While I watched President Biden’s speech to both houses of congress last night I remained convinced that he is a good and decent man who truly wants to help the American people. I was also convinced that he is a product of Washington politics who has never done anything but be a politician. Therefore he does not understand the negative impact his policies will have on innovation and young start-up and private companies in general.
In addition to pursuing policies that will stifle innovation, he is using a lot of rhetoric to sell rather grandiose plans that he and his advisors may think are popular with some voters, but that in the long run will lead to more political division and strife within our fragile democracy. His administration does not seem to understand that what he proposes will not only harm innovation, but drive a great deal of cost into company operations that will stifle job growth. He clearly wants to help the “middle class” as he calls it, but he seems to have a 1950’s and 1960’s style outlook on how to provide that help.
Large scale government programs that will have to include private company involvement and much higher taxes may have worked in the 1960’s, but in a globally competitive world these ideas are no longer relevant. For example it is unclear how advocating union membership is going to help members of the middle class fit into a world of Artificial Intelligence, Machine Learning and Cryptography where advanced computer skills, not manufacturing assembly skills are the most important ones for citizens to obtain.
While helping people is a good goal, it seems like pushing such large plans through the legislative process in such a short time will lead to resistance that will drive the country farther apart. Given that a lot of the programs may not do much to aid the economy in its global modern form, pushing them through with a slim Democratic majority will also foster ill will. In describing the plans and what they are intended to address, the language used appears to vilify business and business leaders. The tone and rhetoric used to describe them, and the plans themselves seem quite harmful to not just the economy, but the state of political discourse overall.
In this post I want to explain how the tax plans President Biden proposes can stifle capital investment in start-ups, hurt small businesses of all kinds and lose jobs instead of “create millions of jobs” as he projected in last night’s speech.
Here are some of his plans that raise taxes to “pay for” some of the initiatives:
- Raise the corporate income tax rate to 28%
- Institute a “minimum corporate tax” of 15% on corporations over a certain size
- Raise the top marginal tax rate to 39.6%
- Raise the capital gains tax rate to be equal to the top earned income rate (plus the 3.8% Medicare surtax added due to the Affordable Care Act), placing the top rate for selling long term assets to 43.4%. Raising the capital gains rate to one higher than that paid on earned income
Problems with The Plans
-Raise the corporate income tax to 28%
The problem with raising the corporate tax rate is that under the Obama administration (when rates were 35%) we were seeing a number of corporate inversions where the headquarters of a company and a corresponding amount of investment was moving outside of the United States. After lowering the corporate tax rate to 21% in the 2017 tax reduction act this practice almost stopped. We have seen a boost in investment in the United States since the top corporate rates have been lowered and the talk of inversion is now non-existent.
We run the risk of losing investment in our own country by charging rates higher than they are now (21% nominal rate). Compared to countries in the EU that have educated workforces and a “business friendly” climate (like the Republic of Ireland) our top tax rate being higher would give corporations the incentive to move operations off shore again.
The argument Democrats make is that we “don’t want to precipitate a race to the bottom” (lowering corporate tax rates to levels of other countries like Ireland at 12.5%). However, CEO’s of public companies have to investigate the possibility of producing their technology and products in the most efficient manner possible. High tax countries will be less advantageous to certain companies than countries with lower tax rates where their products can be developed for those companies.
According to this source (tax foundation.org) the European OECD countries levy a 21.7% average corporate tax rate. Germany and France are at 29.9% and 28.4 percent respectively, with Portugal the highest in mainland Europe at 31.5%. So running our tax rate higher could precipitate a loss of investment to overseas locales. Far Peak Acquisition Corporation’s Tom Farley, past CEO of the NYSE, made the point that raising corporate rates is a very bad idea as capital is fungible. He mentions that it would be a breach of fiduciary duty to shareholders for a CEO of a public company to not pursue off-shore investment as an alternative to on-shore if the rates increase as proposed under the Biden plan.
-Institute a “minimum corporate tax” of 15% on corporations over a certain size.
This seems to be the “Amazon tax” because President Biden always uses Amazon Inc. as the “bad example” of the corporation “paying zero tax”. He states this in a way that implies they are cheating on their taxes (which they are not; they are following the law). The reason they don’t pay a lot of taxes is that they invest large amounts of their profits into capital equipment to grow their operations and make them more competitive. They build data centers, warehouses, distribution infrastructure, they buy trucks, planes and delivery vehicles. Amazon employs more and more people as a result of this investment. If the 15% of a huge ($54 billion) number is given to the government, then that is 15% not spent on expanding and hiring employees to work in Amazon facilities. I also am skeptical that the government will spend these funds as wisely as Amazon will.
Joe Lonsdale, co-founder of Palantier Inc. and founding partner of 8VC (venture capital firm) also has some interesting views on corporate tax hikes and their impact on start-ups and growing companies like Amazon who invest heavily to maintain growth and employment. Mr. Lonsdale states that rates are best left alone.
So my belief is that we should leave corporate income tax rates where they are and let the for-profit sector build as much infrastructure as they can to grow their businesses.
-Raise the top marginal tax rate to 39.6%
While I think that this is a generally bad idea, if this were the only thing done it may not be as damaging as the other parts of the plan. The next item where capital gains rates are raised beyond the rate of ordinary income is the problematic one.
-Raise the capital gains tax rate to be equal to the top earned income rate (plus the 3.8% Medicare surtax added due to the Affordable Care Act), placing the top rate for selling long term assets at 43.4%. This is a corporate tax rate higher than that charged on earned income
Removes Incentives for Risk Taking
Having the capital gains rate to be higher than earned income undermines the entire venture investing model. It is common for founding members of venture backed start-ups to work literally for years for no or very little salary so that they can build their businesses into something valuable enough to invest in let alone sell for a capital gain. Then it can be years before they earn even a competitive salary that they would have had working at a job with Google, MicroSoft, etc.
My previous start-up was self-funded and I put all the money into the company from past investments I had made without ever taking any salary. For nearly three years I worked essentially “for free”, supporting five other families. My “payoff” occurred when I sold the business. The incentive was to make a good return on my investment. If I had to pay more (in taxes) than I would have had to pay if earning regular (W-2) income I would have been much worse off when I sold the business than I was at the end of the three years when I sold the business to Bloomberg LP. The capital gains rate being lower than the earned income rate enhances the incentive to take risk and innovate on behalf of the economy.
Mr. Lonsdale was again recently on CNBC squawk box explaining that he believes raising the capital gains rate removes incentive for people to leave jobs with large established Silicon Valley firms (Google, Facebook etc.) and take a chance on a start-up. Without a promise of a payoff beyond what one would get earning regular income, most would not choose to take the risk of a start-up and do something innovative. He recently moved his firm to Austin Texas because as he stated: “Silicon Valley is becoming filled with risk-averse individuals”.
He mentioned an example where a person making $3 million per year at Google would have little incentive to join a start-up and to help build something innovative if there were no favorable capital gains treatment. They would have more incentive to stay and earn regular income in such a case than to take a chance and help build a new company.
It takes a lot of courage, commitment and hard work to build a successful start-up and there is risk involved. Therefore, favorable tax treatment is a justifiable incentive to include in the tax code for companies seeking to innovate and build new products. Without this incentive, many jobs will never be created in new industries and the entire economy will suffer.
Makes Established Tech “Giants” even Larger and More Powerful
With less incentive to start companies, the large technology companies will get larger and more powerful. Now, even with a capital gains rate advantage, start-ups cannot compete with the salaries that Google, Apple, Facebook and others are able to offer employees. If this capital gains tax rate is hiked as President Biden proposes, then the technology companies will only get more powerful. Someone on Mr. Biden’s staff should go find Amy Klobuchar (Senator from Minnesota) and break the news to her that they are going to make her job even harder (she wants to break up Facebook, etc.). If Senator Klobuchar thinks Facebook is too big now, then she will be really surprised how powerful it gets when it does not have to compete with smaller, nimble start-ups.
Not Just Start-ups, but All Small Businesses are Affected
It also kills non-technical small businesses that have relied on “sweat equity” to build value into their businesses for years. When a small business owner decides to sell his or her entity they have often sacrificed salary and time with loved ones for years to make the business valuable. To have the sale of the assets taxed at a rate above the earned income rate, it makes the tax burden of completing the sale onerous. Contractors, plumbers, electricians, dry cleaners, restaurant owners will all be affected. This is not a “Wall Street only” issue. It is a “Main Street” issue as well.
Impact on Racial Inequality
Robert Johnson, founder of Black Entertainment Television and a very successful businessman, explained recently how raising corporate taxes and capital gains tax rates will harm black owned businesses. Mr. Johnson was a guest on CNBC Squawk box explaining a plan he proposes for providing tax breaks for investments in black-owned businesses.
Raising Corporate Taxes Harms Black Entrepreneurs
Mr. Johnson pointed out that raising corporate tax rates just reduces the amount of capital available for black businesses. He was interviewed in relation to a plan he proposes where black-owned business should get tax advantaged treatment. Raising their taxes runs counter to that goal and of course stifles economic prosperity for people of color.
Raising Capital Gains Rates Harms Black Owned Private Equity Firms
Mr. Johnson further explained that the Biden plan proposing higher taxes on capital gains is a major blow to Black-owned private equity firms. Mr. Johnson explained that a number of Black-owned private equity firms are “just getting started” (in his words) so such a change in tax policy could damage or totally obliterate their business models.
Since such firms have raised or are raising capital on the basis of a reasonable capital gains rate below the earned income rate (not above it as explained previously) a capital gains rate increase as proposed by the Biden administration essentially puts these new firms out of business.
There are so many unintended negative consequences from the plans put forth by the Biden administration that it is clear they need to be revised. Hopefully they will be changed as they travel through the legislative process.
In my next post I will propose some ideas for how to help the middle class, and also help with racial inequality. There are market-oriented approaches some of which would not require a dollar of tax increases. These would be preferable to many of the things that have been proposed in this tax plan. These are “new thinking” as opposed to “old thinking” (the New Deal was fine in 1932 but it is now 2021).