 6.9%

Unaffiliated Individuals 4.0% 3.5%

Venture Capitalists 2.5% 1.8%

Banks 19.5% 28.0%

Other Investors 18.0% 30.1%

Notes: The "Other Investors" category includes investors who could not be

identified, but who may have in fact been in other categories. Data are from

Charles River Associates, An Analysis of Venture Capital Market Imperfections

reproduced in U.S. Treasury (1985).

from banks or from friends and relatives, stage, many firms would never be viable. accounted for more than 80 percent of If the suppliers of this equity capital, who capitalization in 24,8 percent of the start- may be the corporate founder or friends UPS. and relatives of the founder, are discour- The "bottleneck theory" of equity fi- aged by high capital gains tax rates, then nance may apply to some classes of start- the amount of startup activity could de- up firms, although the importance of this cline in response to higher capital gains view remains to be demonstrated. This tax rates even if most of the funds flow- theory implies that without a certain ing to more mature start-up firms are un- amount of equity finance at a critical early affected.' There is some evidence, how- No. 31 JAMES M. POTERBA 377

ever, that the organized venture capital uals may invest through SBICS, but they market can be used to avoid this bottle- have not been primary suppliers of capi- neck: 45 percent of commitments by or- tal through this channel. ganized venture capital firms in 1985 were Corporate subsidiaries enable large to firms in the start-up or pre-start-up corporations to become involved in devel- stages. opments at start-up firms. They are de- The rapid growth in organized venture signed to provide diversification or inno- capital funding during the last decade has vation for their corporate parents. Venture been widely cited as demonstrating the capital investments through corporate sensitivity of the supply of venture funds subsidiaries face corporate tax rates, so to capital gains tax policy. The evidence they should be much less sensitive to traditionally used to bolster this view, changes in the individual income tax namely the rapid growth in organized treatment of capital gains than invest- venture capital partnerships, is not par- ments through independent venture part- ticularly supportive of this view. Taxable nerships. individual investors have supplied rela- Table 2 presents information on the tively little of the capital these funds have composition of venture capital finance. invested. Individual investors account for less than Organized venture capital consists of one quarter of the capital invested in the three classes of institutions: independent organized venture capital industry. More- venture capital funds, Small Business In- over, their share of the new investment vestment Companies (SBICs), and corpo- flow has declined through time, from more rate subsidiaries. Independent venture than one third at the end of the 1970s to funds are the most important financing only 8 percent in 1988. Although individ- channel. They usually involve a general uals supplied less capital to independent partner or partners who screen potential venture funds after the 1986 capital gains investments and assist the management tax increases took effect, it is difficult to teams the partnership has invested in, attribute this decline to changes in their as well as limited partners who provide tax burdens. Individuals committed $392 . At the end of 1988, million in new capital in 1986. This the total capitalization of the venture in- amount increased to $501 million in 1987 dustry was $31 billion, with almost $25 (after the new higher rates were in ef- billion of the total supplied through in- fect), and then declined by fifty percent- dependent venture partnerships. Com- to $236 million-in 1988. This decline mitments to such partnerships have in- cannot be traced solely to capital gains tax creased fifteen-fold during the last decade, burdens on capital suppliers, however, while funds channelled through SBICs and since commitments by pension funds also corporate subsidiaries have not even dou- declined by 20 percent, those by founda- bled. tions by 25 percent, and those by foreign Small Business Investment Companies investors declined by 33 percent between are licensed and regulated by the Small 1987 and 1988. Business Administration (SBA). They are Corporations emerge as the single most essentially closed-end investment trusts important category of capital supplier. The which provide both capital and manage- corporate category in Table 2 includes both rial assistance to start-up firms. The 1958 nonfinancial corporations investing legislation authorizing SBICs allowed through subsidiaries or SBICS, as well as these entities to borrow three dollars at financial corporations (principally insur- Treasury interest rates for each dollar of ance companies). Of the 37.2 percent of equity capital they raised. Because the the venture capital pool supplied by firms investment income of SBICs is not taxa- at the end of 1988, 20.5 percent was due ble until it is distributed to shareholders, to insurance companies and 16.7 percent SBICs provide an attractive investment was from nonfinancial corporations. vehicle for banks or insurance companies After corporations, the second most im- wishing to defer taxable income. Individ- portant group of capital suppliers are tax- 378 NATIONAL TAX JOURNAL [Vol. XLII

Table 2: Sources of venture Capital Finance, 1977-1988

Fraction of Total Venture Finance From: Individuals Corporations Foreign Investors Tax-Exempt

1977 27.3 60.5 5.2 6.9

1978 29.2 57.1 5.8 7.9

1979 29.8 54.9 5.9 9.4

1980 29.7 53.8 5.7 10.9

1981 28.4 53.0 5.7 12.8

1982 25.3 49.6 7.1 18.0

1983 23.3 44.9 9.1 22.7

1984 21.7 42.6 10.5 25.2

1985 20.7 41.9 11.5 26.0

1986 19.3 40.1 11.1 29.5

1987 18.5 38.2 11.3 32.0

1988 17.9 37.2 11.4 33.5

Fraction of New Venture Commitments From: 1978 36.7 43.7 8.1 11.5

1979 32.9 42.1 6.7 18.3

1980 29.4 45.8 3.8 21.0

1981 22.6 49.7 6.2 21.5

1982 11.8 35.2 13.0 40.0

1983 19.0 34.6 13.5 32.9

1984 15.9 34.4 15.4 34.2

1985 14.6 38.0 17.0 30.4

1986 12.1 30.8 9.4 47.7

1987 13.9 27.2 12.4 46.6

1988 7.9 20.1 13.2 58.8

Source: Author's calculations based on data in Venture CaRital Yearbook, 1988. Calculations are described in detail in a data appendix. No. 31 JAMES M. POTERBA 379 exempt investors such as pension funds uals can work as middle or high-level and foundations. They accounted for 32.5 managers for large firms, or they can start percent of the stock of funds in 1988, and their own firms with a senior manage- were even more significant (59 percent) ment position. 7 A given worker's compen- in the flow of new in that year. sation package is likely to involve a larger The importance of untaxed investors in share of capital gains at a start-up firm this market suggests that pretax returns than at a larger, more established firm. have not been reduced by the favorable By altering the relative tax burdens on tax treatment of venture capital gains to wage and capital gains income, reduc- individuals. If this subsidy were central tions in the capital gains tax make entre- in this market, then untaxed investors preneurship more attractive. would be paying an implicit tax by in- The strongest support for this view vesting in venture projects. These inves- emerges from Holland's (1969) interviews tors avoid other assets with substantial with a number of scientists and engineers implicit taxes (such as tax-exempt debt) working in business firms. He concludes: and their presence in this market sug- . . . it was the [respondents'] opinion that certain fea- gests that the current tax subsidies are tures of the tax structure, particularly the differen- not overwhelming. Finally, 13 percent Of tially low rate of tax on capital gains, helped to move the venture funding pool in 1988 was sup- engineers and scientists from pure laboratory re- plied by foreign investors. These inves- search or a consulting relation to a more direct busi- tors are unaffected by the United States' "S activity in which they served as a leading ex- 3 ecutive in a firm (or firms) which they had been capital gains tax. instrumental in starting or else joined very early in The finding that more than 80 percent the game . . . important in motivating them was a of the funding for venture capital projects chance to participate in the company's growth through 'tock available at a low price or a stock option (Hol- is from investors who, are not affected by land, 1969, p. 483). the personal income tax castsdoubt on the view that changes in the capital gains tax Holland's surveys were conducted when rate affect the supply of funds to new ven- the differential in marginal tax rates on tures.' This is particularly well illus- labor income and capital gains income was trated by the calculations in Table 3. The larger than at any time during the 1980s, first column shows the weighted average so it is possible that the effects uncovered statutory tax rate on realized venture in his study are less important today.' The capital gains, using information on the changes in the relative tax burdens on suppliers of capital in Table 2.' The sec- wage income versus capital gains during ond column shows the effect on the the last decade should ultimately provide weighted-average tax rate of a 10 per- a strong test of the importance of these centage point reduction in the individual factors. tax rate on realized gains. 6 In recent years Although it is premature to draw any the net effect is less than a two percent- strong conclusions on the effect of the 1986 age point reduction in the weighted av- Tax Reform Act on the supply of entre- erage tax burden. Even when individual preneurs, Table 4 presents four summary investors were near the peak of their im- measures of start-up activity during the portance in the late 1970s, a 10 percent last two decades. The various data series rate reduction would only have reduced provide very little support for the view that the average realization tax rate by 3 per- the supply of entrepreneurial activity has cent. declined in the last two years. The first These calculations do not necessarily column reports the Commerce Depart- imply that the individual capital gains tax ment's Index of Net Business Formations. is irrelevant for the level of start-up ac- It is higher in 1987-1988 than in the pre- tivity. There may be an important link vious four years, but not as high as dur- between capital gains tax rates and the ing the late 1970S (when capital gains tax demand for venture capital funds oper- rates were high). This index is very sen- ating through the occupational decisions sitive to cyclical conditions, however, and of potential entrepreneurs. These individ- its strength since 1986 may simply be a 380 NATIONAL TAX JOURNAL [Vol. XLII

Table 3: weighted Average statutory Capital Gains Tax Rate on Venture Finance

Effect of Reducing Individual

Average Tax Rate Tax Rate by 10 Percentage Points

1977 26.5% -2.7%

1978 25.9 -2.9

1979 23.7 -3.0

1980 23.4 -3.0

1981 21.6 -2.8

1982 18.9 -2.5

1983 17.2 -2.3

1984 16.3 -2.2

1985 15.9 -2.1

1986 15.1 -1.9

1987 18.2 -1.9

1988 17.7 -1.8

Source: Column 1 is based on author's calculations using data reported in various issues of the Venture Capital Journal, and presented in the appendix.

Column 3 is -.l*(column 1, table 1). reflection of macroeconomic conditions. partnerships or sole proprietorships when The second column in Table 4 reports possible to avoid corporate tax burdens. the number of new incorporations in each The third column in Table 4 presents year since 1965. This series shows a sub- the aggregate self-employment rate, an- stantial decline after 1986. h is difficult other indicator which may bear on the ex- to link new incorporations with entrepre- tent of entrepreneurial activity. It shows neurial activity, however, because incor- a small increase between 1986 and 1987, porations merely reflect legal changes of with a larger increase in 1988. Once again, existing business with no effects on real however, this may be an unreliable in- activity. This is particularly true with re- dicator of start-up activity since many self- spect to personal service corporations. employed individuals are not starting Since the corporate tax rate is currently businesses with much capital at risk. The higher than the top personal income tax self-employment rate is also sensitive to rate, there is a strong incentive for using changes in the relative demand for the No. 31 JAMES M. POTERBA 381

Table 4: Indicators of Business Start-up Activity 1965-1988

Index of Self-Employment New Venture Net Business (Percent of Capital Formations New Incorporations Labor Force) Commitments

1965 99.8 204.1 8.2

1966 99.3 200.3 7.9

1967 ioo,o 206.8 6.7

1968 108.3 233.4 6.5

1969 115,8 274.0 6.5 1546.3

1970 108,8 263.8 6.3 787.6

1971 111.1 287.5 6.3 690.2

1972 119,3 317.4 6.1 410.6

1973 119.1 329.1 6.1 327.5

1974 113.2 319.0 6.1 279.9

1975 109.9 326.3 6.1 40.6

1976 120.4 374.1 6.0 179.9

1977 130.8 437.4 6.2 123.3

1978 138.1 480.0 6.3 1648.7

1979 138.3 524.3 6.3 695.5

1980 129.9 531.5 6.4 1365.3

1981 124.8 581.2 6.4 2107.5

1982 116.4 565.8 6.6 2578.3

1983 117.5 601.9 6.8 5971.0

1984 121.3 635.1 6.9 5186.7

1985 120.9 662.8 6.8 3843.4

1986 120.4 701.7 6,7 4968.5

1987 121@2 685.4 6.8 5066.5

1988 124.1 682.9 7.0 2100.0

Source: Column one is an index (1967-100) calculated by the Commerce Department and reported in Business Conditions Dizest. Column 2, measured in thousands of incorporations and based on IRS data, is also reported in the Business Conditions Digest. Column 3 is the percent of total employment in self-employment and is drawn from various issues of Employment and Earnings. Column 4 is drawn from the Venture Capital Yearbook and is measured in thousands of 1988 dollars, with deflation by author using the GNPdeflator. 382 NATIONAL TAX JOURNAL [Vol. XLII output of different industries, and it is af- management in 1988 totalled approxi- fected by macroeconomic conditions. mately $31 billion, or approximately one Finally, the fourth column in Table 4 percent of the value of U.S. equity mar- shows total venture capital commitments kets. Table 5 demonstrates the relatively in 1988 dollars. Commitments in 1987 ex- small share of venture-related gains in ceeded their level in 1986, and then de- total realizations. The calculations in Ta- clined in 1988. Even this variable, which ble 5 assume that all of the proceedings is probably the single best indicator of ac- in initial public offerings by venture- tivity by start-up firms, can be difficult to backed firms are capital gains for the analyze over time periods of several years. venture investors.' The first colunm shows In 1987, for example, there was a shift the ratio of venture-backed 1POs to total from early-stage seed finance to later stage realized gains. In the last five years for ttmezzanine" financing. Thus the increase which data are available, these IPOs av- in commitments does not ensure that the erage only 1.1 percent of total realiza- level of start-up activity has increased, it tions. Even doubling these gains to re- could simply reflect funding being chan- flect the gains of investors who do not sell neled to enterprises that were already their shares as part of the IPO as well as started but are now in later stages of de- the gains of investors in other venture velopment. deals which never reach the IPO stage, The data in Table 4 do not yield a con- does not correspond to a substantial share sistent picture of changes in start-up ac- of total realizations.10 tivity since 1986. Further analysis of these data, taking account of economic condi- tions and the output mix of the economy, 3. On Targeting a Venture Capital is clearly needed to understand how tax Subsidy policy affects new business development. The relatively small amount of realized Other measures of the importance of start- venture gains suggests that if one were to up firms such as the share of employment design a policy to aid high-risk startup at small enterprises might also provide firms, the policy should be targeted so as useful insight on this problem. to avoid substantial revenue loss without substantial benefit to start-up firms.'' A 2. The Small World of Venture number of issues of practical tax design Capital arise in crafting such a targeted policy. An across-the-board cut in capital gains tax cut is a relatively blunt instrument 3.1 Targeting by Enterprise Size for encouraging venture activity. Most of One option is to design tax policies to the benefits of such a tax reduction would provide lower capital gains burdens on. accrue to investors in assets besides ven- investments in small firms. It may be dif- ture capital firms. In 1981, for example, ficult, however, to distinguish between the most recent year for which the IRS genuine new ventures and pre-existing published detailed tabulations, only one ventures that have been spun-off into new third of taxable capital gains reflects ap- enterprises. A lower tax rate on capital preciation on common stock. Venture ac- gains in start-up firms would distort or- tivity is only a small share of this equity ganizational structure away from large component. Real property accounts for a firms and toward many small enter- larger share of net gains than does com- prises. Many of the same problems that mon stock in each of the survey years. This arise in policing transfer pricing between underscores an important point for capi- multinational subsidiaries would arise in tal-gains policymaking: a systematic re- transfers between existing firms and start- duction in capital gains tax rates will ups in which they owned equity. There benefit many investments besides equity- would be strong incentives for established financed venture capital activity. firms to transfer patents or other valu- The pool of venture capital funds under able assets to startup firms that would No. 31 JAMES M. POTERBA 383

Table 5: Venture-Backed Initial Public Offerings as Share of Total Capital Gains

Venture Backed 1POs/ Venture-Backed 1POs/ Total Realized Gains Total 1POs

1978 0.1% 36.5%

1979 0.1 20.7

1980 0.6 30.3

1981 1.0 23.9

1982 0.6 37.8

1983 2.5 24.1

1984 0.5 19.4

1985 0.5 15.1

1986 0.6 9.5

1987 1.5 7.6 ------

Source: Annual flow of venture-backed 1POs is drawn from Venture CaRital Yearbook, 1988. Total realized gains are reported in the IRS Individual Statistics of Income, various years. Total 1POs are reported in the IPO Ret)orter, qualify for more favorable tax treatment. It is likely to be very difficult to compare The case for encouraging small firms at these various aspects of industrial struc- the expense of larger enterprises is not ture in deciding what constitutes optimal clear. Several indicators suggest that government policy. workers fare better at large than small firms. Studies which control for worker and firm characteristics find that smaller 32 Targeting by Enterprise Risk firms tend to pay lower wages (Brown and A second possibility is to target high risk Medoff (1989)). Workers at larger firms ventures. As the difficulty in designing are less likely to be injured in the work- regulations for debt versus equity secu- place (Ruser (1985)), and they are more rities suggests, it is difficult to objectively likely to be covered by a pension plan measure the riskiness of an investment. (Small Business Administration (1985)) A risk-based targeting scheme might en- and health insurance (Small Business courage many individuals providing ser- Administration (1987)). Offsetting these vices, such as doctors, lawyers, and disadvantages for employees are the po- tradesmen, to incorporate and find ways tentially greater flexibility of smaller en- to bear risk in order to take advantage of terprises and the higher research and de- favorable tax rates. Many of the imple- velopment intensity of smaller firms mentation problems which would arise in (Small Business Administration (1983)). this case have strong parallels in existing 384 NATIONAL TAX JOURNAL [Vol. XLII contexts such as the design of rules for ficult to analyze the potential effects of personal holding companies. tax changes. Lower tax rates on capital gains may A second neglected issue is the feasi- not be the most effective way of subsi- bility of designing a targeted tax subsidy dizing high risk ventures. If it were pos- for the high-risk start-up sector. Neither sible to distinguish risky activities, some the practical tax issues nor the more the- attention should also be devoted to cur- oretical questions of whether policy should rent loss-offset provisions, since these subsidize small or risky firms have been might have substantial value to potential resolved. Policy discussion has focused al- entrepreneurs." Phillips and Kirchoff most exclusively on the rate of capital (1989) report that 23.7 percent of start-up gains taxation, while other instruments firms fail within two years, 51.7 percent such as loss offset rules or changes in es- within four years, and 62.7 percent in six tate and gift tax provisions on equity in years. The implementation problems as- start-up firms should also be explored. sociated with more generous subsidies for large losses may be smaller than the cor- responding problems with lower tax rates ENDNOTES on certain classes of gains, so these op- tions may warrant exploration. **I am grateful to William Brock, Lawrence Katz, Lawrence Summers, Victoria Summers, and Mark Wolfson for helpful discussions and to the National Science Foundation for financial support.This re- 4. Conclusions search is part of the NBER Program in Taxation. The policy debate concerning the links 'PartsofthispaperdrawheavilyonPoterba(1989). The data on the sourcesof venture capital. funding between capital gains tax rates anc'l ven- have been updated, hence many of the tables do not ture capital activity has been largely mis- precisely agree. The present paper cumulates the stock placed. It is simply not credible to argue of venture capital funds in constant dollars, while the that a substantial fraction of the growth previous paper used the nominal sums reported by Venture without any adjustment. The data in organized venture capital markets since a endix clarifies thesedifferences. the late 1970s is the result of lower cap_ PYNoneof the available data sets on startup firms ital gains tax rates on investors, since most are adequate for determining whether, and in what of the funds have come from investors who circumstances, the bottleneck theory is correct. Freear and Wetzel's (1988) study of equity financing for tech- do not face the personal capital gains tax. nology-based start-up firms in New England shows Across-the-board reductions in indivi ua that individuals play amore important role in the early capital gains tax rates would have a small stages of venture financing. Private individuals sup- effect on the total tax burden on venture plied 21% of the equity to their sample firms, while organized venture capital firms provided the remain- capital financiers, while conveying large ing 79%. Their sample is confined to firms that used benefits on many assets other than ven- equity finance,however,soit excludesthosefirms ture capital investments. which might have started with other sourcesof seed While the links between the supply of capital- The JACA (1985)study doesnot distinguish firms by stage of lifecycle, soit cannot be usedto study venture capital funds and the level of pre-start-u financing. capital gains tax rates has been much dis- 'SeveralPnations that account for substantial in- cussed, two issues which are central for flows of equity investment to the U.S., notably Japan, policy evaluation have received very lim- the Netherlands, and West Germany, donot tax long- term capital gains on corporate equities. ited attention. First, there is very limited 4poterba (1989) reports that 88% of the funds sup- evidence on the extent to which the sup- plied to independent venture fun& were from inves- ply of entrepreneurial activity responds tors who were not affectedby the individual capital to the relative tax burdens on capital gains gains tax. The lower estimate in the present paper applies to all venture capital funding, not just to that and labor income. hiterviews suggest that flowing through independent venture funds. The re- taxes may affect employment venue, which vised approach to measuring the total stock of capital in turn could link capital gains tax rates in the venture industry also affects these estimates. 5The statutory rate is often a poor indicator of the with the denwnd for venture capital ftinds.t effective tax burden on capital gains, since gains are by potential entrepreneurs. Economis s deferred and investors may use portfolio rules to min- understand very little about the entre- irnize their tax burdens. Poterba (1989) emphasizes preneurial process, and this makes it dif- that in many venture investments, however, the de- No. 31 JAMES M. POTERBA 385 ferral benefit is not large; the partnerships typically Lindsey, Lawrence (1986), "Capital Gains Rates, Rev- last five to seven years. enues, and Realizations," in M. S. Feldstein (ed.), 'The calculations in colunms 1 and 2 assume that The Effects of Taxation on . the marginal tax rate on individual capital gains was Chicago: University of Chicago Press. .35 before the 1978 reform, .28 after the 1978 capital Perez, Robert C. (1986). Inside Venture Capital: Past, gains reform, .20 during the 1981-86 period, and .34 Present, and Future. New York: Praeger Publish- in 1987.Lindsey (1986) considers other higher tax rates ers. in the pre-1978 period, but relatively few investors Phillips, Bruce D. and Brace A. Kirchoff (1989). faced these rates. "Analysis of New Firm Survival and Growth." 'The arguments of this section apply both to the Journal of Snudl BusinessEconomics (Winter 1989). founder, the individual who raises capital and be- Poterba, James (1989). "Venture Capital and Capital comes the CEO of the new firm, as well as to top-level Gains Taxation," in Lawrence Summers (ed.), Tax employees who also receive a large fraction of their Policy and the Economy: Volume 3. Cambridge: MIT compensation in the form of stock options or other eq- Press, 47-68. ihty claims. Ruser, John W. (1985). "Workers' Compensation In- 'Hollan&s (1969) conclusions regarding capital gains surance, Experience Rating, and Occupational In- taxation and technology-oriented entrepreneurs were juries." Rand Journal of Economics, Vol. 16 (Win- also based on relatively few interviews. ter), 487-503. 'IPOs are the most succe"d venture outcomes, with U.S. Small Business Administration (1983). The State the highest rates of return. Perez (1986) reports that of Small Business. Washington: Government Print- one start-up in five becomes successful enough to ing Office. warrant a public offering of equity; two in five are U.S. Small Business A(hninistration (1985). The State ultimately merged into larger firms; one in five be. of Small Business. Washington: Government Print- comes a successful small business, with the venture ing Office. capitalists selling their equity stake to the managers; U.S. Small Business Administration (1987). The State and one in five must be liquidated or written off. The of Small Business. Washington: Government Print- return on investment is approximately 600% in the ing Office. first case, 100% in the second and third, and -100% U.S. Treasury Department, Office of Tax Analysis. in the latter. Thus, EPOs are likely to account for more (1985). Capital Gains Tax Reductions of 1978. than half of the capital gains on venture investments. Washington: U.S. Government Printing Office. "Until the last few years venture-backed 1POs ac- Venture Economics. (1988). Venture Capital Year- counted for roughly one third of total 1POs. The rapid book, 1988. Wellesley, MA: Venture Economics. growth of closed end mutual fund issues in 1986 and 1987, however, swelled the flow of 1POs and reduced the relative importance of venture-backed deals. Data Appendix "Any targeted policy will have adverse incentive My estimates of the stock of venture capital effects in distorting the organization of economic ac- and the division of this stock among various tivity. The efficiency costs of such distortions would need to be far larger than reasonable calculations investor types are based on information from would suggest in order to offset the revenue losses from the Venture Capital Yearbook and various is- an untargeted capital gain reduction. sues of the Venture Capital Journal. "Auerbach (1989) notes in this context that cur- To calculate the amount of capital supplied rent Section 1244 provisions for losseson stock in small by each investor class, I adopt a straightfor- business corporations enable entrepreneurs to deduct ward perpetual inventory approach beginning $100,000 of lossef, on joint returns. with data for 1977. This was the first year when I could find tabulations of the stock of capital managed by private independent venture funds, REFERENCES corporate subsidiaries, and SBICS. I use data on the identity of marginal suppliers of funds Auerbach, Alan J. (1989). "Capital Gains T-at- and Tax Reform." National Tax Journal, Vol. 42 (Sep- in venture funds in 1978 (again, the first year tember). for which I could find data) to allocate the stock Brown, Charles and James Medoff (1989). "'jphe Em- venture funds under management in 1977. ployer Size Wage Effect." Journal of Political Econ- Venture Economics reports the following ag- omy, forthcoming. gregates for the stock of funds in 1977 ($mil- Freear, John and William E. Wetzel, Jr. (1988). "Eq@ lion): uity Financing for New Technology-based Firms." Unpublished paper, University of New Hampshire, Venture Center for Venture Research. Economics Adjusted Holland, Daniel M. (1969). "The Effect of Taxation on (1977 Dollars) (1987 Dollars) Effort: Some Results for Business Executives." Na- Private Independent tional Tax AsFociation Proceedings of the Sixty- Venture Funds SecondAnnual Conference on Taxation, Boston, MA: (PIVF) 866.9 1516.1 pp. 428-517. SBICs 611.8 1070.0 JACA Corporation. (1985). Access to Capital by Sub- Corporate Subsidiaries 1022.0 1787.4 categories of Small Business. Washington: Small Business Administration, Office of Advocacy. I calculate the 1977 stocks of funds invested 386 NATIONAL TAX JOURNAL [Vol. XLII by investor class as: ing a simple set of rules. These data are shown in Table A-1. Values for 1977 and 1980-1988 Individualsll7l = .40*PIVF1977 + .55*SBIC1977 were drawn from Venture Economics publica- tions. I interpolated the 1978 and 1979 values. Corporations,977 = .25*PIVF1977 + .45*SBIC,977 My rules for allocating changes in each cap- + CORPS1117 ital category across investors are as follows. I assume that 45% of the capital invested through Foreignl977 = .15*PIVF1977 SBICs is provided by corporate investors in every year, and allocate the remaining 55% to TaxExemptl.77 = .20*PIVF1977- individuals. (This is based on estimates of the relative size of the two categories drawn from In each case PIVF1977, SBIC1971,and CORPS1977 tables in the Venture Capital Journal.) All cor- correspond to estimates using 1987 dollars. porate subsidiary investments are assumed Using these initial conditions, I update the taxable at the corporate rate. Investments four stocks of capital by investor type using through PIVFs are allocated among individu- Venture Economics' estimates of the change in als, corporations, foreign investors, and tax ex- the pool of funds invested in PIVFS, SBICS, and empts based on annual data on the composi- Corporate Subsidiaries. Since Venture Eco- tion of capital inflows to private venture funds. nomics reports the stock of funds in each cat- These data on the share of PIVF investinents egory in nominal terms, I first convert the in- are reported in Table A-2. The resulting stocks crement to each capital category in 1987 dollars, of venture capital investment by investor type then I allocate it across investor categories us- are presented in Table A-3. No. 31 JAMES M. POTERBA 387

Table A-1: Change in Invested Capital for Venture Capital, 1978-1988

Independent Venture Corporate

Partnerships SBICs Subsidiaries

1978 528.6 428.3 151.6

1979 425.7 393.4 139.3

1980 445.7 360.9 126.4

1981 1,001.7 250.4 375.6

1982 2,118.6 -353.1 353.1

1983 4,304.7 113.3 679.7

1984 3,934.3 260.1 404.4

1985 2,567.3 314.2 583.7

1986 4,020.8 161.2 537.3

1987 4,640.0 220.0 20.0

1988 2,079.3 -9.7 -19.3

Notes: Each entry is measured in millions of 1987 dollars. Values are based

on author's calculations using information from Venture Economics. 388 NATIONAL TAX JOURNAL [Vol. XLII

Table A-2: Source of New Capital Commitments to Independent Venture Funds

Insurance Other Pension

Individuals Companies Corporations Foreigners Endowments Funds

1978 0.320 0.160 0.100 0.170 0.090 0.150

1979 0.230 0.040 0.160 0.150 0.100 0.310

1980 0.170 0,130 0.180 0.080 0.150 0.290

1981 0.230 0.150 0.170 0.100 0.120 0.230

1982 0.210 0.140 0.120 0.130 0.070 0.330

1983 0.210 0.120 0.120 0.160 0.080 0.310

1984 0.150 0.130 0.140 0.180 0.060 0.340

1985 0.130 0.110 0.120 0.230 0.080 0.330

1986 0.120 0.100 0.110 0.110 0.060 0.500

1987 0.120 0.150 0.110 0.130 0.100 0.390

1988 0.080 0.090 0.120 0.130 0.110 0.470

Source: Venture CaRital Yearbook 1988 and various issues of Venture CaRital

Journal. No. 31 JAMES M. POTERBA 389

Table A-3: Estimated Investments in Venture Capital Pool, by Investor Type

Individuals Corporations Foreign Investors Tax-Exempt

1977 1,194.9 2,647.9 227.4 303.2

1978 1,599.6 3,129.6 317.3 430.1,

1979 1,913.9 3,531.1 381.1 604.6

1980 2,188.2 3,958.0 416.8 800.8

1981 2,556.3 4,766.9 517.0 1,151.4

1982 2,807.0 5,511.9 792.4 1,998.8

1983 3,773.3 7,275.7 1,481.1 3,677.6

1984 4,506.5 8,859.4 2,189.3 5,251.3

1985 5,013.0 10,174.9 2,779.8 6,303.9

1986 5,584.2 11,629.2 3,222.1 8,555.6

1987 6,262.0 12,954.6 3,825.3 10,829.2

1988 6,423.0 13,367.6 4,095.6 12,035.2

Notes: All entries are millions of 1987 dollars. Calculations are described

in the appendix.