I’ve been trying for weeks to get around to cataloging just how many bad economic policies Obama has proposed. Michael Boskin did the job for me in Tuesday’s Wall Street Journal. Here’s the opening paragraph:
What if I told you that a prominent global political figure in recent months has proposed: abrogating key features of his government’s contracts with energy companies; unilaterally renegotiating his country’s international economic treaties; dramatically raising marginal tax rates on the “rich” to levels not seen in his country in three decades (which would make them among the highest in the world); and changing his country’s social insurance system into explicit welfare by severing the link between taxes and benefits?
For all the “We are the change we’ve been waiting for” yak-yak about a new generation or whatever, and for all the celebrated economists who are advising him, the odds-on candidate for the U.S. presidency has apparently decided to do his best to recreate the economy of the late 1970s.
One important part of this is the incentives that his tax policies will create. A lot of the argument that marginal tax rates matter for the overall growth of the economy can seem pretty theoretical. For one thing, will somebody really stay late at work for $2 million per year, but not $1.8 million? Lots of smart liberals ask some version of this question, and the only realistic answer is “probably not”. Further, the fact that the whole topic is so boring works to obscure its importance.
So I’ll focus on an area with which I have some direct experience, and that is a crucial mechanism by which Obama’s proposed tax policies would likely reduce economic growth and job creation: new company start-ups. Long story short, expect many fewer new companies to be founded if Obama gets his way on economic policy. Given that something like 7 million people in the U.S. work in companies that are or were venture-backed, including a majority of the employees in high-growth sectors of the economy like computers and software, this is likely to matter a lot in the long run.
The key thing to keep in mind about the economics of starting a growth company is that generally you are trading lower current income and much longer hours for some years in exchange for the low-odds chance of a big payday. I’ll work through a typical, somewhat simplified, example for a venture-backed technology company.
Anne is a young engineer at Motorola who has what she thinks is a great idea for a new software product. It’s probably a 10-1 shot for Anne to get a venture capitalist to invest in her idea, even if it’s a good one. But let’s assume that, driven by her dreams of ultimate success and wealth, she invests a year or so of nights and weekends, and successfully gets funded. At this point she has something like a 20% chance of getting the company all the way through to a successful exit that makes her a lot of money. She faces the prospect of working much longer hours and living on much lower wages for about a decade, knowing that she has excellent odds of realizing, only after years of such work, that this was all incredibly stupid, and that she would have made a lot more money if she had just kept her job at Motorola and gotten home for dinner every night.
If she succeeds, it would all be worth it. That’s why, if you had a reasonable expectation of success when getting started, then many, many more people would start companies (probably about as many as go into long-hour / high-stress work like investment banking, corporate law and strategy consulting). But when you multiply the payoff by odds of success that vary between maybe 1% and 20%, depending on where you are in the process of company formation, the expected value of this payout doesn’t look so obviously compelling. The potential pot of gold has to be very big to get people to make the leap.
Now, it’s easy to say “OK, but Anne makes so much money if successful, that it’s hard to see how higher taxes on the back-end would actually change her decision about whether or not to start the company. If the company succeeds, she’s still incredibly rich under anybody’s tax plan, and if it does not, then rates don’t matter anyway.” But consider Anne’s incentives as they exist the moment before she makes the leap. As she considers whether to do it, her potential payday gets two big haircuts under the Obama plan versus current tax rates: (1) she loses an additional 10% of her payout when she sells the company or goes public, due to the higher capital gains tax rate, and then (2) unless she plans to buy and eat an immense number of pizzas and cheese steaks the day she sells the company, she will invest the proceeds, and will now expect to pay higher taxes on all of the capital gains, dividends and interest income that she will earn on this in perpetuity. The second haircut is actually the larger one (*).
Under the Obama tax plan, therefore, Anne would rationally have to foresee higher odds of success in order to make her as likely to decide to start the company as she is today. How much higher? By my figuring, about 30% instead of 20%. That is, she would have to believe that her odds of success were somewhere between 1-in-3 and 1-in-4, instead of 1-in-5 today, to be as likely to start the company. To get a sense of how huge the difference between a 20% and 30% chance of success is in this situation, consider that this is about the difference between the odds of success for a new venture-backed company started by a first-time entrepreneur versus the odds of success of a new venture-backed company started by a founder who has already done at least one successful start-up. Talk to any venture capitalist on earth about just how much more likely the second guy is to get funded than the first.
Some people start companies because they are driven by a dream that transcends rational economic calculation, but most (successful) entrepreneurs that I know are pretty serious about comparing risks to opportunities. While quantifying how much Obama’s proposals would suppress entrepreneurship is probably a fool’s errand, they would almost certainly reduce new company formation a lot versus what it would be under current tax law.
But hey, who needs so many new companies anyway? I’m sure the industrial and transportation sectors will be a huge engine for job growth. Well, maybe not so much after we introduce a “cap-and-trade” system for carbon dioxide emissions – in plain English, after we begin to ration the nation’s primary energy source so that we can help to prevent potential weather problems that may develop for people who may live in other countries many decades from now. How about health care? That’s a growing part of the economy. So let’s be sure to beat up all of those evil pharmaceutical companies and their obscene profits. I’m sure we’ll do just fine with reduced investment in biotech-based drug development. Well, the economy is “financializing” pretty heavily – I’m sure we’ll get lots of new jobs there. It’s not like this sector is in crisis, and already shedding jobs or anything. Maybe we could raise taxes some more, and pump many, many billions of dollars into Fannie and Freddie without any discipline for management so that we can have the government direct more of the financial sector. Political allocation of resources always creates productive jobs. While we’re at it, let’s over-regulate our financial markets. It’s not like we’ve already driven huge amounts of capital-raising offshore, and we all know that we’re the world’s financial capital by birthright. Ah, but the fact that we’ve driven down the value of the dollar so much will help a lot of export-oriented companies to grow. Except that we’ve decided that NAFTA and other free trade agreements don’t sound so great. Rather than fixing the previous problems (as examples on a long, long list) that would enable us to grow in a manner that creates more benefits for the broad middle class, let’s try to build some walls around our economy. There’s such a great track record for this strategy.
Growing inequality and middle-class wage stagnation are big problems for America. But trying to re-regulate the economy and redistribute income is a cure worse than the disease. Of course, all of my criticisms of Obama’s economic plans would also be a lot more useful if his opponent seemed to care at all about any of these issues, and was presenting creative alternatives. Further, for all of my litany of dumb things Obama wants to do (and things that the current government is doing right now) to inhibit growth, the United States is a very rich country with a strong economy. Subject to normal ups-and-downs, it is likely to keep growing for a long time even if Obama does all he wants to do. If you keep eating enough french fries, however, eventually you’re going to have a heart attack.
*: Obama has asserted that he wants to create a capital gains carve-out for company founders, which would improve things marginally for Anne. As I’ve argued in previous posts, it’s going to be very hard to do this in a way that doesn’t lead lots of people (or more precisely, their very smart tax attorneys) to find lots of ways of recasting many existing activities as “founding companies”, which would undermine the higher capital gains tax rate. Therefore it’s unlikely to happen, and hard to know what it would really look like if it did. The highly respected, center-left Brookings / Urban Institute Tax Policy Center declines to consider and score Obama’s assertion on this subject for just such reasons. But let’s assume that somehow it was accomplished, and Anne would face the same capital gains tax rate on her sale under the Obama plan as she does today. Because of all the other haircuts she takes on her portfolio, she is still much less likely to start the company. In this case, she would have to increase her expected odds of success from 1-in-5 to a little better than 1-in-4.