It's a Maker's Economy: Don't Pity Wealthy Job Creators

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Our economy and tax system already bestow large rewards on people who start successful businesses. It's the rest of America that needs help.

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Reuters

The political event of the week was the release of a video of Mitt Romney going all in on the "producers-vs.-takers" theory of the world: That America is divided between "producers" who work hard and pay taxes and "takers" who see themselves as victims, demand entitlements from the government, and don't care about their own lives. Paul Ryan has long been a proponent of this theory (see Mike Konczal for an intellectual history). The Republican Party styles itself as the party of the producer. Eric Cantor's Labor Day tweet praised business owners: "Today, we celebrate those who have taken a risk, worked hard, built a business and earned their own success." Instead of "penalizing success," they argue, we should unleash the producers by further reducing taxes on the wealthy (including those who make their money through passive investments).

If any of these talking heads had ever started a real company, they would know this is ridiculous. America is not a nation where successful entrepreneurs see their income siphoned away by the greedy taxman and and grasping labor unions. It is exactly the opposite.

The modern paradigm for the way business should work, at least in the media and the popular imagination, is the Silicon Valley startup company. Some kid has a brilliant idea, starts a company, and changes the world. The question is, who gets the rewards? The answer is that the rewards flow overwhelmingly to the founder(s) and the venture capital firms who made early investments. As of the Facebook IPO, for example, the founders owned far more shares than all non-founder employees put together (see the S-1). The same was true of the founders of Ariba, a company from the last boom that I worked for in 2000 and 2001.

That's just the way it is. When a company is funded, the founders and the VCs divide the stock among themselves, setting aside some in a pool to grant options to non-founder employees. There is a market price for employees, and the market price is that even the very first employees get only small fractions of what the founders and the VC funds get. Apparently no Facebook employee other than the founders and a few hired as senior executives has even one-thirtieth as much stock as Zuckerberg. And as far as I know, the engineers who get 0.1% and work just as hard as the founders who get 30% don't think that this is fair or unfair. It's just understood that that's the way it is.

If you look at the S-1 of almost any technology IPO, you'll see that the VCs (capital) also own far more stock than the non-founder employees (labor). That isn't to say that the investors in VC funds make a killing. Instead, as Felix Salmon reported, VC investors would be better off buying stock index funds, at least since the late 1990s. It's the venture capitalists themselves who make the killing, since they get 2% of their bad funds and 20% of the funds that are lucky enough to invest in the likes of Google and Facebook.

The basic economics of the industry funnel most of the gains to founders and VCs. And then our tax system kicks in, showering them with additional gains. VCs benefit from the famous carried interest loophole: although they more or less work for their money (pitching to investors, screening companies, executing transactions, attending board meetings), they get to pay tax on most of it as if it were gains on capital investments.

Founders of successful companies make virtually all their money in the form of long-term capital gains. From a tax code perspective, it's obvious why this is so. They bought their shares on day one, when the shares weren't even worth printing on paper, and they sell them much later when they are worth a lot. From a substantive perspective, though, it's a great tax break, since what a founder really contributes to the operation is her labor, and lots of it--yet she gets paid as a contributor of capital.*

Our economy and tax system already bestow large rewards on people who start successful businesses. In 2001, I co-founded a software company. If the capital gains tax rate had been twice as high at the time, I wouldn't have thought twice about starting the company. I didn't even know what the tax rate was. (In fact, it was 20 percent, not the 15 percent it is now, and when Microsoft and Apple were founded, it was over 35 percent.) If I had had to give up more of my stock to the VCs in exchange for funding, I still would have done it (not that I would have been happy about it). I had plenty.

The rewards of success are already far bigger than they need to be to encourage innovation and risk-taking. We job creators -- my former company employs hundreds of people, most of them in the United States -- are doing just fine. It's the rest of America that needs help. 

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*For the record, I don't think there should be a preference for capital, and in White House Burning we proposed drastically reducing that preference (by raising the capital gains rate to 28 percent). But as of now, there is one, and both founders and VCs benefit from it.

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    James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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    James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.
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