Baseball Crank
Covering the Front and Back Pages of the Newspaper
September 27, 2011
POLITICS/BUSINESS: Job Creation and the Rich: The Facebook Story

President Obama is on the prowl for new targets for (1) raising more tax revenue and/or (2) demonizing "the rich" for campaign purposes. Among Obama's proposals, besides raising taxes on high-income individuals generally, is to more than double the tax rate paid by many private equity and venture capital investors from 15% to 35%, by reclassifying sales of their businesses (or shares in their businesses) as ordinary income rather than capital gains (more detail here and, drawn from prior versions of the proposal here and here). A common trope being retailed in some form or another by Obama and his allies is that taxing the wealthy and private equity and venture capital has no impact on job creation. As is common to liberal arguments, rather than argue that they are proposing a worthwhile tradeoff, liberals deny even the possibility that their policies involve any tradeoffs whatsoever. As well they might: the voters are hardly going to accept anything right now that impedes the growth of private sector businesses and jobs.

Now, there are a lot of economic angles to this argument, which have been ventilated in more detail elsewhere. But a concrete example may be useful in illustrating how wealthy individuals, private equity and venture capital contribute to the growth of businesses and jobs: the story of Facebook.

Facebook, as you may recall, was largely the brainchild of 20-year-old Harvard student Mark Zuckerberg, and - to simplify a story that has involved a lot of acrimony and litigation - was founded by Zuckerberg and his roommate Dustin Moskovitz in February 2004 to provide a way for Harvard students to interact online. The company was not created in response to any consumer demand to spend money on such a product (seven years later, it still doesn't cost you anything to have a Facebook account, and the company's revenue comes mainly from advertising and similar streams). It was created because the founders thought it was a good product and that creating it would generate its own demand (the antithesis of demand-is-everything Keynesian economic theory). They were right - they got 1,200 subscribers within 24 hours, and the user base of Facebook has grown like wildfire for years since, to over 800 million today.

But while they were not exactly paupers - each invested about $1,000 at the start, and later $10,000 - there were limits to how far Zuckerberg and Moskovitz could spread their business idea without investment. Enter the money. First came Eduardo Saverin, also a Harvard student, the son of a wealthy Brazilian businessman; Saverin had reportedly made some $300,000 investing in oil futures, and put a stake in Facebook to become one-third owner and the company's first CFO. That got the venture off the ground, born from the start in commodity trading profits. (Saverin was later bought out to resolve litigation)

Just four months after the company's founding, in June 2004, it got a major investment: $500,000 from Peter Thiel. Thiel had been running his own multibillion-dollar hedge fund since 1996, and had made $1.5 billion in 2002 from taking PayPal (which he founded) public and selling it to eBay. Once again, an investor flush with cash from hedge fund profits and the sale of a new business provided the rocket fuel that allowed Facebook to take off from dorm-room startup to major online network. (Thiel reportedly received a 7% stake in the company, now worth well over a billion dollars).

As a startup, Facebook needed constant inflows of cash. The company moved its headquarters to Palo Alto around the time Thiel invested, and spent $200,000 in mid-2005 to buy facebook.com (its prior domain name was thefacebook.com). It cost money from the very beginning to defend against lawsuits. And the company seems to have lost millions in its first two years of operations.

Yet the product itself grew and grew, expanding overseas by the fall of 2005, and the constant inflow of capital kept it able to sustain that growth. Venture capital firm Accel Partners put $12.7 million into Facebook in April 2005, followed by Greylock Venture Capital, which invested $27.5 million that same year. By 2007, Microsoft invested $240 million in exchange for just a 1.6% stake in the company, implying that the whole enterprise was now worth $15 billion. Today, Facebook has over 2,000 employees, and expects to grow that to 9,400 employees by 2017.

Anecdote is not the singular of data, and like most stories of individual companies you can overdraw the policy implications from Facebook's growth. Yes, Facebook is an extreme example. Yes, Facebook grew in the shadow of the Bush tax cuts of 2001 and 2003, but it also grew up in high-tax states like Massachusetts and California, and of course I couldn't tell you the particular tax rates paid by the various wealthy investors in the company. But Facebook's story, and thousands of others like it (if less dramatic) illustrate three timeless truths:

(1) Growing businesses need capital;

(2) Capital for risky startup ventures - especially ones with as steep an upward growth trend as Facebook - tends to come primarily from wealthy individual investors and from the venture capital and private equity vehicles they fund (the business career of Mitt Romney is full of examples of this); and

(3) The more of that capital you have, and the better the after-tax returns it can earn, the more seed corn there is to grow still more of those businesses.

You would think that President Obama - who at least in 2008 drew a lot of support from Zuckerberg and his Silicon Valley ilk - would appreciate this concept. But Obama remains the same man who in the primary debate in 2008 in Philadelphia told Charlie Gibson that he wanted to raise the capital gains tax "for purposes of fairness" regardless of whether it brought in more revenue. Even as the economy has stagnated and dragged down his own political fortunes with it, Obama seems unwilling to even consider the importance of private capital in any recovery. Investors in new businesses, consider yourselves unfriended.

Posted by Baseball Crank at 6:09 PM | Business • | Politics 2011 | Comments (34) | TrackBack (0)
Comments

None of which proves that increasing taxes decreases capital investments and/or job creation. Don't get me wrong-I agree with the general point that if you tax income/capital gains enough, at a certain point you will remove the incentive to invest. But your example does not make clear that an increase such as Obama is proposing would in fact have that effect-i.e., it's not clear from your example that "but for" a reduced tax rate those investments would not have been made. I don't mean to discount the possiblity-or perhaps even probability- that Obama's proposal would sufficiently discourage such investments, but it could very well be, based upon the information you have provided to us, that those same investments would have been made even if the Obama tax rates were in place.

It seems to me that no matter how high the tax rates, if people are earning (or perhaps more accurately, reasonably expect to earn) profits on their investments, they will invest. Only once tax rates eat up all profit-not certain marginal profit, but all profit-will the incentive to invest be removed. This is sheer speculation on my part and I'd love to see empirical studies on the matter (I'm sure some exist with which I'm unfamiliar), but it seems like a more than sound hypothesis because if you're turning a profit you're turning a profit; higher tax rates just mean you're turning LESS of a profit. Whether you're turning a mega-profit or just a small one (because of taxes), you're still making more money than if you DIDN'T invest. This is true because, for the most part, people invest money they have to spare-they don't use little Jimmy's college fund and they don't use the money they put away for the down payment on their house (yes I know there are more than a few unfortunate examples of this not being true but these are not the investors who are creating jobs). If it's all throw-around money to begin with, then some profit taxed greater, while not as good as more profit taxed less, is still better than leaving that money idle.

I've made more than a few assumptions. What do you think?

Rich

Posted by: Rich at September 27, 2011 6:24 PM

Crank, I think this is apples and oranges. The proposal to raise the tax rate on carried interest (which I believe is what you referenced at the top of the article) would hit managers of PE and VC funds, not the investors (your #2 above) that contribute the lion's share of capital to those funds (~98%). The tax change wouldn't have affected Thiel, Saverin or any of the passive investors in Greylock, Accel, etc. It would affect the guys who run Greylock and Accel.

The question, I think, is whether the proposed tax hike on fund managers would cause them to stop trying to raise capital to run VC and PE funds, thereby causing a source of funding to dry up (unlikely in my view given that pension funds and other institutional investors will want to have exposure to alternative assets - more likely they'll just have to pay PE/VC managers more).

BTW - I used to work with a guy who was a classmate of yours at HC. Larry Naughton?

Posted by: Jeremy at September 27, 2011 6:26 PM

Rich - As I said, I'm citing an illustrative example here, not a full-dress argument on the point, which I don't have time today to write. But as a general matter, there are two issues - one is that taxation drains the pool of capital available to invest, and the other is that marginal tax rates reduce the return on investment and thus reduce the number of investments that can be profitable, thus discouraging investment. You have to work with both sides of the problem.

Jeremy - Yes, I hear from Larry all the time.

Posted by: Crank at September 27, 2011 6:29 PM

Rich is on the right track here re: the effect of marginal tax increases (though I'm a big fan of leaving the business rates the same, and raising the personal ones). Moreover, Facebook really isn't any disproof in Keynesianism. Given that Facebook has been receiving substantial investment since 2004 - long before the market tanked - you can't say that expectations of demand had nothing to do with the investment choice.

I'm sorry to say that conservatives, like liberals, love to trot out these anecdotal stories as proof of their general beliefs about economic behavior, most of which are rooted in the highly oversimplified assumptions of their favorite economic theories.

By all means, I'd love to read the dressed-up arguments, but I really doubt they will be much better.


Posted by: MVH at September 27, 2011 8:01 PM

Look, one of the first things you learn in Finance 101 is ROI. Companies (and individuals) have so much cash to invest. They calculate what they think they can make and allocate the capital from top down until they run out of cash.

When you jigger the tax code to limit the return on an investment, then other, less productive investments are chosen. Sometimes these alternatives will be overseas and won't create jobs here.

I don't give a rat's about hedge fund managers and what rates they pay. But if you begin with the premise that tax rates won't affect business decisions as long as there is some profit to be made, that just defies reality.

Posted by: spongeworthy at September 28, 2011 10:11 AM

Sponge, wrong on all counts. I don't, and never will, look at tax rates to decide just how much profit I can pull out of something. The question is will it fly, not why should I if the guvmint gets a bite.

It IS a Democrat vs. Republican argument, because the Republicans see the government (and therefore, by extension, the originating agent, the Constitution) as the enemy, Democrats see it as an ally. There wasn't a single business that made the decision not to invest in the 1950s when the highest tax rate was 90%. Ninety per cent. Ninety. Got it? Did it stop Pan Am or TWA from buying 707s? Nah, didn't think so. Is it wrong to tax insane profits wrung from everyone by oil companies? No, because BP and Exxon would charge as much no matter what, would invest the same in R&D no matter what. And it's not as those those yahoos invented the business.

Would Romney, as Bain Capital, not buy out loads of companies and fire everyone if he and his board were going to make less? No.

Taxes are not meant to take money away like Robin Hood, but to pay for services We the People expect. Not just FEMA. There is a new listeria outbreak from cantaloupes. For those of you who don't know, it was food poisoning (look at the history of Heinz and ketchup, a fascinating story, and why their ingredients list "red ripe tomatoes) to realize that the people demanded government action after a nationwide food safety crisis.

Simply put, the GOP is claiming that letting the Bush tax cuts die is the same as the Anti-Christ, is full of shit. SO many claiming it would end inventiveness, and new business. Entrepeneurs never ever look at the tax code for their business. And existing ones (like mine) depend more on bank credit than on what is taxed after. In the end, if I've made enough profit that I am taxed more, it means I've done my job, and I will let the FBI catch criminals, the FAA let planes land safely, the NIH to find bad diseases early, the FDA to keep me from getting listeria from canteloupes. It's what we pay to be in a society together.

Posted by: Daryl at September 28, 2011 2:29 PM

What an insight survey, I like your article.

Bread Machine click here

Posted by: Bruce at September 28, 2011 2:47 PM

One of the underappreciated consequences of high marginal tax rates on capital (dividends as well as gains) is that it promotes the formation of large corporations as tax shelters. By retaining and reinvesting earnings taxes can be postponed indefinitely, so profitable companies in particular are under tremendous pressure to expand. Interest being an expense further encourages expansion by loading up on debt.

I really wonder if the average size of US corporations could not be significantly reduced by changing the tax code to encourage dividend payouts over earnings retention at the earning level of a typical company. The simplest way would be to make dividends an expense (the same as interest), while maintaining a higher corporate tax rate than the personal rate on dividends/interest. Thus a corporation would need to be generating above market returns on its retained earnings to cover the higher tax rate or face strong shareholder pressure to pay out the earnings as dividends.

There is a natural tendency for profitable companies that have largely saturated their primary markets to turn into de facto holding companies. They acquire other businesses or attempt to enter other markets simply to continue to postpone the day their intial investors have to start paying taxes. I worked for a company that for 30 years plowed most of its very strong operating margins into a host of unrelated business ventures, most of which were miserable failures and a handful of which paid off. Why? Because almost half the stock was owned by the founder's family and it made more sense to graft a mediocre venture capital arm onto the existing company than to pay taxes on the income paid as dividends and invest in a pure VC firm. (At least until the family decided a couple of years ago to take advantage of the Bush cuts, take the money and run and sold out in a huge cash deal.) Sure managers will want to expand anyway, but by breaking the alignment between the managers' desire to run a bigger, more important company and the stockholders' desire to shelter income from taxes create a self-interesting, self-financing watchdog to limit companies to where there are real economies of scale.

Posted by: phwest at September 28, 2011 5:31 PM

Correct me if I'm wrong here, but what foreign competition was there for businesses in the 1950's? That tax rate became unsustainable as Europe and Japan rebuilt their industries.

Posted by: Mark D at September 28, 2011 6:06 PM

I get the general drift of Daryl's post, but no, you can't use the 1950's and the 90% corp tax as an example for the reasons Mark mentioned.

Another point I wanted to make re: the capital gains and government revenue. You can't simply say "well revenues increased when Clinton, et al dropped the capital gains tax." Obama isn't wrong to say a lot depends on Wall Street. If you're in a protracted bull market, you can have an increase in revenues simply because the taxable gain is larger. The issue is how much you would have collected had the rate has been higher.

Obviously, you can't ignore the reality that some shareholders will be more willing to cash in their stocks when rates are lower, thus generating more revenue. But again, this is subject to the law of diminishing returns. As the cap gains rate gets lower, you will get less of this effect.

Posted by: MVH at September 28, 2011 6:28 PM

Sorry - the last sentence of the second paragraph should read: "had the rate been higher."

Posted by: MVH at September 28, 2011 6:30 PM

"the voters are hardly going to accept anything right now that impedes the growth of private sector businesses and jobs."
What private sector job growth?

Also, you'd be surprised what the voters will accept. Once the corporate MSM starts calling the private sector job losses a Luntzian term like "job exclusivity", you'll see the voters eat it up. After all, they fell for calling the rich who no longer pay their fair share "job creators".

Posted by: Berto at September 29, 2011 11:57 AM

"...the rich who no longer pay their fair share."

Who? And what percentage, say, is a "fair share?" Envy much?

Cordially...

Posted by: Rick at September 29, 2011 5:48 PM

Well, a fair share is something determined by Congress to be the right amount, or it can pass the smell test. For instance, BP and Exxon getting enormous breaks for doing their jobs doesn't pass the smell test. GE, well, that is a maybe it smells, maybe it doesn't, but probably does, because you shouldn't get off on a technicality on paying NO taxes at all.

Does someone very wealthy take out what a poor person does? Well, in a way yes. Maybe not in services, but in living here. Clearly something they choose to do, and a change in tax rates from 34 to 38 per cent is not going to make anyone move away. Changing to 40 per cent won't do it either. If they wanted to, they would just move away anyway. If that slight change to a tax rate that was perfectly fine for services rendered 20 years ago will make you leave, then don't let the doorknob hit you on the ass on the way out. For those of us of all manners of income who choose to stay, it's because we believe we have a stake in Mr. Madison's document, and it's worth paying what is really among the lowest tax rates in what we like to think of as civilization to do so. And it's not taxes or rates that make us angry, it's paying it out and not thinking we are getting our money's worth that pisses us off. I haven't heard anyone grouse about FEMA the last couple of years. Our complaints about flying are restricted to the privately run airline industry. I think our air traffic controllers are overworked and spectacular. Flying used to be special. Ooops, that was when it was regulated. Sorry, it's so much better now

Posted by: Daryl at September 29, 2011 5:56 PM

Here's my favorite "insight" from the Crank:

"As is common to liberal arguments, rather than argue that they are proposing a worthwhile tradeoff, liberals deny even the possibility that their policies involve any tradeoffs whatsoever."

Yes, folks it is liberals who argue -- EVERY piece of evidence to the contrary notwithstanding -- that lower taxes increases government revenue. No tradeofff whatsoever.

Posted by: Magrooder at September 29, 2011 7:17 PM

"Well, a fair share is something determined by Congress to be the right amount, or it can pass the smell test."

Well then, the current marginal rates are fair. If they don't go by your sniffer, what's a fair rate, and *why* is it fair?

Thanks/cordially/Yr Obt Svt...

Posted by: Rick at September 29, 2011 7:46 PM

Magrooder: first of all, I've never argued that that's always the case, only that the pro-growth effects of tax cuts help offset revenue loss, and in some cases (depending where you are on the Laffer Curve) can wholly pay for themselves.

Obviously it's a complex issue to quantify because there are so many variables in govt policy and economic growth, but "EVERY piece of evidence" is typical of the approach your side takes to these discussions.

An interesting item: marginal rates are lower today, yet the top 1% of the population pays 38% of the taxes compared to 13% in 1960.

Posted by: Crank at September 29, 2011 8:18 PM

"An interesting item: marginal rates are lower today, yet the top 1% of the population pays 38% of the taxes compared to 13% in 1960."

That's one way to slice it, but not terribly convincing. The income of the top 1% has skyrocketed since 1960. I have to think the taxes paid as a percentage of income are lower now for the top 1% than they were in 1960. How important is it that you pay 38% of the taxes when it's costing you relatively less than it did in the 60's?

I have nothing against raising personal income taxes on the top 1% or 5% or whatever. The idea that this is somehow going to kill economic growth is silly. The bigger point, missed by liberals, is that it won't raise a lot of money. There just aren't enough of them. It can be part of the mix, sure, but you're kidding yourself if you think it's the answer. The whole debate is basically rearranging the deck chairs on the Titanic.

Posted by: MVH at September 29, 2011 8:41 PM

If you follow the link, it shows that the top 1% has seen its share of income slightly more than double, but its share of the taxes nearly triple.

Posted by: Crank at September 29, 2011 8:43 PM

Takers are so precious. Like crabs in a bucket, yet
under the delusion that their 'toods are for the greater good.

Cordially...

Posted by: Rick at September 29, 2011 8:48 PM

Crank,

My post should have been clearer. I was talking about taxes paid as a percentage of their own, individual incomes.

Posted by: MVH at September 29, 2011 10:25 PM

Rick,
Envy Much? No, that's the name of a rapper. I was just being honest about how the rich aren't paying their fair share of taxes. It caused something called "the deficit". Look it up. It was a big shit deal for no nothings on the right just this past summer.

Crank,
I'm in. I'll pay 75% of the taxes in exchange for 95% of the income.
Also, are you going to let Rick call the guys who sign your paychecks "takers"? I'm thinking 'criminals" is more honest.

Posted by: Berto at September 29, 2011 11:46 PM

"An interesting item: marginal rates are lower today, yet the top 1% of the population pays 38% of the taxes compared to 13% in 1960."

Of course, that is the case, the gap between the haves and the have nots has grown exponentially in those 50 years.

Posted by: Magrooder at September 30, 2011 8:57 AM

"I was just being honest about how the rich aren't paying their fair share of taxes."

Your honesty can't be assessed absent a declaration of what is a "fair" share. I'll tell you mine: a TBD flat rate for ALL filers, with a large, fixed exemption (say...$30,000) for ALL filers. And eliminated or all-but-eliminated deductions.

Everyone is treated the same. Sounds fair. Some folks earn lots and lots of money. To quote Ms. Warren of MA: "good for you!" And no concern of mine.

Cordially...

Posted by: Rick at September 30, 2011 10:58 AM

Rick,
I could get behind the flat tax w/ an exception for the first $50K earned. After that it jumps a half percentage per each additional $50K earned.
Also, I'd go back to the days when corporations also paid taxes. If there is anything we learned from the Reagan lassaiz faire nonsense, it's that corporations need to be taxed and regulated.

Your idea of treating everyone the same---no whining about the 50% who pay no income tax, while crickets for the Fortune 1000 who do the same--sounds like a good plan.
Would you tax dreaming? Because good luck getting the corporations and the rich to buy into a system they can't rig.

Posted by: Berto at September 30, 2011 11:35 AM

Berto, since I am someone who actually signs people's paychecks, I'll take a line from Nixon here and say, "I am not a crook."

And Crank, we, and I mean ALL of us, demand far more of government than we did in 1960. Our defense industry, which is really a jobs program, since we always used to power down our military after a conflict, has grown to insane proportions. Medicare didn't exist; I don't think FEMA did, but if it did, it was a lot smaller. The EPA has grown as we have actually grown to like the smell of clean air and the taste of fresh water. Medical costs have more than skyrocketed. They are now travelling at warp speed to the delta quadrant. Because now doctors do a lot more than hold your hand at a house call and say there isn't much more they can do.

Posted by: Daryl at September 30, 2011 12:08 PM

Crank, some of the stuff you write with a straight face is unreal. Casually writing that the top 1%'s PROPORTION of income has only slightly more than doubled is hilarious. That means (as everyone except, apparently, you) that their overall incomes have SKYROCKETED. Having the country be wildly top-heavy when it comes to earnings seems of no concern to you when it, in fact, is a gigantic problem and a huge spoke in the wheel of why there is such a large unemployment rate.

Posted by: jim at September 30, 2011 1:27 PM

"I could get behind the flat tax w/ an exception for the first $50K earned. After that it jumps a half percentage per each additional $50K earned.
Also, I'd go back to the days when corporations also paid taxes. "

Dear Berto,

You'd seek to reintroduce what I'd call UN-fairness, by adjusting rates based on reported income. The pancake-flatness preserves the uniform structure, but gets at that Monopoly kapitalist money via what the most wealthy would wind up paying in the *effective* rate. The proper percentage to set for all income earners is the great question/battle, not the rent seekers and special classes seeking favors.

Maybe plutocratic corporate friends of Obama get off the tax hook, but Murika has one of the highest corp. tax rates in the developed world. Then what might trickle down in dividends gets taxed again at regular rates. Just paying it forward...it sure has worked out great so far.

Cordially...

Posted by: Rick at September 30, 2011 4:15 PM

To continue with corporate tax rates, here's a suitably left-wing source confirming my statement:

http://www.guardian.co.uk/news/datablog/2011/feb/21/corporation-tax-rates-world

Jim--What precisely is the "gigantic problem" you which you allude. The "income pie" is not static, and what the Silicon Valley plutocrats and NBA superstars make is no skin off my nose, food off my table, nor opportunity lost to me.

Cordially...

Posted by: Rick at September 30, 2011 4:20 PM

Rick,

You don't see a problem with an incredibly small portion of the population controlling a vast amount of the income? Are you super-wealthy? Doesn't work in Mexico, didn't work in pre-Revoultion France. It doesn't work for a variety of reasons. One is that it creates a static income pie for everyone else. Middle class income only barely keeps pace with inflation since Reagan while the wealthy have become super-walthy. This is not a sustainable economic model or in any way good for society. I can't see how you can argue that giving the vast proportion of wealth to a small number of people is a good idea.

Posted by: jim at September 30, 2011 7:01 PM

Rick,
If the rich can't buy access or use their money to rig the game, what they make is no skin off my nose either.
The fact that they can (and do) is what I'd call UN-fairness.

Posted by: Berto at September 30, 2011 7:27 PM

Gentlemen, Gentlemen,

The supposed threat from the moguls would be bending a big government to their favor. To you, the answer is to trim the rich. Mine is to trim the gubmint so its corruptions are less widespread, significant and felt.

And please explain how burgeoning bank accounts of Gates, Buffet, Soros & the Koch Bros. have made the economic pie grow static. Who has demonstrated this?

Love that "*giving* the vast proportion of wealth" trope. Yep, I threw some coin into their kettle outside the grocery store last December. Gates earned his/Streisand earned hers; anything good on TV tonight?

Cordially...

Posted by: Rick at September 30, 2011 8:42 PM

Rick,

You are blissfully unaware I guess. Incomes in the middle class are flat at best since Reagan yet the upper 1, 5, 10 and 20 percent have benefited disproportionately. I guess you are okay with an upper class that dominates income, purchases access that allows them to maintain their income stature and does little for the general welfare. If that's your position that's fine but it seems odd that if you aren't amongst the super-wealthy you are fine with their obtaining an increasing level of total earnings while people in the middle are exposed to more and more risk with no income advantages to go along with that risk and insecurity. Monarchies are inherently bad things and that is the direction this country is headed at least in terms of who controls the bucks and access to power.

Posted by: jim at September 30, 2011 11:51 PM

Completely aware, and yet blissful about the income quintiles. Government is the greater threat to liberty and well-being than Scrooge McDuck.

Don't tread on me...or thee.

Cordially...

Posted by: Rick at October 1, 2011 8:59 AM
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