Sunday, March 8, 2009

The Effects of Taxation on Entreprenuership

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This post by James Manzi about Obamanomics being bad news for innovation made the blogosphere rounds this week. While it got some people excited, specifically the "tax cuts solve all problems" crowd that I have previously addressed, the argument has some gaping holes in logic. It begins by citing Edmund Phelps as follows:

For an academic macroeconomist, Nobel laureate Edmund Phelps can sound shockingly in touch with the real world. In a recent interview, he described the possible implications of the large government-spending programs in President Obama’s stimulus package: “There’s . . . a chance that the perceived increase in the role of government of this sort will have some unanticipated effects on the animal spirits of entrepreneurs.”

Now, Phelps' statement clearly isn't definitive, and certainly doesn't mention taxes in any way. In some blogging jujitsu, Manzi uses the credibility of Phelps, who clearly wasn't making the same point, to support a diatribe about the Obama tax plans:
In fact, not only the stimulus package itself, but the higher taxes that it will require—both tax increases explicitly proposed in the president’s budget and the expectation of large future tax increases because we’re paying for all this spending with the national credit card—are likely to reduce the number of entrepreneurs in America.

What evidence does he supply for making such a dramatic leap? Just an abstract thought study, using an engineer who has an idea to start a business. His point being, the deciding factor for an entrepreneur taking the leap to start a business is a calculation based on the success rate of businesses and the expected payoff:
But consider the prospective entrepreneur’s incentives as they exist the moment before she makes the leap. 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.

As an engineer, who has considered starting a couple different businesses, I will say this just isn't true. While the stakeholders providing the funding for a venture almost assuredly would factor in expected payoff, an entrepreneur is thinking very differently. First, they absolutely will not think 'their idea' has only a 20% chance of success, it's the "it can't happen to me" syndrome, although they will be aware that failure is a possibility. Second, how their life will change immediately after making the leap to being self-employed and what happens to them in the event of failure, is a much much larger consideration.

In other words, the ability of the entrepreneur to provide for the day to day needs of his household, and the ability to recover if the venture fails. Can they meet their household's monthly cash flow requirements? Will they have to forgo health care coverage? Can they afford college for their kids? How quickly can they find a job if the venture fails? These are examples of what an entrepreneur is thinking about immediately before they make the leap. The differences between an upper income bracket tax rate of 35% and 39% (or slightly higher) and how that would effect the entrepreneur in the event of success, probably isn't even in the way back of their mind.

However, don't take my word for it. Let's take a look at what the data tells us. The below graphs are from the US Census Bureau:


Disclaimer: This data does not include non-employers, which can be found here. It also only looks at the net increase in number of businesses, not the number started in any given year.

The census data only goes to 2006, so we can only compare the first 6 years of each presidency. After 6 years, Clinton and Bush had presided over a net increase of roughly the same amount of businesses (375K to 369K respectively). Clinton's final two years, coinciding with the height of the tech boom, included a huge jump to a final net increase in businesses of 557k under his presidency. Keep in mind the top tax rate under Clinton was exactly the same that Obama is proposing it return to.

Clearly, the data doesn't support Manzi's argument that a return to a 39% tax rate will negatively affect entrepreneurship and innovation. In fact, by addressing health care and college affordability as well as energy and infrastructure, the safety net Obama is creating for entrepreneurs could lead to an increase in new business starts. At the least, there isn't going to be some grand implosion of innovation due to a 4% increase in taxes as Manzi suggests.

16 comments:

Anonymous said...
March 8, 2009 at 9:41 PM Delete Comment

Thanks for your deatiled comments on my article.

I am an engineer who had started a couple of businesses. I went through exactly the calculus that I described prior to doing so. Not everyone does, but for my argument to be valid not all potential entrepreneurs need to go through the calculation, but only some of them, in order for this to have the argued effect on the margin.

I did not say that tax rates are the only thing that will influence these decsions, only that BUT FOR these tax increases that more entrepreneuers would take the leap.

Best regards,
Jim Manzi

Pauline May said...
March 9, 2009 at 9:36 AM Delete Comment

I would also argue that the higher corporate tax rate would encourage entrepreneurship, by incentivizing keeping capital within the business and not withdrawing any or all profits for personal income gains.

That, to me, is the crux of the argument. My investment in my own business is the best tax break I can get for that business.

Pauline

Anonymous said...
March 9, 2009 at 9:51 AM Delete Comment

Manzi is a conservative but not completely disconnected from reality I find. Of course his venue NRO calls forth a requirement to reinforce a certain viewpoint so this inevitably colors his opinionating. That said he seems to have retreated to parsing in the face of hard evidence that reveals the speciousness of his arguments. I've never started a business, but have run several and know and have known dozens of entrepreneurs and I can't think of one of them with whom I've discussed the reasons they went into business as saying it had anything whatever to do with tax rates. In fact his whole premise smacks of those marginal issues on which conservatives base so many of their arguments eg. millions for marsh mice or a single payer health system can't work because of a few bad anecdotes from Canada. Because the fundamentals of their case are so weak these days conservatives are continually forced to rely on marginal issues to make arguments. It's completely phony and will be the death of them because most people outside the base can figure out it's peripheral.

Anon said...
March 9, 2009 at 10:01 AM Delete Comment
This comment has been removed by the author.
Anon said...
March 9, 2009 at 10:07 AM Delete Comment

Jim,

I'm curious as to what constitutes "some of them" in order for your argument to be valid? Mike pointed out in the Census Data that there was very little correlation between the tax rate and the net increase of businesses. From that, I would think that very few entrepreneurs would be effected by the tax rate. Also, what do you think about the other point regarding the increased safety net through health care and education reform offsetting the few that are dissuaded?

Mike, I'm glad your second post continued the trend from your first. It's nice to see research and support in blogs when most people just blast their opinions without any factual data to back it up.

Anonymous said...
March 9, 2009 at 10:12 AM Delete Comment

Manzi only addresses one kind of entrepreneur: the kind he was. I started a retail business. Employed 50 people in 3 locations. Never got rich, but made a living and lived a lifestyle better than employment would have provided. Started it in 1979, in a miserable economy. Tax rates played no role in my calculations.

The above charts show net business creation in the hundreds of thousands per year. How many of those businesses were like mine, and how many like Jim's? Which sector employed more people? The animal spirit of entrepreneurship has little to do with 4% differences in tax rates.

Mark said...
March 9, 2009 at 10:24 AM Delete Comment

I have started 3 and sold 2 software businesses. Current tax rates had zero impact on my decision making process. Far more important: Could the business succeed, did I have a realistic chance of selling our services/products, was I willing to make the commitment in time/effort/money to make it successful, was there an achievable endgame? A few percentage points of tax rate really only drove what I took home as profit - with the higher rate, I would, as a commenter said above, look to ways to reinvest in the business instead of taking home everything.

Anonymous said...
March 9, 2009 at 10:48 AM Delete Comment

As someone who has both started a small business (disclaimer, it never took off), invested in a few and run another, I can say a marginal increase in income tax rates has had no influence on my motivations in any of those roles. As an entrepreneur, I was concerned with the very things you mention, making ends meet. While I was aware of the possibility of a payoff several years down the road, it didnt factor in to the calculation very much and where it did, the income tax rate was irrelevant. As an investor, I realized that the investment was a multi-year one, so the tax rate that I was concerned about was long-term capital gain, not income. Only as a manager did the income tax rate affect me, but that was because my salary was high enough, but I cant think of any place where it affected my decisions.

Anonymous said...
March 9, 2009 at 11:20 AM Delete Comment

I am an actual entrepreneur, and marginal tax rates have (and have had) absolutely nothing to do with the decision to start a business. Most pro forma financial statements (used in making a financial plan for a new business) don't even have a "tax" line item. And in fact, most entrepreneurs would still be taxed at the prevailing top marginal rate whether they started the business or worked as an employee for someone else.

Another right-wing-scare-tactic blown out of the water by facts.

Anonymous said...
March 9, 2009 at 12:04 PM Delete Comment

Mark Cuban had a good post about this a while back: http://blogmaverick.com/2008/10/23/the-cure-to-our-economic-problems/

The line that jumps out at me:

Entrepreneurs live to be entrepreneurs. I have never had a discussion with anyone about starting a business that included tax rates. Ever. If anyone that wanted an investment from me made a point of discussing tax rates as an impact on their business, I wouldn't invest in them. Ever.

Anonymous said...
March 9, 2009 at 1:58 PM Delete Comment

It's interesting that you include 1992 as Clinton year, when he wasn't President, and 2000 as a Bush year, when he wasn't President. If you start with 1993 and 2001 respectively, and take the 5 Bush years which appear on your graph and the first 5 Clinton years, you will see substanially great job growth during the Bush years.

Anonymous said...
March 9, 2009 at 3:13 PM Delete Comment

"substantially greater new business growth"

Mark said...
March 9, 2009 at 5:21 PM Delete Comment

Manzi's totally wrong about the motivation for starting new business. It has become exponentially harder to build a venture-backed business (return relative to investment) over the last decade. Companies that had barely-working prototypes and no revenue sold for upwards of $500M in 1999; companies that are close to profitability sell for barely their annual revenue in 2009.

The expected payoff for the founders has dropped by a factor of 100. Yet has there been a huge drop in the number of people looking for venture funding? Hardly. So a potential 15% reduction in payoff couldn't possibly register.

Anonymous said...
March 10, 2009 at 1:15 PM Delete Comment

I disagree with Mr. Manzi's position on marginal tax rates. In my late 50's, I left "corporate world" three years ago to start my own business. Tax considerations were were only minimal and marginal tax consideration was non-factor. Decision was based on anticipated ability to provide needed monthly income, lead a desirable lifestyle, provide a substantive service and generally enjoy what I was about to do.
Ken

Mike said...
March 10, 2009 at 10:38 PM Delete Comment

Thanks for the comments. See my responses/clarifications here:
http://noemptywallets.blogspot.com/2009/03/responses-to-taxes-and-entrepreneurship.html

--Mike

generic cialis 20mg said...
November 30, 2010 at 10:17 AM Delete Comment

Interesting article, added his blog to Favorites

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