Silicon Valley's Fiscal Sacrifice

The startup ecosystem depends on the recycling of the profits from successful startups into new angel investment, venture capital funds, and bootstrapped ventures. This flow of capital is the lifeblood of Silicon Valley.

The story of Elon Musk is a well known example. When Paypal was bought by eBay, his stake in the company was liquidated for $180 million after tax. Musk resisted the urge to retire to a nice beach and reinvested every last dollar he owned into three daring and innovative new companies: Space X, Tesla, and Solar City. Exhausting his once-mighty bank account, he borrowed money from friends to pay his rent. Today, those three new companies look like three winners.

Musk's story shows how the world-changing ventures of today rely on seed capital from the successes of five years ago. This process depends on the ability of founders to keep their winnings from the startup game so that they can play again. That is why the rate of the capital gains tax is so important to the health of the tech economy. The capital gains tax rate determines how much of the proceeds from successful startups stays with founders in Palo Alto and how much gets shipped to Sacramento and Washington D.C.

In recent decades the governments of the United States and California have developed a nasty habit of running unsustainable budget deficits, putting upward pressure on tax rates. Fresh tax measures passed during the 2012 election and immediately thereafter, combined with tax changes mandated by President Obama's signature healthcare law, will increase the capital gains burden on entrepreneurs by 52% this year - from 24.3% to 37.1%. The details are shown in the chart below.

The crop of new capital available for seed and angel investment will be 20% smaller next year than it would have been without the tax increases[1]. The state and the nation are being called to shared sacrifice to address our massive public debt problems and no one can say that Silicon Valley is not doing its part.

The negative effects of higher taxes on investment growth are exponential. If a would-be successful venture is not funded because of higher taxes then that also reduces the size of the next round of capital that would have been funded from that venture's success. This is the mathematical effect of reducing an exponent. The growth rate of wealth is slowed and future tax revenues are reduced with each would-be successful startup that is not funded.

I don't doubt that Silicon Valley can absorb a 20% hit to its new capital stock, especially if the money is used to pay for worthwhile public infrastructure projects. And it is likely that fewer than 20% of future success stories are found in the marginal 20% of investment. For that to be true we have to assume that investors have some sort of expertise, that they are better at picking good investments than random choice. I feel that is a reasonable assumption

But there is some magnitude of tax increase that the startup ecosystem could not absorb. Today, we take for granted the ability of a talented young team with a bright idea to raise $100,000 or $200,000 to get off the ground. With high enough taxes the seed funding ecosystem will shrink to a much more conservative level.

It could be worse. The top marginal tax rate on ordinary income in California will climb over 50% next year - the highest in the nation. It is fortunate that the capital gains rate is significantly lower.

I hope that the US and California governments use this new tax revenue to shore up their leaking balance sheets so that they do not need another pint of blood from the tech economy. We only have so much to give.

[1] a 14.8% tax increase divided by a previous base of 75.7% pretax income