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By Jim Manzi

Uncontrolled: The Surprise Pay-Off Of Trial And Error In Business, Public Policy, and Society

Eye on the News

Jim Manzi
The Innovation Squelch
Obamanomics is bad news for American entrepreneurs.
March 3, 2009

Selected Responses:

Sent by Rob on 03-06-2009:

This is nonsense, because you are forgetting to take into account one obvious fact: that your second million is worth much less to you than your first million.

If you take this into account when calculating the expected return of the potential entrepeneur, then (my mathematician's instinct tells me) you will find the small (in percentage terms) increase in future expected taxes has a tiny impact on her decision. Which is also what one's instinct tells one from the beginning.

Sent by Jeff Perren on 03-05-2009:

The situation is a little more dire than even the author's estimates suggest. Even the most fanatic entrepreneur, even one zealously and irrationally devoted to the welfare of the Collective and not their own personal gain, would find it much more difficult to succeed in the current and projected environment.

You simply cannot remove capital by taxation (or water it down via inflation) at such a prodigious rate and fund growth. That's apart from the non-financial issues, like trying to predict what the likely sales environment will be in two to five years under a regime which sows massive uncertainty daily with aplomb.

Sent by David Mendels on 03-05-2009:

As an actual high-tech entrepreneur (senior executive in leading software firm from pre-IPO to multi-billion dollar market cap), I've helped build a company, I have invested in start-ups, I have acquired start-ups, and I have worked in a company that was acquired. I'm in that top 2 percent bracket that will pay more taxes under Obama. I also would personally benefit financially by the elimination of the capital-gains tax on start-ups. I am actually one of those Silicon Valley Obama supporters whom you assert "may find themselves in an uncomfortable environment" because we have been presumably betrayed by the president.

You are dead wrong. I speak for myself, but also have spoken to many peers, and the fact is that we are not stupid - we see an economy in precipitous decline and a lot of tough choices to make. Things were bad on November 4th, when Obama was elected; but they are much much worse now. We don't expect Obama to be stupid, either - "a foolish consistency is the hobgoblin of small minds" (I am probably mangling that quote.) When we voted for Obama, we knew he would raise our marginal tax rate. If delaying an elimination of capital-gains taxes on start-ups is one of those tough tradeoffs, that is OK. We are not going to suddenly stop building companies, or turn on Obama, for one or two or any small number of tough choices - in the big picture, he is showing that he gets the seriousness of the situation and that he is keeping consistent with the priorities and general direction he espoused in the campaign, while also being reasonably pragmatic about the details. If he is backing off from a detailed promise, such as this tax cut at this time, that is not the end of the world. It's just one of many details and tradeoffs we all have to wrestle with, and it seems pretty reasonable given the deterioration in the months since November 4.

Sent by Preston on 03-04-2009:

You are correct. I am one of those strategy consulting types you mentioned and harbor entrepreneurial ambitions. Over the last year, I have assessed and passed on two start-up opportunities, because after building the business models and looking at the potential after-tax income under a variety of scenarios, I saw that the gains came up short compared to the less risky income I can reasonably expect to enjoy from my current career. Potential entrepreneurs and smart businessmen in general perform thorough planning and analysis of opportunities under a range of expected futures, and it comes naturally to consider likely regulatory and taxation regimes. To assume otherwise - that we will make major life changes and investments without considering these factors - is both naive and, quite frankly, insulting to our intelligence.

Sent by Keith Ogden on 03-04-2009:

Manzi misses the biggest impact. Certainly the individual who invents might do so anyway. But the VC or private investor who funds the start-up will demand a higher rate of expected return. This will basically mean taking a much larger piece of the company for the same amount of money. In the old days, your inventor might have sold 20 percent of the company for $1 million. With higher taxes on the successful deals, the same VC will now demand more of the company for the same $1 million.

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.” 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.

Consider a hypothetical aspiring entrepreneur: an engineer, say, with an idea for a new company. First she has to invest a lot of her own time just to develop her idea to the point that it could win funding from a venture capitalist or angel investor. The odds of going from idea to funding are, say, ten to one against. But let’s assume that after working nights and weekends for a year to produce a working prototype, write a business plan, and recruit a team, she finally gets funded by a professional venture capitalist. Having cleared this hurdle, she gets to quit her job and work much longer hours for much lower wages for about a decade. All the while, our engineer knows that she has only a 20 percent chance of steering the company to a successful exit that makes her a lot of money.

If entrepreneurs had a higher success rate, then many more people would start companies (probably about as many as go into long-hour, high-stress, high-compensation work like investment banking, corporate law, and strategy consulting). But when you multiply the potential payoff by the low odds of success, the expected profit doesn’t look so compelling. The pot of gold has to be big indeed to get people to make such a risky leap. Today, we’re increasing the deficit as a percentage of GDP to levels not seen since World War II. 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. The pot of gold has suddenly gotten a lot smaller.

Now, it’s easy to say, “Okay, but this engineer will make so much money if she’s successful that higher taxes on the back end won’t 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 fails, then tax rates don’t matter anyway.” 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. 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.

Rationally, she would therefore have to foresee higher odds of success in order to make the leap to start the company. How much higher? By my figuring, if you use Obama’s campaign proposals for long-run capital-gains, income, and FICA tax rates as a (probably conservative) guide to where rates may go, the prospective entrepreneur would have to increase her estimated odds of success at the moment of funding from 20 percent today to about 30 percent under the new tax regime in order to have the same financial incentive to start the company. That’s a huge difference; in fact, it’s about the same as the margin of difference between the odds of success for a new venture-backed company started by a first-time entrepreneur and the odds of success for a new venture-backed company started by a founder who has already done at least one successful start-up. Any venture capitalist can tell you how much likelier the second guy is to get funded than the first.

During the campaign, presumably thinking of his Silicon Valley supporters, Obama proposed eliminating capital-gains taxes on start-ups in order to offset some of the tax effects that I’ve highlighted. This idea was always make-believe. As I predicted last July, the president’s just-released budget has “delayed” the proposal until 2014. Translation: it isn’t going to happen. Like the college students who stayed up late to hear Obama’s campaign speeches only to find his first significant action to be a stimulus program that will transfer about $1 trillion from them to the Baby Boomers, Silicon Valley Obama supporters may find themselves in an uncomfortable environment. A government-dominated economic era may not be an auspicious one in which to start companies that threaten big, incumbent corporations with lots of political clout.

The concept of “animal spirits” recognizes that not all economic decisions are made entirely with spreadsheets. Some people start companies because they’re driven by a dream that transcends rational economic calculation. But most successful entrepreneurs are pretty serious about comparing risks with opportunities. Higher 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. 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.

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