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.
That's the current picture. Bleak enough as is, right? So how to Obama's proposed tax increases impact the picture?
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.
So there you go. Our young entrepreneur works long and hard for not much money on the hopes of a big payout at the end, and while the payout is still there, it's not nearly as big as it once would have been. The question is now whether or not the smaller payoff is worth the sacrifice to get there.
The bottom line:
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.
I don't think this will discourage everyone from trying, mind you. This scenario is just one of the many ways in which entrepreneurs can make money. It is possible to start a company with the goal of simply drawing a regular paycheck, albeit from yourself, and a larger one than you were getting before. For those people, if they can keep their income below Obama's suggested threshold of $250,000, may not encounter the high taxes.
On the other hand, who goes into business hoping to make less than $250,000 per year? I'd dare say most people would like to think they could make more than that. The question is whether they're willing to give up more in taxes for the priviledge.
I think Manzi is correct that this will discourage entrepreneurship at least a little. But even a little can be a lot.
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