Given that the Trump Administration plans on lowering the individual income tax rates and corporate income tax rates for pretty much all taxpayers, economists and other observers have been debating what type of effect this might have on economic growth (hint: the debate will never end).
Within this vein of discussion on the overall effect of taxes on economic growth is one area intricately related to the private equity and venture capital universe. The question is whether taxes matter for company startups and startup company valuations.
The Left Side of the Debate
On the left side of the debate are individuals who simply argue that startup companies tend to be headquartered in what are typically classified as high income tax areas. For instance, a recent report from the left-leaning group Policy Matters Ohio argued that there’s no evidence that a higher income tax rate lowers the presence of so-called “unicorn” companies (unicorn companies are firms with a valuation of at least $1 billion).
As shown in the following graphic, 55 of the 87 unicorns studied by the Policy Matters Ohio group were located in California, well known as a very high tax burden state. Other members of the exclusive unicorn group include 10 companies in New York, 6 in Massachusetts, 4 in Utah, 3 in Illinois, and 2 each in Washington and Florida. Of these states, only Washington and Florida don’t have an income tax.
The obvious inference, according to this group, is that tax policy doesn’t matter for startup companies to set up shop. Rather, what matters is a vibrant and educated workforce.
The Right Side of the Debate
On the other side of the debate are individuals who clearly see a connection between income tax rates and economic growth.
As shown in the following graph, states with lower corporate tax rates generally experience stronger employment growth across time. This is shown by the linear regression line through the two series. On the left (vertical axis) is the employment growth across time by state. On the bottom (horizontal axis) is the corporate tax rank. A state with a lower number is a high corporate tax state. A state with a lower corporate tax is closer to the right side of the graph. The line through the two measure shows that as corporate income tax burden goes down, employment growth is generally higher. The flip also holds. As corporate income tax goes up (movement to the left on the graph), employment growth is generally lower.
Who’s Right?
So, who’s right?
Well, the answer lies in who you want to believe and how complex you think the relationship is between employment growth and corporate income tax rate. With this said, there are at least two arguments why the Policy Matters Ohio study is potentially misleading.
First, startups, including the 87 unicorns included in the Policy Matters Ohio study, generally don’t make much money. Their valuation is based on expected profit. So, when you’re an owner not making any taxable profit, then the tax rate probably doesn’t matter.
Second, taxes are imposed when owners start selling their stock after an initial public offering. Owners surely think carefully about tax policy when it actually comes time to sell their profitable shares.
Conclusion
In thinking about whether the individual income tax rate affects unicorn companies, the answer lies in a complex discussion about when taxes matter and what owners do to address taxation.
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