High Taxes Kill Jobs
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.
Well, since you’ve decided to drop any pretense of respect for those whose opinions differ from your own, let’s be frank.
Jim, where is this money going to come from? This is my constant frustration. Conservatives constantly make overtures towards fiscal responsiblity, they constantly claim to want to cut taxes— but they have no specific cuts in spending in mind. And do you know why? Because the conservative rank and file has come to defend Medicare, social security and the prescription medicines benefit as vociferously as liberals do.
I can’t tell you how many times I’ve talked to people lately, regular people, who claim to be small government conservatives, but would absolutely revolt if you cut their Medicare, their social security, or their prescription drug benefit. It happens all the time. In general, as an abstract concept, they’re all in favor of small government. But in specific, they don’t want a single one of their benefits to be cut. And this is a lesson that conservatives, I’m sorry, are simply going to have to learn: the American people have gradually grown to expect their government to provide more than many fiscal conservatives are comfortable with. Culture is more powerful than politics, and American culture has become infused with the idea that (horror of horrors) there are times when the government must provide for its citizens what they can’t provide for themselves.
The United States is graying, and can be expected to for some time. The older population is going to be around longer than any that has preceded it. These people vote, have an extremely powerful lobby, and they depend heavily on government subsidy. If you think social security was a third rail before, I invite you to consider how powerfully protected it will be as more and more baby boomers advance into senior citizens.
I long for the time when conservatives won’t be under the misapprehension that broadly genuflecting to “the free market” is all that’s required to make an argument. I know this idea is held, indiscriminately, with an iron grasp of zealotry by conservatives, but not everyone is convinced that a freer market will always produce greater justice or abundance. And even more, people who think that’s the case will only apply that thinking as a vague concept, something to be held as a “core belief” but that has no actual referent to public policy. More and more people in their lives are finding that freer markets haven’t created these miraculous panaceas that conservatives have been claiming for 40 years. And your side has to confront that fact, rather than ridiculing those who feel that way.
By the way, I know how we can save trillions of dollars and not cut a single beloved social program. But as the word “Iraq” doesn’t appear in your post, I’m assuming you think that method of saving just isn’t serious.
— Freddie · Jul 31, 04:47 PM · #
Jim, this post disappoints me greatly. I’ve come to respect your data driven efforts to advance the conservative agenda. This post is just BS supply side talking points. Is there any evidence that slightly higher capital gains rates discourages capital formation or job growth? It may have some marginal effects, but if we are dealing with the subject anecdotally, higher rates in the late 90s didn’t seem to be much of an impediment to an incredible period of capital formation and job creation in the tech space. More Manzi, less Kudlow.
— Steven Donegal · Jul 31, 05:12 PM · #
Freddie:
I wasn’t trying to present a comprehensive tax plan, spending plan and budget. My points were that (1) higher taxes on capital gains and capital income really will reduce the number of start-ups that will be created, and (2) this policy is an example of many that apparently assume we will have an ever-expanding economic pie to divide up.
I haven’t bothered to crticize McCain’s policies in this area because (as I said in the post), it doesn’t matter much hat he says because he doesn’t seem to care about any of it, and is unlikely to be president.
I’ve said in prior posts that I think the whole American political leadership class is drunk with perceived power, and is frittering away our future. I’ve studiously avoided commenting on the war in Iraq as a specific potential instance of this, as my qualifications include never having been to Iraq, never having been shot at in anger and not speaking, reading or writing Arabic.
Steven:
Thanks for the compliment.
One quick thing is that I was trying to point out that all of the taxes on dividend income and so forth also impact a potential entrepreneur’s decision-making. A second is that Obama has proposed raising the federal capital gains tax from 15% to 25%, so that’s not what I’d call “slight”.
With these modifications, I think this is a valid question. There are, as you may imagine, many dueling econometric studies on this subject. The most relevant natural experiment is the 1997 act that changed cap gains rates feer than normal simultaneous chnages in other taxes. If you’ve read my other posts, you’ll know why I am so skeptical of claims of causality that ould arise from such analyses. So, while I could cite lots of studies tat “prove” my point, I think they’re all basically BS.
As I said in the post, however, the incentive effect on potential entrepreneurs is large. On the margin, it seems to me inarguable that all else equal you will get fewer start-ups when the pot of gold you get for success is about a third lower.
— Jim Manzi · Jul 31, 05:54 PM · #
I’ll challenge you on the notion that entrepreneurs consider tax policy when deciding to take the decade long slog of turning their scratches on a napkin into profit making enterprise. It seems highly unlikely as it would seem very imprudent to consider tax policy considering its fluidity. In 2002, according to your analysis, it would have been a good time for Anne to start her venture considering the shiny new low capital gains taxes. That should pay off in 2012 or so, just as Obama has managed to get them back to 1996 levels. Doh! The Capital Gains rate is probably our most volatile tax rate so basing your business decisions on the current rate would probably only be done by the most foolhardy entrepreneurs who probably aren’t smart enough to make it anyway.
— KJ · Jul 31, 06:53 PM · #
Jim, this is backwards. Obama’s plan involves eliminating the capital gains tax on start-ups, as you note in your (*) footnote. (As far as I understand it, this isn’t currently in effect. If so, ignore #1.)
1) Assuming some sort of risk-neutrality, your numbers on % likely to leave Motorola, and the bigger haircut capital gains (let’s say it’s 66% of the motivation) in the increase from 20% to 30%, back-on-the-envelope Anne now only needs a ~13-16% chance of success in order to take the plunge, less than before. Under President Obama and a Democratic supermajority and their capital gain tax exemption, Anne is more likely to try and make a startup. Seriously.
2) “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.”
Smart move to bring Brookings into this, but, unless I’m missing it, that’s not why Brookings didn’t score this. p. 11 of what you cite:
==
We do not model the following policies for which Senator Obama has stated support because of data limitations and/or insufficient detail about the policies that would be enacted…(3) elimination of capital gains taxes affecting start-up businesses…The revenue and distributional consequences (by income) of these policies are small in relation to the other policies discussed.
==
Third sentence is key. Whatever the micro-incentives of Obama’s policies (which I’d argue from #1 is net positive), the effect on macro-level revenue from capital gains is going to be negligible for budget forecasting purposes, which is the only thing they are trying to do. It is not because they believe it won’t happen or because the final product be a twisted version of what was proposed, which is what you imply they are doing.
3) Assuming you are right and the tax lawyers show up like hyenas, what’s the problem (from your point of view)? The bias will be that too few people will pay capital-gains, not too many. Since you are proposing a monotonically-increasing relationship between lower capital gains and job growth, this can only be good, right? (Again, from the point of view of this entry.)
(Side note: I left Motorola a few years ago to go study to become a financial engineer and perhaps maybe someday start-up a risk management group. Ha! Good call on the company.)
— Mike · Jul 31, 06:55 PM · #
KJ:
Great question. As I said, I simplified the description of the calculation. Anybody looking forward will consider a probability cloud of possible captial gains (and dividend, icnome and other) tax rates, among many other uncertainties. Pushing them up now would certainly raise the mean of this distribution. This is exactly how I thought about this issue when considering doing my first start-up.
— Jim Manzi · Jul 31, 07:07 PM · #
Mike:
All great questions / issues.
1. The way I model it out, Anne is financially indifferent between doing a start-up under current tax laws with a 20% chance of success, and doing a start-up with a 30% chance of success under the Obama cap gains, dividend and other tax proposals as analyzed by Boskin and the Tax Policy Center. If Obama were to be able to introduce a modification (as per note *) in which Anne paid the same cap gains tax as she would under current rates, then she ould need a 27% chance of success to be indifferent. If you’re saying that Obama would have a regime in which company founders paid literally no cap gains on the sale of Founder’s Equity, then this effect would almost exactly cancel the effect of the higher rates Anne would pay on her protfolio, and she would be indifferent between the current law and this hypothetical tax regime (again, as I’ve roughed out the calculation).
2. When the TPC says “insufficient detail”, that’s what I was trying to point to. I apologize if I wrote too loosely here.
3. I was asserting that he was unlikely to get such a provision without tax lawyers making mincemeat out of it, and would give up on the carve-out rather than give up on the higher cap gains rate. I certainly think no cap gains tax for start-ups would lead to, all else equal, more start-ups and resulting growth.
It’s a great question you ask as to whether I’d be for zero cap gains tax for company founders. While, as one, I’m tempted to say “Hell, yeah!”, here’s how I’d try to think about it more objectively. On one level, I’m critical (to the point of being emoitional in the penultimate paragraph) about politicians who simply assume that we’ll always have lots of growth no matter how much we burden the growth-creating parts of the economy. They assume away a foundation. But of course there is an even deeper foundation, which is not only physical infrastructure but social cohesion that allows this growth to happen. How many start-ups would happen if there were no US Army? How about if 50% of the US population were an underclass?
So I don’t think taxes should be zero. I also don’t think that all taxes should be collected from people with very little money, so in the end, you’re going to have to have a lot of money forked over by (among others) people who’ve made a lot of money. I think that the tax code is far more complex than it needs to be, and reform is warranted. The last thing I’d want to see is more carve-outs for special cases, in this instance, founders of companies. Without putting myself on the hook for developing a tax plan, I’d say the principles should be simplicity, broad base and low rates.
— Jim Manzi · Jul 31, 07:34 PM · #
This post just seems like just a lovingly detailed tautology: that higher taxes on investment reduce investment. Since consumption taxes reduce consumption, payroll taxes reduce wages and job creation, etc., it’s really not helpful to detail each particular sort without any sort of comparison between them. However, I must take exception to this out-of-character slam:
the odds-on candidate for the U.S. presidency has apparently decided to do his best to recreate the economy of the late 1970s.
Actually, the maximum rate in 1976 was 39.9%. Obama’s proposed top rate of 25% also happens to be the top capital gains tax rate from 1942 until 1967. Which, coincidentally I’m sure, was also a period of excellent growth in the US.
— Bo · Jul 31, 07:44 PM · #
Thanks for your response back. (If only a fair tax policy could be determined in blog comments!) I’m under the impression that Obama wants to eliminate all capital gains on start-ups:
http://obama.3cdn.net/b7be3b7cd08e587dca_v852mv8ja.pdf#page=4
Search “start-up”. And that’s from September ’07 – so it has been around a while.
Lord knows how that will go through, but it wouldn’t suprise me if the capital gain tax rate on start-ups was lower than now, even much so, next year if Obama is elected. Though Lessig-esque google/tech/quant kids have been a huge resource for the Obama campaign (I speak as one of them), one I think they want to build on.
Keep up the good work!
— Mike · Jul 31, 07:49 PM · #
Mike:
Thanks very much. Well, if it happens, I’ll be in the enviable position of having argued against something that will work to my material advantage – so I’m hedged on this either way!
I agree about the political economy of this. It is clearly meant as a way of building on SV financial support.
Bo:
I think the huge swing here vs. the 1970s is uncapping the payroll tax. Boskin provides a detailed build up in his article. Your broader point is correct, though: marginal tax rates however you want to slice it were a lot higher in the 1950s and into the 1960s than anything contemplated today. I think, however, we live in a very different world now.
— Jim Manzi · Jul 31, 08:31 PM · #
Jim, your healthcare complaint seems shoehorned in and not really relevant to your thesis. One can easily argue that Obama’s health care policy would be good for job creation and entrepreneurship as health insurance costs are usually a pretty big cost for entrepreneurs. And you also undercut your thesis of regulation = bad by mentioning the housing crisis, which is generally accepted to be due to a lack of regulation in letting lenders do whatever they want.
Look, I’m an Obama guy, and we probably just aren’t going to see eye-to-eye on some of these things. But I do respect your point of view and I think your arguments could use a bit more thought is all.
— The Lev · Jul 31, 08:36 PM · #
I think the start-up scenario is the least of our problems with increased capital gains, interest, and dividend taxes. The main problem is that we have an inflated dollar, and these types of policies only prevent people from investing their money.
People will have cash-on-hand to spend, and consumerism will probably rise with the variety of social programs he is proposing (like another stimulus package). There will be a large increase in publicly-funded jobs in transportation, agriculture, healthcare, and energy, further swelling the middle-income ranks with disposable income.
None of this money will be save though, since the incentives for doing so are gone. We know his spending programs are not tailored for a balanced budge, so we can expect high budget deficits, which will most likely be blamed on Bush (some of it deserved). Hide budget deficits will lead to more inflation, eventually, making all of us less wealthy.
While I am totally opposed to most taxes, and certainly all tax increases, I can stomach them if the revenue is used to reduce the deficit and balance the budget. This is why I could stand Clinton, as slimy as he is. Both candidates will do nothing for a strong dollar, I am afraid.
— mattc · Jul 31, 08:45 PM · #
I think the huge swing here vs. the 1970s is uncapping the payroll tax.
IIRC, the president who raised payroll taxes to (within a point of) their current rate was named Reagan, no? I haven’t run the numbers but Obama’s removal of the cap doesn’t seem any more extreme than Reagan’s 50% hike in their rate, and a far less regressive one to boot. I mean, Boskin’s one sentence complaint with raising the payroll cap, “The result is a remarkable reduction in work incentives for our most economically productive citizens.” sure sounds like he’s demanding that less productive citizens, i.e poor people, cover the deficit instead.
Besides, relative to income and corporate taxes, the payroll tax is simple, broad-based and has a low rate. Isn’t that exactly the kind of tax you just said you would support?
— Bo · Jul 31, 11:42 PM · #
As far as I have been able to tell from my vast readings on the subject, the relationship between taxes and wealth production is very hard to determine, though many people have opinions.
— cw · Aug 1, 03:06 AM · #
I’ve heard this Conservative theory of low taxes and prosperity about a hundred times. It’s persuasive. It sounds logical. But historical data is more likely to support the opposite, if anything! I think that is the real, unstated reason Conservatives hate Clinton so much: He increased taxes and achieved all that Conservatives claimed tax cutting would do, but never did. What I’d like to see is a post explaining why tax cutting hasn’t worked, and what we have to do different next time so that it will… or maybe it just doesn’t work in the real world!
— johnw · Aug 1, 04:01 PM · #
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.
Then there’s two strategies for encouraging more such companies to launch. You could increase the low-odds payoff. Or you could ease the pain of lower income and longer hours by moving taxes to the rich and creating subsidized health insurance.
In other words, we can either help yesterday’s winners or tomorrow’s winners (i.e. today’s losers).
— Consumatopia · Aug 2, 12:21 PM · #
Jim, I have been involved in four startups (all successful, in total netting tens of millions)—as the principal in two of them. I have worked with, collaborated with, and been friends with dozens of of other startup entrepreneurs.
I cannot think of a single case in which I or they considered tax consequences in deciding whether to do the startup—even to the point of holding up a mental thumb and squinting at the tax code. The future prospects are far too imponderable at that early stage to consider possible/maybe 20% differences a decade down the line.
It’s just not how startup entrepreneurs think at that stage.
Really: did you spend more than a microsecond considering tax implications in deciding to start your business(es)? No; you just said, “I think this can be a success—maybe a big success.”
I agree with other posters: this armchair theorizing isn’t useful, and isn’t up to your standard.
— Steve Roth · Aug 2, 05:57 PM · #
Gents-
Thanks for letting me horn in on this thread. I hesitate to say this with Jim Manzi in the room, as he’s the exception in a lot of ways, but here goes.
In 18 years as a venture capitalist, I’ve actually been lucky enough to back a few successful startup entrepreneurs. Most rewarding part of my professional life. And not a single one of them gave a rip about anything you guys are talking about. To a man (and so far they’re all men), they were like Richard Dreyfus in Close Encounters. They were so possessed that they just kept making mounds in their mashed potatoes. I would submit that Jim is very much an outlier in his approach.
Respectfully,
jt
— john thornton · Aug 3, 12:38 AM · #
Steve / John:
Thanks for your great comments, and sorry for the delayed repsonse, but I’ve been in a no-electronics beach area all weekend.
I have a lot of respect for your esperiences, but I think you guys are really pushing a ball uphill if you’re trying to argue that something like a one-third reduction in the expected payoff from an activity will not materially reduce the level of that activity. We can trade stories all day long, but you don’t just have to demnostrate that some or even most entrepreneurs would have gone ahead in the face of a worse expected payoff, but that materially all would have done so.
Best,
Jim
— Jim Manzi · Aug 4, 03:42 PM · #
We can trade stories all day long, but you don’t just have to demnostrate that some or even most entrepreneurs would have gone ahead in the face of a worse expected payoff, but that materially all would have done so
No, they don’t—because many entrepreneurs could be deterred by the absence of things those higher taxes could pay for, like health insurance subsidies. Or, they might believe those higher taxes could pay for research and infrastructure necessary to grow the economy and make their innovations more profitable in the long run.
— Consumatopia · Aug 5, 04:07 PM · #
Consumatopia:
I take your point. That’s what I was trying to get at when I said earlier in this comment thread that:
I think that Steven and John were referring to the specific financial incentives that face an inddivdual entrepreneur in terms of an investment decision, not that person as a voter. I get that, if such effects as you describe are real (and to an extent, as I said, I think they are) then ultimately, they would have to impact the decsion-making of some potential entrepreneurs at some point in the future.
— Jim Manzi · Aug 5, 10:30 PM · #