Giving venture-capital partnerships favorable tax rates might be counter-productive

See ‘VC: An American History’ Review: The Seed Spreaders. Marc Levinson reviews VC: An American History by Tom Nicholas in The WSJ. Excerpt:

"the venture-capital industry in its modern incarnation is a creation of the U.S. government. The Small Business Investment Act of 1958 led to the creation of hundreds of venture-investment companies, which were entitled to federal loans and extremely favorable tax treatment. Although some were frauds, others seeded such consequential startups as Intel. A 1979 law allowed pension funds to invest in venture capital. And reductions of tax rates on capital gains since the 1970s have allowed venture capitalists to collect their pay mainly through capital gains rather than more highly taxed wages, minimizing their tax bills. At the same time, the federal government has been a major customer of VC-funded startups in computing, software and semiconductors. As Mr. Nicholas puts it: “Government policy had powerful supply- and demand-side effects.”

How successful have these policies been? If investors’ returns are an indication of whether money has been spent well, venture-capital investing is not a particularly beneficial activity. While venture funds outperformed public equities in the 1990s, in both the 1980s and the early 2000s investors would have been better off putting their money into an index fund. Venrock Associates, which managed the investments of pioneer venture capitalist Laurance Rockefeller, turned an initial $288,000 investment in Apple into a storied $116.6 million gain in 31/2 years. But excluding Apple, its portfolio showed an annual return of 3.4% on investments made between 1969 and 1978.  Rockefeller’s “stunning success with Apple . . . was close to accidental,” Mr. Nicholas observes, but it made up for money-losing investments in a number of long-forgotten companies.

It is an article of faith that ready access to venture capital makes an economy more dynamic. Mr. Nicholas frames the case historically, contending that “the spillovers into the real economy generated by venture investing during the 1990s were powerful and pervasive.” But he focuses entirely on the U.S. and offers no information about how high-risk startups are funded in other countries.

By some measures, other countries may have more dynamic economies than the U.S. The Bloomberg Innovation Index has ranked the U.S. eighth among the most innovative countries in 2019 after leaving it out of the top-10 last year; the leaders for this year are South Korea and Germany, which don’t provide venture capital the American way. Startups are flourishing in countries such as Israel, Estonia and even Norway, according to European Union statistics, while data from the U.S. Census Bureau puts the number of new American businesses expecting to hire employees at less than half the level of 2004. And the World Intellectual Property Organization reports that South Korea, China and Japan, among other countries, outpace the U.S. in patent filings per $100 billion of gross domestic product.

So perhaps the history of U.S. venture-capital investing is not quite the triumph that Mr. Nicholas would have us believe. It might be the case that, by gracing venture-capital partnerships with favorable tax rates, we encourage investors to put resources into dogs like Pets.com."