angel investorMaking it easier and more lucrative for wealthy individuals to become angel investors would seem like a great goal, but not all good intentions produce good results. Mashable reported yesterday on a proposal in the New York state legislature to offer a tax credit for angel investors, and while that may sound great, it’s actually quite problematic.

First, here’s how it would work:

The Angel Investor Tax Credit, proposed by Democratic Assemblymember Micah Kellner, would give a 25% tax credit to investors who put between $25,000 and $1 million of their money behind a New York City-based startup. 60% of the startup’s employees must be based in the city for the company’s investors to qualify for the credit.

This isn’t an original idea; as local angel Bic Stevens wrote in MassHighTech last year:

In 1988, Maine enacted the first state legislation to provide investment tax credits to angel investors.  It was followed in 1993 by North Dakota, in 1996 by Ohio, and in 1998 by Kentucky and Virginia. Twenty-two states, including six since 2005

Since this current proposal is for New York, Boston is in the perfect position to realize why it is so troubling. Angels only get the credit if they invest in NYC companies. That would give New York startups an unfair advantage when it comes to raising seed funding. And while angels likely invest even closer to home than VCs, we know that Boston VCs invest significantly in New York and vice versa.

Geographic handcuffs are a major cause of distortion in government-run venture capital efforts, and we should seek to avoid them in the tax code just as we do elsewhere. If every state were to copy this behavior — and each time another one does this there’s more pressure on the others — it would result in a distorted market where angels are actively discouraged from looking across state lines. If you value market efficiency, that should be a good reason to oppose this provision.

Moreover, tax credits are an overused policy mechanism because they don’t appear to “cost” anything. While spending programs are often attacked for wasting money, lost tax revenue is less frequently subject to political attack because, well, who doesn’t like lower taxes?

But a tax credit is a subsidy. The revenue that’s lost could go to something else. So the question to New York, and any other state considering something like this, is whether there’s something else this money could be better spent on.

If we think that angel investors should get a tax credit, it’s much more efficient for that to happen at the federal level, rather than state by state. The federal government gets a bad rap these days thanks in large part to the hyper-partisanship of Congress. But some things are best left to the federal level, and tax breaks for angels is one of them.