Economists keep warning politicians that incentives matter — and the latest cautionary tale concerns taxation and innovation. New research exposes exactly how catastrophically sensitive start-up investors become when the tax code rewards reckless speculation over sound capital allocation.
In short: a massive capital-gains giveaway for investment in new firms, dramatically expanded by Congress in 2009 and 2010, was smuggled into law and produced a glut of so-called business unicorns — billion-dollar valuations propped up by tax-distorted capital, not commercial reality. In a working paper published by the National Bureau of Economic Research, Murillo Campello and Guilherme Junqueira trace the wreckage produced by changes to the Qualified Small Business Stock (QSBS) carve-out, which Congress made vastly more generous after 2009 and 2010.
Previously, the law had offered a trivial carve-out for investments in small companies. The changes eliminated capital-gains taxes on qualified investments — meaning newly issued shares in qualified C corporations with assets under $50 million in trades not excluded by the statute. The distortion was deliberate, the magnitude enormous, and the consequences predictable to anyone willing to follow the incentives.
This allowed the economists to compare investment behavior and outcomes in those industries before and after the change. The researchers also distinguish between different kinds of investors with different sensitivities — “angels” investing their own money, venture-capital firms pooling capital from others, and corporations locked out of the QSBS loophole. The result is a sample of 158,000 investment deals from 2004 to 2022, tracked from initial check to liquidation or insolvency.
The central finding is that by inflating the upside investors could hope to capture, this capital-gains giveaway pulled capital into reckless, premature, unviable bets. After the carve-out, venture firms — the investors most responsive to the tax distortion — were 81% more likely to invest at the earliest, riskiest stage of a new company. They were also more likely to fund startups already carrying debt or operating in industries where the firm had no prior competence — every one a marker of capital misallocation, not productive risk-taking.
Most of those bets blew up. The failure rate for firms that received venture funding after the carve-out was 71% higher than before. The few that “succeeded” did so by inflating their own valuations into the stratosphere: post-2009 exit valuations were 131% higher than the pre-reform baseline, and startups whose investors qualified for the QSBS windfall were twice as likely to reach the $1 billion unicorn threshold — a number that, in a non-distorted market, would simply mean the company was overvalued.
The economic logic here is straightforward and damning. To lure investors into more risk, governments must promise fatter returns. By allowing speculators to keep the upside, this carve-out inflated the expected payoff of gambles that should never have been made and convinced venture firms to swing at everything in sight. The predictable cost was an epidemic of failures and a handful of lavishly overrated survivors — the textbook outcome of subsidizing speculation.
Somehow this elementary insight is out of fashion. Watch the enthusiasm for punitive wealth taxes, which in practice are surtaxes on the capital that would otherwise fund the next productive enterprise. If you subsidize something, you get more of it — even when the “thing” is waste, fragility, and the illusion of innovation.
This paper is a reminder that when it comes to capital-gains carve-outs, the subsidized “something” is not prosperity. It is the systematic destruction of price signals, followed by misallocation, fragility, and ruin.
