Saving Our Country in Three Steps

Our country is in a seeming death spiral at the hands of twin domestic problems: our government spends $7 trillion with $5 trillion in revenue, with a trillion of that going to interest, while the concentration of wealth has reached unstable proportions. The common thread between these two issues is, yes, tax policy.

So far, we have come up with two solutions that don’t work: Cory Booker’s idea that the first $75k of income should be tax-free and various forms of wealth tax initially proposed by Elizabeth Warren. The first is a tax cut for the poor and middle class, which is great, but doesn’t move the dial on the deficit or the super-rich’s wealth. The wealth tax is impractical because most assets held by the 0.1% are hard to value, people will leave to avoid it, and it would most likely be ruled unconstitutional by the Supreme Court.

I have three simple ideas that, while they won’t solve all our problems, would meaningfully move us in the right direction: eliminate the qualified small business exemption (QSBS, Section 1202); eliminate the capital gains treatment of carried interest (Section 1061); and limit the capital gains deferral on publicly traded securities to a decade.

Let’s take these one at a time.

I have made almost all my money through successful venture capital and private equity investments. For many of my best deals, I paid NO FEDERAL TAX. I know that sounds insane. I thought so too when my accountant first told me. But it’s because these investments qualified as small business investments at the time of my original investment. The fact that they then grew 10x or 100x before we exited didn’t matter. Someone like me paying zero taxes on massive gains is immoral and wrong, while the lawyers and accountants who slaved over my deals must hand over half their compensation to the government.

Billionaires come in two flavors: entrepreneurs and those who invest large sums in alternative strategies such as venture capital ($1.25 trillion total assets in the US) or private equity funds ($3.5 trillion in assets in the US alone). The investors benefit from an absurd loophole.

A PE manager can make billions because of what is called the “carried interest,” which means they receive 20% (or more) of the upside on all invested capital. So, if you have a $10 billion fund that grows to $30 billion, 20% of the $20 billion gain, or $4 billion, is owed to the General Partner (management). This is compensation, pure and simple, and should be taxed as such. But it is not. For reasons that defy logic (other than super-rich people lobbying Congress), carried interest is taxed at the massively lower capital gains rate, even though no capital investment is involved.

The richest of the rich own massive businesses that they generally started. Elon, Warren, Jeff Bezos. These people pay literally no taxes. If you have $1 billion of equity, you can let it continue to grow tax-free. The smartest thing to do is to leave that in place and go borrow your $100 million from a bank each year, using the stock as collateral to fund your big lifestyle.

I propose we limit the tax-free period for unrealized gains on publicly traded stocks to 10 years. So, a decade after Elon founded Tesla, the federal government would calculate his personal unrealized gain on his shares, from his cost basis to the last trade on the tenth anniversary, and send him a bill for federal tax at the capital gains rate. If he is still holding the shares after 20 years, do the same thing, and so on.

This will force the richest among us to stop avoiding taxes altogether. Doing the math on this policy for the magnificent seven (collective market cap of $12 trillion) yields meaningful revenue for the federal government. They will doubtless borrow the money from their bank to pay the tax bill and still have plenty of capacity left to plan an absurd wedding in Venice or a quarter-billion-dollar compound in Miami. But at least we would have forced them to do their part for our country.

Downstream, I would like to see capital gains taxed at normal income rates and an overhaul of the estate tax, which raises next to no money because it is Swiss-cheese, allowing the richest to avoid it altogether.

These ideas generate revenue, but to balance the budget, we also have to address the $7 trillion in spending, specifically $1.5 trillion on Social Security and $1 trillion on Medicare. I would suggest that, ultimately, we need to move to a defined-contribution retirement model rather than a defined-benefit model, as every company did decades ago. And we have to get to the bottom of runaway medical costs and subpar care compared to the rest of the industrial world. But that’s for another post and another day.

Let’s start with my three proposals and see how far they get us toward closing the wealth gap and the government deficit.

Tom Matlack was the CFO of The Providence Journal, founded the venture firm Megunticook Management, and is known for pioneering the search fund model in Latin America and the “Matlack Formula” for CEO performance compensation.

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This post was previously published on Linkedin.com.