Politicians anxious to keep feeding the government are talking about new tax ideas, e.g., a special tax that would kick in when a person earned over $1 million per year. One problem with this approach is that it represents a further discouragement to investors and entrepreneurs in a country that is already looking like a bad place for most kinds of investment.
Employees and managers have done a lot better than U.S. investors over the past 10-20 years. A mid-level employee might earn $400,000 per year. An investor or entrepreneur, by contrast, might earn very little for 5-10 years and then finally cash out with $1-2 million. For that one good year, the investor looks like a rich guy, ripe for high taxation, but in reality the employee has done far better, especially on a risk-adjusted basis.
This is not an argument against a special tax, by the way, merely a reminder that it will further push the U.S. toward a culture in which young people want to be employees and managers at established companies.
I would argue that most people start a business to have a better lifestyle while their working _not_ for the big payout after 10-20 years. Nobody goes into starting a business thinking. “I’m going to sacrifice my standard of living for the next 2 decades so I can live in comfort when I’m significantly older than I am now”
All the proposals I’ve seen are to make capital gains tax the same as normal rates. So that 1 year you made 1 million dollars, you would pay the same rate on that income as you did the other 10-20 years worth of income. I just don’t see the how this would demotivate someone.
Some say that there are too many people in the software industry that want to be entrepreneurs. So if your hypothesis is right, it could actually bring some balance back. http://www.boston.com/business/technology/innoeco/2011/10/is_boston_spawning_too_many_st.html
I grant you ‘managers’ get paid too much, but…
“merely a reminder that it will further push the U.S. toward a culture in which young people want to be employees and managers at established companies.”
You mean, like they did back in the middle of the previous century, when Richard Feynman wanted to work for Bell Labs, and Claude Shannon and Dennis Ritchie actually did? Isn’t that rather that preferable to them setting up non-businesses like Groupon and on, and on, and on? Most of what little actual innovation we’ve seen lately has come from big, established companies like Apple, IBM, or Samsung.
Doctors undergo a similar scanario. They earn relatively little for many years while in residency (while loan interest is accruing too) then have a big step up in income. That puts them into a higher tax bracket and everyone thinks they are rich.
I am a mid level manager at a big box retailer, and after twelve years there I make more than anyone else but four people: around fifty thousand dollars a year. And I work hard for that, but I never went to college; is there something to be said for the idea that the rich people out there, most of them, are smarter and they deserve their money more? I mean, I save via a 401k plan, and part of the reason why is that this reduces my taxable income, and the company kicks in a hundred percent of what I put in: it’s just smart to save this way. But my company offers this to probably 310 people in my facility, and less than 40 of them have joined in it, and that is simply dumb. The people aren’t dumb, but it’s a dumb choice. I’m not sure anyone should make a billion dollars in a day, but if Soros is smart enough and gutsy enough, well, he earned it. Isn’t the bigger issue the discouraging of effort and achievement? “Don’t get rich…or you’ll just have to give it all back so America can make Iraq safer for Iraqis.”
Some quibbles about the math: a manager making $400,000 per year would clearly be in the 1%, not mid-level. If an entrepreneur earns little for 5-10 years only to cash out with $1-2M, then it doesn’t make economic sense to be an entrepreneur irrespective of tax policy. For the level of risk and time value of money, the cashout better be much higher than that. As it is, if an entrepreneur is clever and careful, he will get capital gains tax treatment at Romney-esque 15%, rather than 38%, so an additional tax on income above $1M should have little effect on the entrepreneur (or investors).
The problem is, no matter what kind of income you tax, it would discourage the behavior that brings that particular kind of income. Since the govt needs the taxes anyway, all it needs is to find a “the least discourageble” slice of public. Whether or not the guys that make over $1M fit that, I don’t know. But the bottomline, the question should be framed as “is dicouraging high earners better or worse that discouraging low/middle earners?”, not as “should we discourage high earners, period?”
No mid level employee I know makes a $400K salary. Many of my friends who work on WS have a salary less than that with a bonus that puts them over but not this year!
I always ask the question, where would the $$$ go a rich tax were implemented. Usually it would go to accountants and lawyers to find the loopholes but I have a hard time believing that people below Gate and Buffet would dump all their money into offshore investments that tend to be riskier especially if the money is parked in the same country.
BTW a $400K salary puts you in the mythical 1%. Also what has changed with young people. haven’t they always wanted to be a part of an established company for the most part? From what I see even most of the web innovators goal is to get bought by Google, Apple or MS.
You tax something, you get less of it.
Liberals understand this when they propose high taxes on tobacco and junk food, yet they don’t seem to understand the same phenomena applies to job-creating investment.
Tax investment in this country and investors are that much more likely to invest their capital in other countries.
Tax investment, you get less of it. Why is this hard to understand?
Good points. I don’t think there’s many mid-level employees making $400k/year outside of investment bankers and lawyers though; I’m pretty sure that kind of salary would put you around the 98th percentile of all households. Also, the employee’s salary is taxed as ordinary income, whereas the entrepreneur’s cash-out is presumably a long-term capital gain, which has a much lower tax rate. I assume the law is meant more for extremely wealthy people who are able to pay low tax rates because all their annual income comes from capital gains and dividends, so I’d be interested a breakdown of how much money those people make versus entrepreneurs receiving one-time lump sums (I actually just heard the other day that 87% of all capital gains in the US go to people with annual incomes over $200k). It seems easy enough to allow people to choose a single year in which to be exempt from the higher rate if they know they’re coming into a windfall that probably won’t be repeated.
At the margin I doubt the law would have much effect on entrepreneurs. My impression is that the larger issues facing American entrepreneurs are 1) consumers here are very jaded and flighty, whereas Chinese or Brazilian consumers might be delighted to have a new Pizza Hut open in their neighborhood it takes a lot more than that to impress Americans, and 2) there are thousands of wannabe entrepreneurs and oceans of VC cash, so anyone who comes up with a profitable idea (or an unprofitable one, e.g. Groupon) is immediately swarmed with clones which may all just serve to drag each other down.
” a culture in which young people want to be employees and managers at established companies”
That seems to work fine for East Asia.
David: When I said “mid-level” I should probably have said “in management at publicly traded companies”. I did not mean to suggest “near the median income for the U.S.” but rather “An employee of a Fortune 500 company but not a top executive.”
At the margin I doubt the law would have much effect on entrepreneurs. My impression is that the larger issues facing American entrepreneurs are 1) consumers here are very jaded and flighty, whereas Chinese or Brazilian consumers might be delighted to have a new Pizza Hut open in their neighborhood it takes a lot more than that to impress Americans, and 2) there are thousands of wannabe entrepreneurs and oceans of VC cash, so anyone who comes up with a profitable idea (or an unprofitable one, e.g. Groupon) is immediately swarmed with clones which may all just serve to drag each other down.
There’s a more general problem here: over the last three decades, everyone’s income has become much more variable. It’s not just entrepreneurs. Peter Gosselin: If America is richer, why are its families so much less secure?
To deal with this from a tax point of view, Canadian tax expert Robin Boadway proposes using income averaging. “To mitigate the problem that current taxable income does not reflect lifetime income, a system of general income averaging is both feasible and suitable, and should be instituted. It will be especially important for those with volatile incomes, such as entrepreneurs for whom risk-taking is a characteristic. General income averaging is not without its practical problems, such as how to deal with new entrants into the labour force or how to account for changes in the level of taxation and public services over time. Any form of general averaging will be imperfect, but it will be better than no averaging.
If you’re interested in tax policy, the whole paper is worth reading. From New Directions for Intelligent Government in Canada: Papers in Honour of Ian Stewart.
Ryan,
I could not disagree more. I am the owner of several businesses and from the outset, I knew it would be lean times for awhile until I got things established. Then I expected the “big payday”. Most folks starting their own business feel the same way.
And Phil, your OP is spot on! Kudos!
Raising a capital gains tax (the main way to tax the specified category) would discourage investing (especially speculative investment). This blog has pointed out several times that a) capital is incredibly cheap (in many respects the govt. is paying you to borrow money) and b) that this policy has lead to many bubbles and other bad things. Perhaps it isn’t an unreasonable policy to stimulate the economy on the one hand and then tax investments strongly on the other hand. I’m not an economist but it doesn’t seem crazy to counteract deflation with stimulus, some redistribution of wealth, and a disincentive towards speculation. In terms of entrepreneurs producing real wealth, I would think cheap capital is a stronger incentive than higher capital gain taxes later, so if one takes the two policies together one could still argue that it is entrepreneur neutral.
Does America really need more investment?
Although they’re building infrastructure at a breakneck pace in China, they’ve still got huge amounts of capital with no better destination than U.S. Government Bonds.
Big companies are stacking up billions in the bank (pg — why not write a piece on what it means that Apple has $100 billion in the bank?) and the performance of the stock market seems to indicate that financial markets are unable to absorb capital and put it into productive use.
Perhaps the excess of capital could be cured by a massive wave of defaults or a burst of inflation that rises wage and price levels by a factor of 3 or so, but taxing people who have more money than they can invest productively and directing more to people so they can afford goods and services might be the least painful. Entrepreneurs will benefit because they’ll be people who can buy what they’re selling — if we can keep the extra money from being sucked up by the financial or housing sectors, health care, higher ed, or local taxes.