Magazine article American Banker

The Mythology - and Myopia - about Taxing Capital Gains

Magazine article American Banker

The Mythology - and Myopia - about Taxing Capital Gains

Article excerpt

The Mythology --And Myopia-- About Taxing Capital Gains

ONE INTRIGUING TAX reform fight involves capital gains: the taxation of profits on the sale of stock, bonds, or property. Because capital gains rates are lower than rates on ordinary income, they've traditionally been seen as a tax dodge for the rich.

Now the Senate would eliminate the preferential rates. "Hold it!' cry high-technology companies and venture capitalists. The lowering of capital gains rates in 1978 and 1981 triggered an investment boom in computers and electronics. Raising rates now would smother risk-taking, entrepreneurship, and innovation.

The argument is beguiling--and wrong. Entrepreneurship and innovation are the economic chic of the 1980s. But the case for a preferential capital gains rate incorrectly presumes that entrepreneurship and risk-taking are so good for the country that they deserve special encouragement. Promoting risk-taking involves the same danger as subsidizing milk production: You may get more of it than you want. Bribing too many people to start new companies may mean too many new companies. Many end up bankrupt, which is as wasteful as surplus milk.

The capital gains issue goes to the heart of the tax reform debate. Can government, through tax preferences, manipulate spending in socially useful ways? A complex tax system presumes the answer is yes. The argument for a simpler tax system, with lower rates and fewer preferences, is that government can rarely predict the precise consequences of tax breaks and that the unintended side effects often offset benefits.

Anyone who believes that entrepreneurship and risk-taking are always desirable should be sobered by a study of the disk drive industry by two Harvard Business School professors, William Sahlman and Howard Stevenson. Disk drives store computer data, and the industry's story is a classic boom and bust. Between 1977 and 1984, venture capital companies poured more than $400 million into dozens of new companies. The proliferation of firms accelerated technological innovation, but by late 1984 the industry was in a shambles. Excessive investment had created overcapacity and depressed profits.

Typically, start-up companies are financed by venture capital funds. If the company succeeds, the venture capitalists sell stock to the public at huge profits. Many venture capitalists escaped the disk drive debacle, says Mr. Sahlman, because they sold stock before the crash. But there was a huge waste of investment and human talent. It's disruptive when engineers or executives abandon established companies --where they play vital roles--to begin new companies that ultimately fail. Finally, overcapacity and low profits harm the international competitiveness of U.S. companies. "The companies are so weak,' says Mr. Sahlman, "that the Japanese may be able to storm in and blow them away.'

Change the details, and similar stories could be written about personal computers and other computer-related products. …

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