DP3263 Start-ups, Venture Capitalists and the Capital Gains Tax

Author(s): Christian Keuschnigg, Soren Bo Nielsen
Publication Date: March 2002
Keyword(s): capital gains taxation, double moral hazard, venture capital
JEL(s): D82, G24, H24, H25
Programme Areas: Public Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3263

A model of start-up finance with double moral hazard is proposed. Entrepreneurs have ideas but lack their own resources as well as commercial experience. Venture capitalists provide start-up finance and managerial support. Both types of agents thus jointly contribute to the firm's success, but neither type's effort is verifiable. We find that the market equilibrium is biased towards inefficiently low venture capital support. In this situation, the capital gains tax is particularly harmful. The introduction of a small tax impairs managerial advice and leads to first order welfare losses. Once the tax is in place, limitations on loss offset may paradoxically contribute to higher quality of venture capital backed entrepreneurship and welfare.