- Perspectives
Encouraging Defense Investing: Incentives Matter
By James Parker, Co-Founding Partner of Leonid Capital Partners
Show me the Incentives, and I will show you the behavior
In a previous edition of Quartermaster, I explored the rationale for imposing harsher tax treatment on capital investments in adversarial economies—the proverbial stick.
Now, let’s talk about the carrot: how to drive private capital into critical National Security technology sectors through preferential tax treatment.
Now, I don’t know if any of you have noticed, but President Trump has made some waves recently. Stop, I know you are shocked and surprised.
No, I’m not talking about cancelling Politico subscriptions or stopping the production of the god-forsaken copper incremental demon. (which, for the record, I am totally for abolishing. The penny does nothing but convince my 4-year old son it is special because it is a different color than the rest of the coins I randomly bring home.)
I am talking about Trump’s recent support for rolling back the carried interest tax deduction for private equity, venture capital and like-kind investments. Now, I recently called for a similar blanket treatment for investments in foreign – namely adversarial – economies, and with good reason. Investment in economies of our national adversaries does nothing but work against our nation and our economy and there is zero reason to support said investment with preferential tax treatment
That being said, eliminating preferential tax treatment altogether would/will kill the proverbial child in the cradle. You want investment firms investing in our economy, creating jobs in our communities, and adding our global competitive advantage, and the way you encourage them to do that is with advantageous incentives – namely preferential tax treatment.
But let’s take it a step further
The United States has identified key critical technology areas essential for national security, from artificial intelligence to advanced materials. Jason Rathje and the Honorable James Geurts recently had a great conversation on this topic Hondo’s podcast Building the Base.
Yet, funding these innovations remains an uphill battle. The prevailing venture capital model is fundamentally mismatched with national security needs—massive exits are rare because government customers are inherently risk-averse, slow-moving, and bound by complex procurement rules. With all due respect to my friends and colleagues at Palantir, we can’t just change the market multiples on defense primes and fix things (“Hello, Mr. Market? I’d like to speak to your manager.”) – but we can change investor incentives.
The Fix: Smart, Targeted Tax Incentives
Rather than spinning up new government-backed investment vehicles—an approach that is costly, bureaucratic, and largely ineffective—we should instead reframe the risk-reward equation for private capital.
As the saying goes, show me the incentives, and I will show you the behavior.
Investors are rational actors; they will go where the best risk-adjusted returns are. If we want to encourage more capital into critical technologies, we must structure tax policy accordingly. Fortunately, there is precedent for this approach.
Precedent: The QSBS (Qualified Small Business Stock) Exemption
A strong example of how tax incentives can shape investment behavior is the Qualified Small Business Stock (QSBS) exemption under Section 1202 of the Internal Revenue Code. The QSBS exemption allows investors in qualifying small businesses to exclude up to 100% of their capital gains—up to $10 million or 10 times their basis—from federal taxation if they hold the investment for at least five years. This provision has successfully funneled capital into early-stage startups, stimulating innovation and job creation.
A similar approach tailored to critical technology sectors could produce even more significant results. By expanding preferential tax treatment beyond traditional small businesses and specifically targeting national security-related industries, we can channel investment into the technologies that matter most.
How It Would Work:
- Deductible Management Fees for Investors in Critical Technologies
Currently, investors in investment funds pay management fees out of pocket without tax deductibility. This creates an unnecessary drag on returns, particularly for long-duration investments. Allowing investors in designated critical technology funds to deduct these fees would immediately enhance after-tax returns, making these investments more attractive.
- Reclassifying (or Elimination) of Ordinary Income Tax Treatmetn on Critical Technology Investments
Critical to tax policy is reducing the tax burden on the key players in any transaction. Similar to improving the tax treatment of management fee deductibility, improving the tax treatment of investors in DOD critical technology areas to avoid ordinary income treatment (DISCLAIMER: like our investors at Leonid Capital Partners) would be a key factor in driving behavior.
It bears repeating (and I promise I will repeat it again), investors are only so patriotic – it is a great theme to break a tie, but in the end investors will always follow the economic incentives (ie, lower risk or higher returns.)
- Eliminating (or Reducing) Capital Gains Tax on Critical Technology Investments
The primary lever for attracting capital is adjusting after-tax returns. By reducing or entirely eliminating capital gains taxes on investments in qualified critical technology companies—similar to QSBS—the risk-adjusted returns would increase dramatically. This would lower the cost of capital for these companies, enabling them to raise non-dilutive funding and build a stronger financial foundation.
- Individual Investment Treatment Rather than All-or-Nothing Fund Designation
A crucial feature of this proposal is that it does not require an entire fund to qualify for preferential tax treatment. Instead, individual investments could be designated as eligible, allowing generalist funds to participate without needing to shift their entire strategy. This flexibility would maximize capital flow, encourage non-specialist funds to expand their investment envelope, while keeping capital markets efficient.
- U.S. Investors Only
These benefits should be available exclusively to U.S. investors, ensuring that tax incentives strengthen domestic capital formation and keep economic gains within national borders.
The Impact: A Stronger Capital Base, Lower Cost of Capital
When investment returns increase, the cost of capital decreases. It’s that simple. Lower cost of capital means these companies can raise money on better terms—less dilution for founders, lower interest rates on debt, and ultimately more robust businesses ready to serve national security needs.
Compare this approach to the government’s current preferred method: standing up new, bureaucratically encumbered entities to deploy capital. Rather than putting existing taxpayer dollars at real risk through cheap leverage or large direct equipment financing programs, this model changes the burden on taxpayers to an opportunity for private investors – where it should be.
Incentivizing private capital in this manner ensures that investments flow efficiently to critical areas, without the inefficiencies and constraints of slow (and costly) government-administered programs.
Private capital, properly incentivized, will always be faster, more efficient, and better at identifying winners than a government agency allocating capital based on committee consensus.
A Note on My Own Conflict of Interest
We have encountered this issue firsthand – in certain stares (namely Massachusetts), investors often hesitate to commit capital because, after paying ordinary income tax (because of our inherent income generating strategy) at both federal and state levels and being unable to deduct management fees, their projected net returns begin to approach the fundamental risk-free rate. No Investment manager in their right mind would make such an investment, no matter how strongly (or patriotically) they felt about it.
The trick is making sure those patriotic investors (and they do exist) are seeing the incentives necessary to drive a decision in favor of support critical investment in our collective national enterprise.
Yes, I run a private credit fund that lends to national security-focused companies. And while these tax incentives would benefit me, they would also create a more competitive environment by drawing additional capital and new entrants to the space, directly and indirectly through traditional private equity and venture capital.
I say bring it on. I want nothing more for the United States to technologically overwhelm any and all adversaries through sheer force of will. There is no nobility in a fair fight, and I want all of our sons and daughters to be protected in the envelope of our economic and technologic might.
This is the policy path forward. We don’t need more government-managed funds. We need a tax framework that makes investing in critical technologies the smartest financial decision in the market.
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