Capitalism 2.0: Tax Policy

In my formula for creating a thriving small-business system, governments do not need to do a whole lot. But they can do a few things that could add positive momentum to the process. So I’m making some tax policy recommendations that could really bring about meaningful “change.”

There are four constituencies we need to take into account in crafting an entrepreneurship-friendly tax policy: entrepreneurs, angel investors, venture capital firms, and corporations. Let’s look at each separately.

My capitalism 2.0 vision assumes entrepreneurs need to to learn the tricks of bootstrapped entrepreneurship so that they can keep maximum control over their destiny. This recommendation assumes that entrepreneurs would be putting their own savings into their ventures. Thus, we need a tax policy that makes it as attractive as possible for entrepreneurs to “invest” in their own ventures, especially at the early stages.

For example, an aspiring entrepreneur ought to be allowed to create a tax-free pool of income for use as personal venture capital. Such a pool of capital would go a long way to help kick-start new ventures. It is like the 401(k) program that allows you to save money for retirement without having to pay taxes.

To further help entrepreneurs, we also need to get rid of payroll taxes, which are unnecessary burdens imposed on fledgling and fragile companies. A lot of entrepreneurs don’t hire full-time staff because of the payroll tax burden, and this inhibits the creation of new jobs.

The next constituency is angel investors. These days, traditional venture capitalists hardly participate in early stage investments. The bulk of the responsibility of early stage investment is shouldered by angels, who are usually not the Bill Gates and Warren Buffetts of the world. (See “The Real VCs of Silicon Valley.”) More often than not, an angel turns out to be the entrepreneur’s uncle, who is a doctor making $400,000 a year and can afford to invest in the nephew’s audacious dream and unproven idea.

The misconception that the angels are the very rich people worth hundreds of millions leads people to think that these guys would invest anyway, tax or not. But most entrepreneurs – especially first-time entrepreneurs – don’t have access to such high-net-worth people.

Thus, governments should be very careful how these $400,000-a-year uncles are treated from a tax policy point of view. The choice may well be between $250,000 being invested in a start-up or that $250,000 going to the government as income tax.

Angels should also be allowed to create pools of tax-free capital for investing in start-ups, especially in unknown, unproven entrepreneurs who often don’t have access to venture capital. It is not so different from a tax-free account set aside for a child’s education. It is also similar to allocating money to “foundations” to fund nonprofit “causes.”

The third constituency is the venture capital firms. The expectation is that venture funds would take risks, fund innovation and essentially keep the entrepreneurship engine moving. In reality, venture funds have become lazy, risk-averse, and interested only in later-stage investments. (See “Fund Envy.”)

Venture funds should have a tiered tax structure, whereby they pay lower capital gains taxes on investments in early stage companies and higher taxes on later stage deals. It is not dissimilar to the concept of long-term capital gains versus short-term capital gains, except those that take the risk of funding ventures with a 7- to 10-year horizon should have incentives to do so.

Finally, corporations can play a critical role in this equation. Venture capital funds only fund ideas that have the potential to become very large enterprises. However, the vitally important small business eco-system needs to have investors that fund smaller businesses. So, corporations that have a strategic stake could play the role of investor for this category of entrepreneurs.

As an example, let me point you to eBay. Many eBay millionaires came into existence as the e-commerce giant created an online marketplace for buying and selling goods. Even more entrepreneurial families making $100,000, $200,000, or even $300,000 off eBay transactions have created healthy, resilient lifestyles while living the dream of self-employment.

Conceivably, eBay, Amazon and their ilk could even fund some of these small retail businesses if they were offered tax incentives to do so. Companies in other sectors could follow suit. SunPower could fund solar farm entrepreneurs. Google could fund online publishing start-ups. Whole Foods Market could fund small fruit-juice makers.

Governments are struggling to close tax loopholes to address corporations who are stashing money away in tax heavens, paying minimum taxes in their home countries. Perhaps a way to lure back that investment –on a tax-free basis – would be to provide incentives to them to invest in small businesses.

The policy ideas described above could have a widespread impact on the world economy and reframe capitalism.

This segment is a part in the series : Capitalism 2.0