Obama Presidency

Silicon Valley Would be Badly Hurt by Obama's Tax Policies

| by Cato Institute

Silicon Valley became famous as a great incubator of partnerships
that helped develop companies like Apple, Cisco, eBay, Google, Intel
and Sun Microsystems. But if President Barack Obama has his way,
Silicon Valley will be hammered.

Obama outlined a budget that would more than double federal taxes on
general partners — the entrepreneurs who incur the risk of assembling
and managing partnerships for startups, distressed companies, real
estate projects and other ventures.

A significant part of their
compensation is what is termed "carried interest" — generally a 20
percent share of what's left over after a portfolio company has been
sold, after limited partners have been repaid their capital
contributions with a preferred return, and after partnership expenses
have been paid.

Currently carried interest is taxed at a 15 percent capital gain tax
rate, but President Obama wants to tax it at a 39 percent ordinary
income tax rate.

"States will undoubtedly follow the lead of the federal government
and treat carried interest as ordinary income, too," says Jim Anderson
of SVB Financial Group, San Francisco, which serves about 550 venture
capital partnerships in the U.S., India, China, Israel and the U.K.
With higher federal taxes plus state taxes, general partners would face
a total hit around 50 percent. The tax hikes don't apply to limited
partners who provide the money, but they're not the ones who decide
whether a business venture is started or where it would operate.

An advantage of a partnership structure, which has been used for
decades, is that it tightly aligns the interest of the general partner
with the interest of the limited partners who provide almost all the
capital. The only way a general partner can make money from the carried
interest is to run the business so that limited partners make money.

In this respect, a partnership offers a compelling advantage over a
corporate structure, quite apart from the lower costs of a partnership.
In recent years, we have seen the interest of corporate executives at
odds with those of shareholders, as these executives arranged "poison
pills," "golden parachutes" and outrageous bonuses even when they ran
their companies into the ground.

Startup companies do not have access to public stock markets, bond
markets or commercial paper markets, and often they cannot get
commercial bank loans. Expertise and financial support — over $10
trillion — from venture capital firms as well as private equity firms
is crucial. As University of Chicago economist Steven Kaplan put it:
"Evidence for the positive productive effects of private equity is
unequivocal."

SVB's Anderson believes that Obama's proposed tax hikes would be
injurious for Silicon Valley, driving venture capital enterprise away
to lower-tax jurisdictions and possibly out of the country. Big venture
capital firms like Accel, Sequoia Capital and Summit Partners are
exploring opportunities in Asia, China, Europe and the Mideast. Silicon
Valley has depended on startups to maintain a fertile entrepreneurial
environment as older companies lose their competitive edge.

Silicon Valley would be especially hard hit by Obama's soak-the-rich
taxes. According to a recent survey, two Silicon Valley ZIP codes have
the highest average gross incomes in the state. These people make the
state's biggest mortgage payments, and Obama plans to squeeze them by
reducing the deductibility of their mortgages. All this plus higher
California taxes could spur an exodus that might eventually turn
Silicon Valley into a ghost town.

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