Taxes and Entrepreneurship and Causality
Andrew Sullivan has a post up that quotes two different authors attacking the argument that I made in City Journal that higher tax rates will tend to produce, all else equal, less entrepreneurship.
The first of these at least attempts to make the argument from evidence. The author asserts that tax rates were higher under President Clinton than under President Bush, and there was a greater increase in net new businesses under President Clinton than under President Bush, so therefore my conclusion “just isn’t true”.
There are some problems with the analysis, but more fundamentally, with the logic.
First, the analytical problems. As the author notes, he is looking at “net increase in number of firms”, which is new formations less eliminations, so it does not actually capture new starts. I think that a much more direct analysis of this kind in regard to my assertion would be to compare government spending as a percentage of GDP (I referred in the article to current tax laws plus the rational expectation of future tax increases) to total dollars of new venture capital commitments (I described a venture-backed entrepreneur, and quoted the number of jobs created by venture-backed start-ups as evidence for the importance of the issue). I did this only as a response to some of these criticisms. You’ll find that there is a negative correlation with R-Squared of 0.28 between these two variables – that is, as government spending becomes a larger part of the economy, venture capital funding of businesses tends to drop.
Did I just prove my thesis to be correct? Of course not. This is very slightly less naïve than the alternative analysis, but shares the same fundamental logical problem. There are many, many factors that drive new company formation, and the expected future tax bite is only one them. This is why argument that “Hey, we had higher tax rates and lots of new companies under Clinton, so therefore tax rates don’t affect new company formation” is so empty.
Consider an analogous case where Andrew and I disagree about taxes. Andrew has frequently argued that we should increase gas taxes in order to reduce climate change, dependence on unstable oil suppliers and so on. He believes that higher gas taxes will, all else equal, discourage use. But the federal tax on a gallon of gas stable at about 9 cents per gallon from 1983 to 1990. It was roughly doubled in steps from 1990 to 1997 to 18.4 cents per gallon. But, look, gasoline consumption in the U.S. kept rising steadily over this period. So can we conclude that proposed future increases in taxes on gas won’t lead to a reduction in use? Andrew doesn’t think so, and neither do I. The price of gasoline and its relative economic benefits are impacted by many other factors. The same is true for entrepreneurship.
The open question is what these rates of company formation (or gas usage) would have been but for the tax changes.
The second item that Andrew cites (a quote from Matt Miller in an article by Kathleen Parker) makes the same essential argument, but without a real attempt at analysis:
“We know from the Clinton boom of the 1990s that marginal tax rates of 39.6 percent put no brakes on entrepreneurship or growth. And the modest limits Obama is proposing on the value of itemized deductions for mortgage interest and charitable donations puts their value exactly where they were under Ronald Reagan, which no one would say was a ‘socialist’ interlude for the U.S. economy. So everyone jumping up and down about how supposedly ‘radical’ Obama’s plan is should calm down and look at the facts.” [Bold added]
Once again, this is a claim for causality with no evidence – what would these have been under a different tax regime?
This paragraph also elides between a directional and a quantitative argument, when it argues that these are “modest”. First, in my article, I was clear that I was referencing current increases plus the rational expectation of future increases. Second, the argument that “Well, this is so small, how could it change anybody’s decision in practice” is a fallacy of pricing. Do you think you would not have bought your last car if it cost literally one dollar more? Why doesn’t every car company in the world raise the price of every car $1. That would be a lot of incremental free cash flow. Once at that price level, why don’t they apply the same logic and raise price $1 again. This road leads to infinitely expensive cars.
We don’t always consciously understand our decisions, and you only have to deter the marginal car buyer (or entrepreneur), not the average one, to experience price elasticity different that zero.
I was carefully circumscribed about my claim:
tax burdens raise the price of entrepreneurship. When you raise the price of something, then, all else held equal, you usually get less of it.
That is, I didn’t claim that we would have fewer new company formations in the next decade than we did in the last. I didn’t even claim that the net effect of the overall Obama political program would be positive or negative for entrepreneurs. The only reason I wrote the article was to provide an estimate for the quantity of “price increase” that would be experienced by a typical potential entrepreneur, because I thought this quantity might be surprisingly high to lots of people. I’m quite surprised at the specific point of controversy that my article has engendered. I thought that non-zero elasticity of economic behavior to price was pretty uncontroversial.
I am a life-long small businessman and this is for me the most interesting and puzzling part public policy. Not being burdened by being an economist or politician I tend to look at tax policy as a pragmatic amalgam of various vested interests an the simple fact that government provides services that are crucial to my being able to be in business, it cannot, in the long term, spend money it does not have, and that there are limits on how heavily it can the economy without effecting the economy’s ability to generate tax revenue, and that if government services are sufficiently eroded, it will ultimately effect my ability to make money.
I’ve been in countries where the government has completely destroyed the economy through over taxation, and I’ve been in countries where the government does not have the mechanisms to effectively collect revenues, let alone spend those revenues in a way that makes it easier to do business. I certainly don’t want that.
I’ll add that I’ve also been in countries where poor access to credit stifles innovation and makes everyone poorer and more wasteful, and apparently now I’m living in a country suffering from the ill effects of credit being available too easily.
What is the correct balance or how to arrive at that balance, I really have no idea. Like I said, I’m a small businessman, not a politician or economist.
I do know that whether you’re on the left or the right, you don’t want to put me out of business. Earlier this week I calculated the raw materials cost of our enterprise against the gross retail revenues. I was rather astonished at how much “wealth” my wife and I have created out of a little money, a little plastic, a novel idea and a little risk taking.
— Tony Comstock · Mar 9, 06:50 PM · #
Exactly – good post.
When we eliminate the hysterics and carpet chewers, the discussion is whether we should accept a lower rate of business formation in order to provide the remaining businesses (and the rest of society) with a better educated workforce, or more efficient infrastructure, or whatever.
— peter · Mar 9, 07:18 PM · #
I guess you didn’t shop at the Circuit City closeout, then.
— Chet · Mar 9, 07:29 PM · #
Here’s the thing, Mr. Manzi. A while back you were thinking about gauging economics pundits on the stimulus or lack thereof: make a prediction, then we see how close it was to right, then we know how good a pundit you are. And there has been a real interest in this kind of thing: people saying for example, that we should discount the subsequent musings of pundits who were wrong about the progrss of the Iraq war (say). The problem being that there’s no incentive structure. You get something right, you get something wrong, you just keep writing op-eds.
So I want consequences, dammit, and nature has provided. You think there’ll be a significant effect on entrepreneurship, someone else says, no, that’s crap. OK. What I want to hear is pundits saying, If I’m wrong, I’ll go see the Jonas brothers movie. If I’m really, really wrong I’ll see it in 3D.
When someone does that, I’ll know he means business and is willing to stand by something. Otherwise it’s just words.
— Sanjay · Mar 9, 09:12 PM · #
Re-reading I see that I’ve left out a number of words that would clarify my meaning, but the gist seems to be there, or I hope it is.
I don’t know what a Jonas movie is, but it sounds bad the way Sanjay says it, especially in 3D. I don’t expect we’ll see Mr. Manzi or other pundits taking up the challenge.
One thought for Sanjay (painfully obvious, but worth saying.) Op-eds are judged by how entertaining they are to read. This is as it should be.
— Tony Comstock · Mar 9, 09:24 PM · #
I don’t think Jim has much of a leg to stand on here – yes, a ton of stuff influences entrepreneurship, and his “all else held equal” claim is almost certainly correct. But Manzi’s own analysis ignores that all else would not be held equal with new taxes from the Obama administration – those taxes would go to spending programs which would also have some kind of effect on the marginal behavior of an entrepreneur. Maybe Manzi thinks those would be negative results, though I think that the improved access to healthcare Obama’s arguing for would be a net boon for new businesses, since it’d be a decreased cost for them during their formative years. (Not to mention entrepreneurs might be more likely to start up businesses if they themselves, and their families, have cheaper access to healthcare when they leave their current arrangement.)
Now obviously it’s very difficult for anybody to prove that we’d have more or less entrepreneurship when all the effects of Obama’s taxes, pro and con, are taken into consideration. But, again, that’s not what Jim’s original article did either. In fact, the practical upshot of his article seemed to me to be “new taxes hurt entrepreneurship, so therefore they’re not a good idea.” That is to say, it’s clearly making an argument towards a political end. That being the case, I feel it’s disingenuous for Jim to then turn around and argue that it’s surprising that anybody would disagree with his purely academic conclusion, and that his opponents really should consider more stuff in their analysis. Let’s not pretend that the City Journal piece was anything other than an attempt to argue against Obama’s new taxes, selecting whatever facts and arguments seemed appropriate, and let’s recognize that the responses to Jim’s piece were the exact same thing coming from the opposite political side.
— Chris · Mar 10, 02:42 PM · #
It gets very complicated, but really the end goal of tax policy should be to broaden the middle class. I would say, then, that generally keeping taxes low on middle income families is important. Then again, it’s true that the wealthy often provide many of the jobs that employ those in the middle class, so higher taxes on the wealthy can hurt job creation, which then hurts the middle class. However, I think we’d have to see much higher taxes on the rich before we’d see that happen in any significant way, and meanwhile we have a very real budget to pay for. In the reality of the situation, I can’t see a way around higher taxes.
Ideally, I think we’d see the gradual scaling back of the Federal government and Federal taxes in favor of more local funding, but this sort of transition is out of necessity a slow one, and certainly in the midst of this sort of economic downturn such a move is pretty much unthinkable. The fact is, at this point in history the States and local governments simply aren’t in a position to do anything about this mess.
Of course, I’d also say that globalization and internationalization of business makes it very hard for any level of government other than the Federal to have much influence whatsoever, so that leaves us with very little in the way of negotiating for a smaller state.
— E.D. Kain · Mar 10, 03:20 PM · #
Chris:
You seem to be arguing against a statement that I didn’t make. You say that the “upshot” of my article was “new taxes hurt entrepreneurship, so therefore they’re not a good idea.”, but you have access the whole text – where does it say that?
As per this post:
I was carefully circumscribed about my claim:
That is, I didn’t claim that we would have fewer new company formations in the next decade than we did in the last. I didn’t even claim that the net effect of the overall Obama political program would be positive or negative for entrepreneurs. The only reason I wrote the article was to provide an estimate for the quantity of “price increase” that would be experienced by a typical potential entrepreneur, because I thought this quantity might be surprisingly high to lots of people. I’m quite surprised at the specific point of controversy that my article has engendered. I thought that non-zero elasticity of economic behavior to price was pretty uncontroversial.
— Jim Manzi · Mar 10, 03:38 PM · #
I apologize, but I think you thought I was being snarky when I said “I guess you didn’t shop at the Circuit City closeout, then.”
That was actually meant to be a point about non-zero elasticity, since the Circuit City closeout – as well as the CompUSA closeouts before it – was an example of dramatically increased demand as a result of increased prices on the same goods.
The “I’m Rich” iPhone app, “deals” at Target (buy two for more than twice the price of one), and so on – there’s a dozen examples in our day to day lives of companies trying – and succeeding – to drive greater demand via higher prices. Rationally, it shouldn’t work – but people are not rational, therefore it does.
— Chet · Mar 10, 04:11 PM · #
This is where is just gets bizarre to me. I’ not a +$250Ker, I’m not a republican, I’m not even a conservative, and I’ve never voted for a GOP candidate for national office. But in my eye, Jim has been, as he says “circumscribed”. I am a business person and take it for granted that “non-zero elasticity of economic behavior to price was pretty uncontroversial.” because if I didn’t I wouldn’t be able to make rational decisions about my business.
Here’s the other thing that (most) people who don’t run businesses just doesn’t understand; by and large a business lives or dies on the last 10%. The ‘non-profits don’t hurt markets’ crowd (left and right) don’t get this. The ‘let the rich pay, they can afford it’ crowd doesn’t get it either. They think about their own take home and say “Yeah, I would like it if I got bit for another 5% but I could do it, so certainly the fat cats can take it.”
But that’s just not the way things are. First of all you couldn’t take it if you got bit for another 5%. If you could you wouldn’t have a negative savings rate and a negative net-worth; and second of all none of you mofos live in the nudge. None of you have the option to say “Fuck this shit. It just isn’t worth it anymore. I quit.” so you can’t imagine that anyone would ever do that.
I’d guess that if Jim and I were to have a discussion about what the numbers would look like in an optimized tax structure he’d guess at lower rates overall and a less progressive structure than ‘d guess at. He’d have a bunch of greek letters and operators to make his point, I’d have my gut instinct.
Fine. Whatever. Maybe one of us is right and the other is wrong. Or maybe we’re both wrong, or maybe we’re both right, but we have a different idea about what makes for a optimized tax code and pro-social policy.
But kee ryest on a kracker, we cannot suspend the laws of physics. Water will not flow up hill.
— Tony Comstock · Mar 10, 04:27 PM · #
Jim-
I’d have thought my point about the upshot of your article would be relatively uncontroversial – you say that the only reason you wrote the article “was to provide an estimate for the quality of the ‘price increase’ that would be experienced by a typical potential entrepreneur”, but other than one link to a Wall Street Journal op-ed, you don’t say how you arrive at those numbers. If giving such an estimate was truly the point of your article, you should have spent significantly more time on how you arrived at that conclusion.
Meanwhile, you do have a fair amount of disparaging stuff to say about the Obama administration – you imply that both college-age and Silicon Valley Obama supporters were either delusional or hoodwinked, which seems to go far beyond your “carefully circumscribed” claim. You say above that you didn’t claim the net effect of the overall Obama political program would be negative for entrepreneurs, but you only say negative things about what Obama’s doing. It should be fairly obvious that focusing on one negative aspect of a proposal, while completely ignoring any positive aspects, is in effect an argument against that proposal.
And your last paragraph:
…surely reads to me like an argument against what Obama’s doing.
So, yes, between the lack of details about how you arrived at your estimate, the lack of any consideration of any positive impact of Obama’s plan, attacks on Obama’s supporters and your suggestion that Obama’s tax hikes will hurt the greater economy, I feel pretty comfortable with my earlier assessment of your CJ piece.
And, again, that being the case, I find your protestations of surprise disingenuous.
— Chris · Mar 10, 04:45 PM · #
Jim: “Any prospective entrepreneur must realistically expect higher future tax rates or increased inflation (or both), which will substantially reduce the future payout from a successful start-up company.”
Any prospective employee must expect the same, substantially reducing the future payout from taking or staying in a job. More? Less? I think few of us are able to calc out those probabilities, risks, and returns with any feeling of certainty.
True, the prospect of tax increases on unearned income (gains, dividends) is much more immediate. But those taxes will hit the wage-slave as well: both the employee and the entrepreneur are going to be putting money away in investments at some more-or-less predictable time in the future, in some more-or-less predictable amounts.
But the existing disparity between taxes on earned and cap-gains/dividend income is immense.
Since selling my latest company in 2000 I’ve been living on investments. Pulling down a nice six figures a year (well, five figures in ’08)—the only work required being to transfer money from my brokerage to my checking account.
My effective tax rate for the last three years?
2006: 9%
2007: 13%
2008: 0%
Nothing fancy here: mutual funds, mortgage interest deduction, one kid. Typical stuff.
The highest rate I paid is what employees (well, with their employers) lose in payroll taxes alone.
So yes: higher taxes on cap gains will cause some prospective entrepreneurs to give some more thought when making the leap. But currently, the tax advantages of doing so are profound, compared to working for the man.
And once you’ve made the leap, my experience is that the taxes cause you to work harder and build bigger. You have to to get where you want to be. (You know all about my spreadsheet—which is the explicit mechanism whereby this “income effect” is effected.)
Given how imponderable the future is—how complex the calculations and how uncertain the probabilities—I really think that tax rates are a tiny consideration when people are choosing what to do with their lives.
I’ve been an equity partner and/or principal in four startups—all successful—which have in total sold for tens of millions of dollars. Neither I or any of my compatriots ever gave tax rates the teensiest thought when we decided to take the leap. It just wasn’t a consideration.
Think back: that’s true for you also, right?
— Steve Roth · Mar 10, 05:32 PM · #
Steve, I think yours would be an example of what Taleb calls “picking the winner after the fact.”
— Tony Comstock · Mar 10, 05:40 PM · #
Did I just prove my thesis to be correct? Of course not. This is very slightly less naïve than the alternative analysis, but shares the same fundamental logical problem. There are many, many factors that drive new company formation, and the expected future tax bite is only one them. This is why argument that “Hey, we had higher tax rates and lots of new companies under Clinton, so therefore tax rates don’t affect new company formation” is so empty.
I think our difficulties in guessing how entrepreneurs would have behaved under counterfactual tax policies mirrors the difficulty entrepreneurs would have in determining whether a tax policy (combined with the spending the tax policy facilitates) makes their business more or less likely to be a worthwhile venture.
She multiplies her potential payout by the odds of success. Tax increases influence this calculation directly by reducing the size of the payout. The capital-gains tax that hits her when she sells her company is just the first thing for her to consider. Second and more important are increasing tax rates on dividends, interest income, and (again) capital gains—since she will invest the proceeds she gets from selling her company in a portfolio of stocks, bonds, and so forth, and rising taxes will reduce the present value of the after-tax consumption that the portfolio will generate in perpetuity. In the low-odds scenario of success, she will be in a very high-income category, and all of the taxes on the rich that Obama is proposing or implying will apply to her.
Doesn’t that kind of assume that her expected utility from each dollar earned from a successful venture is constant—no diminishing returns?
— Consumatopia · Mar 12, 03:32 AM · #