Brad DeLong Thinks Taxing An Activity Doesn't Discourage It: I'm Not Sure Why
I made the argument last week that the Obama tax plan would serve to discourage entrepreneurs from founding companies by reducing the expected size of the take-home payday that would result from the creation of a successful company. As an entrepreneur, this seems like a pretty common-sense point to me: if you raise the taxes that I expect to pay when and if I successfully start, build-up and sell a company, then, all else equal, I am less likely to do go about the attempt of starting, building-up and selling a company.
Justin Fox, the Time Magazine economics blogger, offered what appeared to me to be pretty bounded praise when he called this post “non-bogus”. Apparently, though, this was enough to set off prominent liberal economics blogger Brad DeLong.
What surprised me, given that DeLong has always struck me as very smart and lucid, was that hat his attack was so trivial. Among other things, I said in the post that Obama’s tax proposals would mean that a hypothetical entrepreneur (Anne) who starts, builds up and sells a company “loses an additional 10% of her payout when she sells the company or goes public, due to the higher capital gains tax rate…”
Yesterday, DeLong’s summary reaction to the post was:
I think we can stop there. I am a progressive-consumption-tax guy myself—I don’t like to see capital income taxed unless that tax is linked to high consumption spending in some way. But the claim that Anne’s entire stake is subject to the capital gains tax on the day of the IPO is so false as to be totally bonkers.
No, Justin, keep looking.
There are some problems with this critique.
DeLong includes a long quote from my post, but he cuts out a pretty important sentence:
I’ll work through a typical, somewhat simplified, example for a venture-backed technology company. [Bold added]
Normally when you use an ellipsis (…), as DeLong did, to snip out part of a quote that you are criticizing, you shouldn’t cut out something that obviously addresses your criticism.
Hyper-technically, it would have been more complete had I written something like “when she sells the company or goes public and subsequently sells her stock” instead of just “when she sells the company or goes public”. But even this would not have made the post absolutely complete. All real tax law is so complicated that it requires hundreds of pages of law and clarifying opinions, rather than a roughly 1,700 word blog post. This is why I was very careful to put in the disclaimer that this was a “somewhat simplified” example.
But does the simplification that DeLong highlights impact the point of the post? No. He doesn’t bother to explain how it might. It would be hard for him to do this. Under either version of this statement, whenever an entrepreneur actually realizes the monetary gains that are the typical economic motivation of starting the company in the first place, he or she would expect to take home less money due to higher taxes under the proposed Obama tax plan. DeLong’s point has no material effect on any qualitative or quantitative argument made in the post.
It is a totally irrelevant point that is meant to imply that I am a novice who doesn’t know anything about taxation of Founder’s Equity. I’m pretty comfortable with the mechanics of the IPO and company sale process. It seems to me that the way that I stated this point satisfies what I believe should be the key criterion for appropriate concision in such a circumstance: it should neither mislead those who are not expert in the subject, nor confuse those who are.
In the end, is DeLong seriously arguing that Obama’s proposals would not increase taxes on entrepreneurs who accumulate capital? Or is he an economist arguing that increasing taxes on an activity will not result in less of it than you would otherwise have?
Why don’t you go post a comment over there complaining. I’m sure that it won’t magically disappear.
— Bob · Aug 11, 03:17 PM · #
Y’know — and this is actually germane though tangential — I’m wondering if you’ve read Scott Shane’s new Illusions of Entrepreneurship. I’ve been tangled with a couple tech startups some and Shane’s book actually really fascinated me. I got the feeling that there was some room for infringing on incentives to entrepreneurship as long as one was really, really cautious (which I grant you is not the nature of these things).
— Sanjay · Aug 11, 04:26 PM · #
I came here from Dr. DeLong’s blog. Although I have no right to speak for anyone there, and certainly not Dr. DeLong, I will try to summarize briefly the objections made in the post and comments.
1) The uncertainty involved in a start-up is so enormous that any changes in the capital gains tax that have actually been proposed are lost in the noise. When the probability of success cannot be judged within 30%, the time to payoff is 10-20 years, and the amount of the payoff might easily vary by 1000%, the capital gains rate never even gets a line in the spreadsheet.
Not to mention the fact that the tax rate is itself highly uncertain. Mary must judge not what the rate is now, but what it will be when payday arrives. By which time it will have changed how many times?
2) Most projects never get funded anyway. Even if the underlying rate drops, it seems reasonable to assume that on the whole it will be the weaker projects that are not attempted. So venture capital has as many good proposals as before, and the rate of real start-ups is likely to be unaffected.
3) To summarize the summary, we’re talking about restoring the regime the prevailed during the Clinton administration. Somehow, some notable start-up took place during that time.
Your reasoning, “nore tax less activity,” is too general. Back to the actual world.
— George · Aug 11, 05:57 PM · #
George:
Thanks for your comments. Let me react to each point in turn:
1. The difference between a 20% and 30% chance of success (the rough incremental impact of the Obama tax program) does not seem immaterial. 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. Many rational entrepreneurs would consider this. As an example, I in fact did have the relevant lines for this in the spreadsheet that I used to make the decision to do a start-up.
2. This assumes perfect (or to be fairer, excellent) information. There is irreducible unpredictability in a start-up, or else the success rate would be 100%, instead of very low.
3. The argument is that the rate of start-ups would be higher but for the change in tax rate, not that this is the only factor driving the rate of start-ups.
— Jim Manzi · Aug 11, 06:15 PM · #
“The difference between a 20% and 30% chance of success (the rough incremental impact of the Obama tax program) does not seem immaterial.”
Not sure where these numbers come from, but why would the tax rate upon an exit event have any impact on the chance of success of the business itself? As someone who works with VCs and startups, I think you overstate the effect. This may be a real effect for a few people, but if this is the best criticism you have of the Obama tax plan, it must be a pretty solid plan.
— Steven Donegal · Aug 11, 11:03 PM · #
Mr. Manzi:
Thank you for your reply,
The substance of our disagreement is your point three:
3. The argument is that the rate of start-ups would be higher but for the change in tax rate, not that this is the only factor driving the rate of start-ups.
I, on the contrary, think (for the reasons given) that the difference in the rate of start-ups between the two tax rates would be statistically zero.
— George · Aug 12, 01:43 PM · #
George:
So on this point, it sounds like we agree about the direction of the effect, and we’re now discussing whether we should assume that its magnitude differs materially from zero. Here is my evidence for believing this effect would not be “statistically zero”: I estimate the difference in expected value from starting a company under Obama’s proposals vs. cuurent rates to be about the same as the difference in expected value between a company started by an experienced, successful entrepreneur vs. one started by a novice entrepreneur. This is a big difference, as indicated by the bahavior of virtually every professional venture investor.
What evidence do you have for your belief?
— Jim Manzi · Aug 12, 02:36 PM · #
“I estimate the difference in expected value from starting a company under Obama’s proposals vs. cuurent rates to be about the same as the difference in expected value between a company started by an experienced, successful entrepreneur vs. one started by a novice entrepreneur.”
What is your evidence for this estimate? As another poster mentioned,you are making way to big a deal over the exit event. My guess is that about the same number of investors avoid new ventures based on the gains rate as people avoid getting a job because they don’t want to pay income taxes.
— Jeff · Aug 12, 02:49 PM · #
Jeff:
Fair question. Here’s how I did the rough figuring.
Anne owns 20% of the company, so when it sells for $100 million, she gets $20 million. She has to pay capital gains tax on this. If she is in a high-tax jurisdiction (say California, since it’s a software company), this totals about 25%. So after tax she gets $15 million.
She then sets up a reasonably balanced portfolio, and expects to get a 4% real rate of return on this money. Assuming a reasonably growth-oriented portfolio (60 % of the money taxed at cap gains rates / 40% taxed at income rates), her weight-average tax rate is about 33%. So her portfolio produces about $403K after tax per year for her.
This sounds pretty great, but of course, when she made the decision to start the company, she was not certain of success, but had to estimate her odds of achieving this result. As per the NBER paper cited in the original post, in order to establish a benchmark for comparison let’s simplify her estimated odds of success prior to starting the company as a 20% chance of achieving this result, and an 80% chance of getting no cash value for her equity. On an odds-adjusted basis, therefore, Anne’s expected payout is a post-tax cash perpetuity of about $81K ($403K X 20%).
What would be different under the proposed Obama tax plan? Let’s assume that she builds up the company in the exact same amount of time to exactly the same profit level, and sells it for the exact same amount of money. Under Obama’s tax plan, her capital gains tax rate is now 35% instead of 25% (subject to the note in my original post), so her post-tax cash payout is now $13 million instead of $15 million.
Now, when she sets up her portfolio, things start to get a lot worse. Let’s assume she sets up an identical portfolio and still makes 4% real. Her weight average tax rate on these earnings now goes from about 33% to about 46%. So, if successful, her portfolio now produces about $280K per year for her after taxes, rather than $403K. That’s a big haircut. With the same estimated chances of success, her odds-adjusted annual post-tax payout is now about $56K instead of $81K.
What are the odds of success that she would have to assume under the Obama plan to make her annual odds-adjusted post-tax payout equal to the $81K that this would be under current rates? About 29%.
— Jim Manzi · Aug 12, 09:38 PM · #
Pretty odd hypothetical. This isn’t a question of whether the investor would do better with lower cap gain taxes but whether the lower potential would lead them to keep their money in their mattress. And your response still doesn’t address why this is equivalent to choosing between an experienced or novice entrepreneur. Of course, all things being equal, I would prefer to direct my funds to the more experienced. But that is because I am looking for an investment that will grow my wealth regardless of the tax rate.
— Jeff · Aug 13, 01:21 PM · #
Jeff:
The hypotheitcal is not, in my experience, odd. The decison-maker in question is the enntrepreneur. The comparison to the VC investor is for the purpose of providing a benchmark about whether a 50% increase in odds of success is perceived as “material” vs. “staistically zero”
— Jim Manzi · Aug 14, 12:18 AM · #
But you still haven’t shown that. You have only looked at how they would do after they got out of the venture. You need to find someone who wouldn’t go the VC route to prove your point. How much did they put into the business to start with? You need to show that they would likely be dissuaded from making the vc investment for something else because of the tax to make your point.
— Jeff · Aug 14, 12:19 PM · #
Jeff:
I don’t know how to be any clearer about this. Let me try again.
A potential entreprenuer considers starting a business. She considers her expected value creation from doing this. Expected value = economic gain if successful X odds of success. If you lower the economic gain if successful, then in order to have the same expected value prior to starting the company, you must increase the odds of success. As per my illustrative example, you would have to increase the odds of success by about 50% (from 20% to 29%) in order to have the same expected value under the Obama plan as under current tax rates.
You have argued that this difference is trivial, which seems not so obvious to me on its face. In order to illustrate that this difference is significant, I have referened the decison-making by a different party to the same transaction who is geenrally considered to be well-informed: VC investors. 29% vs. 20% is about the difference between the odds of success for a venture started by an expereienced entrepreneur vs. a new entrepreneur. That is only in order to illustrate that it is a non-trivial odds difference have I referenced the VC.
— Jim Manzi · Aug 14, 05:50 PM · #
“You have argued that this difference is trivial” – no one has argued that. What is trivial is the amount of investors who would shy away from vc and therefore job creation based on you projections. That is the bone of contention people have with your post. How can we be clearer?
— Jeff · Aug 14, 06:47 PM · #