DC’s Potential Warren Buffet Problem

June 29th, 2012 | by Ed Lazere

Should so-called “angel investors” in technology companies pay the lowest income tax rate in the city? Today, the DC Council’s Committee on Finance and Revenue marked up a bill that would do exactly that.  Bill 19-764, the “Technology Sector Enhancement Act of 2012,” would lower the income tax rate for gains on such investments to three percent. DCFPI testified against this provision of the bill. Our testimony follows: 

This proposal represents a dramatic change in tax policy.  It would set the income tax rate for gains on such investments at 3 percent, a reduction of two-thirds from the existing 8.95 percent top income tax rate on such gains.  This would set a tax rate on investment income even below the 4 percent income tax rate paid by workers in the lowest tax bracket.  It would create DC’s version of the “Warren Buffet Problem,” with low-paid workers in the city paying a higher income tax rate than some of the highest-income investors.

Such a dramatic change in tax policy – setting a tax rate on investment income that is lower than even the lowest tax rate on employment income — can be justified only if there is clear evidence that it will have positive effects.  Yet there is no such evidence, and in fact there are several reasons to suggest that this tax break would not be effective. Beyond that, there are significant problems with the design of this tax break.  For these reasons, the DC Council should reject this tax change, or at most refer it to the Tax Revision Commission for review.

This proposal is unlikely to lead to substantial new investment in high-tech companies.  Investors make decisions to invest in a particular company based on the riskiness of the investment and the possible rate of return, not the tax rate.  Lowering the tax rate will not turn a bad investment into a good one.  Consider being offered a chance to invest tax-free in a risky company with a modest expected rate of return, or to make a taxable investment in a less-risky company with a higher expected rate of return.  Paying taxes on a substantial gain is much better than paying no tax on a small gain. 

Beyond that, this tax break only applies to DC residents who invest in DC high-tech firms.  Yet any company looking for venture capital will need to look far and wide. The likelihood that a DC start-up company would be able to have its entire capital needs met by DC residents is slim.  This means that the proposed tax break, even if you believe it will act as an incentive, will probably not do much to meet the overall capital needs of high-technology companies.

These are the main reasons that this proposed steep reduction in taxes on investment income would be unlikely to have a marked impact on DC’s high-tech sector.  These are strong reasons to reject this bill.

Beyond these concerns, there are significant flaws in the design of this legislation.  First, the bill seems to offer the low capital gains tax rate to both individuals and businesses, including venture capital companies.  Given that such companies already exist knowing that they have to pay taxes on their gains, there is no reason to provide a steep tax break to venture capital firms.

Second, the bill would offer the tax break to investments that have already been made. If the goal is to incentivize new investments, the tax reduction should be limited to new investments made after passage of the law, by individuals who have not invested in the same company in the past.

Third, describing this legislation as “angel investor” incentives is a misnomer, because tax breaks would not be limited to investments in young firms that are trying to grow. Instead, the bill would provide a steep tax break for investing in any high-tech company, regardless of how large or well established it is. 

Fourth, the bill would provide much deeper tax breaks than angel investor tax breaks offered in many states.  A review of a nine “angel investor” laws shows that none offers a two-thirds tax break.  Instead, it is more common to offer a tax break of 25 percent, which in DC would translate into a rate cut of 2.25 percent instead of nearly 6 percent as is proposed in the DC bill.  Moreover, many states place a cap on the total amount of tax benefits, but the DC bill has no such cap.

Finally, it is important to note, as we have been discussing today, the District already provides very substantial tax subsidies to new high-technology companies, and it is negotiating a subsidy deal with LivingSocial.  Heavy subsidies to both the technology companies themselves and to the investors in these companies seem excessive.

We urge the Council to reject this portion of the bill 19-764.