The Tax That Ate the Economy | Wall Street Journal | 06.24.91

Between May 1990 and this April, the U.S. suffered a net loss of 879,000 jobs. It wouldn’t have happened and there would be no recession today if the financing of small and young companies had not collapsed after 1986, when tax reform mandated raising the top rate on capital gains to 33% from 20%.

Despite President Bush’s repeated calls for a capital-gains tax cut, most of official Washington doubts that the tax is a big deal for the economy. Venture capitalists screamed when the rate was hiked and continue screaming. Yet despite their skill at fostering new technology, they are seen as essentially a small economic force, investing at most a few billion dollars a year. No one is sure how much the country pumps annually into small businesses and entrepreneurial activity. But absent hard numbers, the total is assumed to be comparatively minor and the capital-gains tax’s impact on it uncertain.

The numbers, however, are available. They tell a complex but compelling story.

What might be called the small business and entrepreneurial finance market is really four markets. The capital-gains tax is not the sole influence on these markets, of course. Monetary policy, regulations, even international capital flows have contributed to ups and downs over the years. Here is an outline of the make-up of these markets and what influences them, the sources of the data, and the implications for jobs.

Professional Venture Capital

This is the market everyone talks about — investments in new and growing companies by professional venture capital firms.

Venture Economics Publishing Co. of Needham, Mass., keeps tally of the venture capital industry’s annual investments stretching from 1970 to the present. The industry itself dates to the early ’50s and as late as 1977 disbursed only a few hundred million dollars a year to portfolio companies. Investments mushroomed after the 1978 Steiger Amendment lowered the effective capital gains tax to 28% from 35%, and even more after the 1981 Tax Act dropped it to 20%. Passing $1 billion for the first time in 1980 (all figures are in 1991 dollars), venture capital disbursements peaked at $4.8 billion in 1987. By 1990, commitments had fallen to $2.1 billion.

Initial Public Offerings

Going public is usually considered the last stage of venture financing, although some professionals argue that later public offerings are often part of the entrepreneurial support process.

Prof. Jay Ritter of the University of Illinois has assembled authoritative annual totals on Initial Public Offerings for the years from 1960 to 1990.

The IPO market took off in the mid-1960s, reached $9.7 billion in 1969 (as always, figures are in 1991 dollars), but then collapsed to $2.8 billion in 1970, after Congress increased the capital-gains tax rate. The market recovered briefly in 1971 and 1972 (when $8.9 billion was raised), as a debased dollar and price controls created a bubble in all equity markets, but collapsed again in 1973. By 1974, the IPO market had shrunk to a near-death $142 million, and it remained near death until the Steiger Amendment resurrected it. Then, with setbacks in the 1982 recession and 1984, it zoomed upward to $24.1 billion in 1986, only to expire once more after the boosting of the capital gains tax. Last year IPOs raised only $6 billion.

The financial press has heralded a recent flurry of IPOs. Mr. Ritter believes, however, that when real estate and closedend mutual funds are screened out, this year’s market will prove only a little larger than last’s.

Angels

The term comes from Broadway’s name for people who back shows. This market is made up of private individuals who back new companies. Although nearly invisible, it provides most outside investment for start-ups, says University of New Hampshire professor William E. Wetzel, Jr., its leading authority. Angels tend to be upper-middle class (median family income, $97,000), and many are successful entrepreneurs. Seven out of 10 angels put their money into companies within 50 miles of their homes or offices. According to Professor Wetzel, virtually all firms receiving angel financing are incorporated, making it easier to cash out for a capital gain if all goes well.

In 1988 the Small Business Administration published a study of the angel market titled “The Informal Supply of Capital.” Findings were derived from three regional surveys conducted between late 1985 and mid-1987. The study estimates the average annual angel investment over these years at $40.9 billion (as before, 1991 dollars) or about 10 times the size of the venture capital market.

The angel market appears to have contracted since 1986. Specialists in public financings for emerging biotechnology firms have noticed that the typical company they take public has less angel capital than before, and many have none.

And a new kind of angel financing has appeared — foreign money. People involved in all parts of entrepreneurial finance report that Asians and Europeans have stepped forward, particularly for high-technology projects with international applications. Foreign investors are taxed at home, where capital gains taxes either don’t exist or are lower than here.

Moms & Pops

This market is where the middle class puts its entrepreneurial capital, and like the middle class, it is where most of the money is. Amounts cited here are for yearly capital expenditures of proprietorships and partnerships (not for working capital raised or capital for financial investments), and yet in 1986 the total came to almost twice that of the three other markets combined.

While Mesa Petroleum fits in this group, more typical are small service firms, law and accounting firms (those that aren’t professional corporations) and most new businesses.

Since 1946, the Commerce Department has tracked annual capital expenditures of non-farm, non-corporate businesses using Census Bureau surveys. The Federal Reserve publishes the series in its “Balance Sheet for the U.S. Economy.”

In the low capital gains tax era of the late 1940s to late 1960s (effective rate through most of the period, 25%), non-corporate capital expenditures rose and fell with the economic tide, but generally climbed ($28.5 billion in 1991 dollars in 1946 to $85.7 billion in 1969). After the 1969 hike in the capital-gains tax, they had a setback (as did IPOs and, according to industry lore, venture capital, for which data were first collected a year later), though it was minor.

In the several years that followed, inflation and price controls overwhelmed the influence of the higher capital-gains tax. Proprietorships and partnerships include the smallest and newest businesses, those hardest for regulators to find and throttle. Non-corporate capital expenditures topped $131 billion in 1973. Then came the first oil shock: Between 1970 and 1975, these capital expenditures rose higher and fell farther than in any other period on record.

They started up again in the easy-money expansion of Jimmy Carter’s first two years in office (reaching $99.5 billion in 1978) and dropped after Paul Volcker slammed on the breaks (falling to $77.8 billion in 1980).

In the early 1980s, non-corporate capital expenditures began to move in a new range, thanks to the lowering of the capital gains tax in 1978 and 1981. As a result, although the 1982 recession was the deepest in decades, they remained higher during it ($92.6 billion) than any time before the inflation force-fed ’70s. They peaked in 1986 ($110.1 billion). After the capital gains rate soared that year, they fell to a new and lower range, and by 1990 were the lowest since the early ’60s ($62.3 billion).

Altogether, entrepreneurial investment was at an all-time peak for a low-inflation period in 1986, when $179 billion was raised in these four markets. By comparison, all SEC primary registrations that year (minus IPOs) came to just $287 billion. Of the entrepreneurial total, the middle class Mom and Pop market accounted for 62%; angels, 23%; IPOs, 13%; and venture capital (deleting leveraged buyouts and acquisitions), 2%.

Four years later, the total capital raised in these four markets had probably dropped to $91 billion, assuming angels remained 23% of the total. If investment had continued at 1986 levels through 1990, the economy’s capital stock would now be $247 billion greater.

The National Venture Capital Association estimates that every $50,520 its members invest (again, 1991 dollars) supports one job. The $247 billion of missing new capital therefore means 4.9 million fewer jobs.

Put another way, if the increase in the capital-gains tax in 1986 triggered $247 billion decline in entrepreneurial investment, keeping the tax where it was would have preserved the 879,000 net jobs lost between May 1990 and April 1991, and added an additional 1.6 million more over the past four years. Unemployment today would be less than 5%, as opposed to 6.9%. There would be no recession.

So while most of Washington considers the capital-gains tax not worth talking about, President Bush turns out to have the shrewdest head in town. The capital-gains tax cut is about jobs and, with two-third of entrepreneurial investment capital coming from the Mom and Pop market, about the aspirations of the middle class — not bad causes for a president, or any politician, to champion.