Trump’s Big Tax Hike

By Kevin D. Williamson

Monday, August 08, 2016

Donald Trump is proposing a couple of big tax hikes.

The first one is trivial: It’s the tax hike in Trump Tax Plan 2.0 over the original version. Earlier, Trump had talked about cutting the tax code down to three brackets, at 10 percent, 20 percent, and 25 percent. The new version is 12 percent, 25 percent, and 33 percent: That’s a 20 percent marginal rate hike on the bottom third, another 20 percent hike on the middle, and 32 percent increase on the fat cats at the top. It’s also more realistic for the long term, meaning that somebody or something must have gotten to Trump — maybe the Illuminati, maybe math.

The big, ugly, stupid tax hike he’s planning is on Silicon Valley and its imitators around the country, the economic ecosystem of startup companies and the venture capitalists who put up the cash to turn their big ideas into viable products, dopey computer games, social-media annoyances, and companies that employ hundreds of thousands of people at very high wages. Which is to say, he wants to punish the part of the U.S. economy that works, for the crime of working.

The so-called carried-interest loophole, which isn’t a loophole, drives progressives batty — Donald Trump, Hillary Rodham Clinton, and Elizabeth Warren all get their Underoos over their heads about it. You’ll hear a lot from Trump and others about “hedge-fund guys” who exploit this so-called loophole to beat Uncle Stupid out of a few gazillion dollars in taxes, but it in fact has very little to do with hedge funds.

Here’s how it works: Because the U.S. government wants to encourage investment and because corporations (and, hence, their shareholders) already pay the corporate-income tax, profits from certain long-term investments are taxed at a lower rate than is a salary. This is called the long-term capital-gains tax rate, and for a long time, it was 15 percent for most everybody; a provision of the grievously misnamed American Taxpayer Relief Act of 2012 made it 20 percent for households with incomes in the middle six figures and up, but that’s still about half of what you’d pay if it were taxed the way a salary is taxed — but a salary is guaranteed, whereas investments involve higher levels of risk. To pay the long-term rate, you generally have to hold an investment for a year or more, and that is why it doesn’t much matter to hedge funds, which rarely hold anything that long.

It matters a great deal to two related kinds of investors: private-equity investors (that’s what Mitt Romney used to do at Bain) and venture-capital investors (that’s what the guys who put up the money to develop Facebook do). If you’re a startup that needs money, you can’t really borrow it, or much of it: The failure rate of new businesses is high, meaning that interest rates on such loans would be high, too; Mom and Dad might kick in, but the banks aren’t going to. And they aren’t going to do that if you’re an established but struggling company that needs to restructure itself or a small business with a big idea looking to become a very big business. If you’re the cash-strapped startup, you go to venture capitalists; if you’re the established business, you go to a private-equity group. In both cases, the deal looks pretty similar: You get cash to do what you need to do, and the investor, rather than lending you money at a high interest rate, takes a piece of your company as recompense (for distressed companies being reorganized by private-equity firms, that’s usually 100 percent of the firm) on the theory that this will be worth more — preferably much more – than the money they put into your business. Eventually, the investor sells its stake in the company and pays the capital-gains tax on its capital gain.

The success stories are famous. When retired supermarket executive Thomas Stemberg couldn’t find a printer ribbon one day, he decided that there was an opening in the market for an office-supplies supermarket. Nobody thought this was a very good idea except for Mitt Romney and Bain Capital, which not only put up the money to open the first Staples store but also — here’s the critical part — lent the fledging business their management and financial expertise to help ensure its long-term success. (Federal antitrust regulators currently are doing their best to ensure Staples’s failure.) It isn’t just about writing a check. Similarly, when PayPal cofounder Peter Thiel put $500,000 into Facebook, his investment came with a great deal more than a jolt of liquidity. The same thing happens at a smaller scale when workers ranging from secretaries to programmers come to startup companies that cannot afford to pay them very much in cash but reward them with equity instead. That process is sometimes called “sweat equity.” Redmond and Austin are full of people who had unglamorous jobs in the early days of Microsoft and Dell and were rewarded — sometimes spectacularly — for the risk they took and the cash-money pay they forwent.

As Bobby Franklin of the National Venture Capital Association puts it, “Far from being a so-called ‘loophole,’ the carried interest venture investors receive is similar to stock awards received by the founders of a startup in that both the venture investors and founders commit the time, energy, and creativity against huge risks to build new startups into successful companies.”

The lower capital-gains tax rate is not what drives venture-capital investing in the main. Thiel is said to have made something like $400 million on his $500,000 initial Facebook investment, which is a good deal at a 15 percent, 20 percent, or 40 percent tax rate. It is the promise of outsized returns that drives the venture-capital model, along with, in many cases, a nerdy sense of adventure. Elon Musk knows he’s not going to make money on every big idea he has. That being said, tax rates on investment do matter, at least at the margins — and they will matter much more in the relatively near future. As the technology sector matures, it becomes more like any other established industry, including in its attitude toward startups. Not every investment is going to make 1,000 percent returns or 10,000 percent returns — not in the long run. In the long run, the margins are going to be smaller, which means that doubling taxes on sweat-equity investments will have a relatively larger effect.

Donald Trump does not understand this, because he isn’t a real businessman — he’s a Potemkin businessman, a New York City real-estate heir with his name on a lot of buildings he doesn’t own and didn’t build and whose real business is peddling celebrity and its by-products. He’s a lot more like Paris Hilton than he is like Henry Ford or Steve Jobs. Miss Hilton sells perfumes and the promise of glamour, Trump sells ugly neckties and the promise of glamour. By Trump’s own reckoning, his brand — meaning the cloud of celebrity that hangs around him — is worth more than his actual assets, which ought to tell you something about the nature of his business model, i.e., that it’s show business. Not that there’s anything wrong with show business, but unless you’re talking about ten square miles in Southern California, it’s not much of a foundation for an economy.

Technology leaders from Steve Wozniak to Jimmy Wales have predicted in a group statement that a Trump presidency would constitute “a disaster for innovation.”

There are aspects of the U.S. tax code that are in need of reform, to be sure, but the nation is not struggling for want of sufficiently rapacious taxation of long-term investments. And even though changes are warranted, having every election result in radical changes to the tax code imposes costs of its own that are far from obvious: There is real economic value in continuity and predictability. Continuity and predictability are especially valuable in sectors that are already working pretty well, which our venture-capital and private-equity industries are. The old wisdom is: “If it ain’t broke, don’t fix it.” The new wisdom is, “If it ain’t broke, we’ll see what we can do about that.”

There’s a lot that doesn’t work well in these United States: the schools, the State Department, the immigration system, Baltimore, Detroit, Philadelphia . . . Silicon Valley works just fine. Let’s don’t mess that up.