In order to close the gap, House Democrats took aim at a peculiarity in the tax code which favors wealthy investment fund managers.  The majority of compensation received by managers of private equity and hedge funds is taxed at a 15 percent capital gains rate, rather than the 35 percent rate on ordinary income.  House leaders argue that this compensation is a fee-for-service, not an investment, and should be treated the same as any other source of income.

Unlike hedge fund managers, venture capitalists are investors and not merely managers.  They operate as de facto co-founders of a start-up, making the same high-risk, long-term investment of their time and expertise as the other founders.  If the company succeeds, their share in the profits is taxed as capital gains, just as with the founders' profits on company stock.  Unfortunately, the House bill passed last month fails to provide an exemption for venture capitalists, potentially crippling investment in risky and innovative new ideas. 

The impact of venture capital on the U.S. economy is staggering.  A recent Global Insight study found that venture-backed companies account for over 10 million jobs and $2 trillion in yearly revenue.  Venture capital investment comprises just 0.2% of GDP, but venture-backed companies account for nearly 17% of GDP.  In California, venture-backed firms employ 12 percent of the civilian workforce.  Economists have concluded that for every dollar invested, venture capital produces three times more innovation than traditional corporate research and development. 

Without a strong incentive, venture capitalists will be less willing to assume risky projects.  According to the National Venture Capital Association, a venture is twice as likely to fail as to achieve a high return.  Even successful investments require 7-10 years on average to become profitable.  If Congress doubles the tax rate on these returns, venture capitalists may opt for safer investments, leaving many daring and creative entrepreneurs unfunded.

Alternatively, VCs may leave the U.S. altogether, and fund projects in countries with more welcoming tax policies.  Governments understand that venture capital is a prerequisite for an innovation-driven economy, and that tax incentives are an effective mechanism for attracting investors.  A joint European-U.S. working group on venture capital recently concluded that "the benefits for economic growth that venture capital brings make it essential that policy-makers recognize impediments, like administrative regulations...and taxation rules, to venture investment."  

Governments are willing to compete for the unique skills and resources contributed by VCs.  In China, for example, the Ministry of Finance announced in February that venture capitalists are now eligible for a ‘bonus' 70 percent tax deduction on investments in the high-tech sector.  The Australian Parliament went even further, passing legislation in June which exempts venture capitalists from capital gains and income tax altogether.

The Senate voted overwhelmingly last Thursday to reject the House's VC tax increase, forcing House Democrats to decide this week whether to abandon PAYGO and pass an AMT "patch" without offsets.  Even if the final AMT bill lacks these provisions, House Ways and Means Committee Chairman Charles Rangel has pledged that "we will continue to pursue this issue."  If House leaders fail to exempt venture capitalists from current and future tax proposals, the next Silicon Valley could develop in Beijing, Sydney, or Tel Aviv.