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the past year I've been in umpteen debates with economists, politicians,
and journalists who keep insisting that the problem with the U.S.
economy is weak consumer spending. They're plain wrong. The real
economic malady is declining investment.
If you don't
believe me, just take a hard look at the data. The venture-capital
industry is experiencing a drought. In 2000, financiers provided
$87 billion of this risk capital funding for entrepreneurial start-up
companies. Preliminary estimates from a survey by PricewaterhouseCoopers
show that for the first half of 2001, venture-capital funding will
be less than $20 billion. The pace of venture-capital funding has
plummeted by more than 60 percent in the past 18 months. It's no
coincidence that that's almost exactly the same percent decline
in the NASDAQ from its high last year of 5000.
Venture capital
is the seed corn for high-tech start-ups. These are the most essential
invested funds in our information-age economy because they finance
high-risk, but potentially high-payoff enterprises. Most every successful
telecommunications, pharmaceutical, software, and semiconductor
firm started in the U.S. over the past 20 years was nurtured in
its infancy stages by angel investors and venture capitalists.
Now that funding
is vanishing. Entrepreneurs are starved for financing. And this
is the real long-term threat to the American economy, not the slight
slump in consumer spending that so many of the academic and Wall
Street economists keep fretting over.
What's Washington
doing to help stimulate a resurgence in risk capital pools? So far,
almost nothing.
We know from
experience that venture-capital funding levels are highly sensitive
to the capital-gains tax rate. In the early 1980s when the capital-gains
rate was cut as part of the Reagan tax plan, the venture-capital
industry first started to flex its muscle, more than doubling in
size after inflation, according to the Venture Capital Association.
Then in 1986 Congress did a very stupid thing: It raised the capital-gains
tax from 20% to 28%. The growth spurt in these high-risk pools of
capital subsided. By 1992 the total VC funds raised were still below
the 1986 level. After the 1997 capital-gains cut, there was a near
five-fold power surge in venture financing — until the recent downturn.
This all makes
intuitive sense. If you're going to risk a lot of your money on
a long-shot investment — which is what almost all entrepreneurial
efforts are — you want to make dang sure that if your horse comes
in, the IRS won't snatch away your profits. In an ideal world, there
wouldn't be any capital-gains tax, of course, because these funds
have already been taxed once (when the original funds were earned
by the investor.) (Art Laffer says that the truly optimal capital-gains
rate is negative, but let's not get greedy.)
In any case,
the higher the capital-gains tax, the lower the after-tax rate of
return on venture-capital investment dollars.
If the tax
becomes too confiscatory, people will simply invest in bonds or
relatively reliable blue-chip stocks. That's what's happening now.
The ratio of the Dow to the NASDAQ is a convenient, if imprecise
way to measure investors' willingness to take risks. That ratio
has risen a lot in the past 18 months. Risk aversion is the reigning
orthodoxy on Wall Street these days.
Okay, so what's
to be done to provide some oxygen for the entrepreneurial class?
Cut the capital-gains tax now. If we were to cut the current cap-gains
rate from 20% to 15%, and make that cut effective July 1, 2001,
this would immediately help resuscitate this now-dormant sector
of the financial markets. Also, the tax cut would be immediately
capitalized into the value of existing stocks, because a stock's
value is simply the present value of the long-term after-tax profits
of the firm. That would be a nice way to put value back into the
NASDAQ. It would also help Republicans hold onto the House in 2002.
What in the
world are they waiting for?
Nothing Ventured,
Nothing Gained
U.S. Venture
Capital Funding
(Billions of 2000 $)
1996 12
1997 17
1998 30
1999 49
2000 87
2001 (Est.) 40
Sources: National
Venture Capital Association 2000; PriceWaterhouseCoopers, 2001.
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