How would we know if “The Bay Area Should Levy a 5% Equity Tax on Startups”

In a recent Information article, Sam Lessin proposed a Bay Area 5% equity tax on startups. It’s an interesting idea; I don’t know whether it’s “good” idea. This blog post will not answer the “good” question, but I’d like to use this proposal to explore some ideas in public policy and economics and talk about some of my work that bears on the question.

If a 5% equity tax were imposed, what would happen? Ideally, we’d have a true experiment to settle the question: say we had 300 more or less equivalent Silicon Valleys, half of which got the tax, half of which didn’t, and then we’d check in on them in 5 or 10 years. Yeah, so that’s not going to work.

The problem is clear—we don’t have that many Silicon Valleys, we don’t have that much time, and we certainly don’t have the political power to impose such a tax randomly. Further, it is not clear what we should even look at to assess “good”—we could see how much revenue that tax generated, but what we care about is the revenue generated at what cost to society. If the shadow of a 5% tax causes a huge reduction in the number of startups, then whatever is raised could be very costly indeed. Though even saying something strong here would require some notion of the “quality” of the startups the tax displaced or prevented and whether some other startup would have just filled its place (e.g., kill Uber, get Lyft). We’d also care about who ultimately paid the tax, as the incidence is unclear—is it entrepreneurs? VCs? Workers in the tech sector? Landlords? Consumers of what Silicon Valley makes?

To assess the proposal, we’re going to need to be less empirical and more theoretical. I am highly empirical. I’m a card-carrying member of the credibility revolution. Most of my papers are not just empirical but experimental. That being said, there are important policy questions we care about that we need to answer quickly that existing empirical work just does not speak to. That leaves economic theory or guessing.

Screenshot 2017-04-24 11.18.28

My working paper, “A Model of Entrepreneurial Clusters, with an Application to the Efficiency of Entrepreneurship” is theory paper designed to answer this kind of question (among others). The model is not complex, but it has a few too many moving pieces for a blog post, but I can sketch out the relevant parts and show how to apply it.

In a nutshell, the paper describes a model with three important markets: the market for venture capital, the market for “engineers” and the product market for what successful startups sell. In the paper, would-be entrepreneurs weigh the expected returns to doing a startup to the “safe” returns to being an engineer/employee. A key feature of the model is the notion that lots of would-be entrepreneurs can pursue the same “idea” but that there is a single winner on each idea. This has some implications for the entrepreneurial system. One less startup does mean one less shot at commercializing some innovation, but if lots of startups were pursuing more of less the same idea, the welfare consequences of “losing” that startup to employment is not so bad. Furthermore, it doesn’t have much of a labor market consequences either—there is no “missing” successful startup that is no longer demanding labor.

Anyway, getting back to the tax question. We can think of the tax as increasing the cost of doing a startup. The effects of such a shock are worked out in Section 3.8 in the paper. This increase in cost shifts some would-be entrepreneurs back into the labor market, which lowers wages. This, to some extent, offsets the effect of the tax from the entrepreneurs perspective, as it lowers startup labor costs, making startups ex ante more attractive (imagine Google, but getting to pay 3% lower wages—starting Google is more attractive). So some of the tax gets borne by workers. How much? Well, in the model, the effect of a small change in startup costs on wages is

Screenshot 2017-04-24 11.37.58

which, uh, may still leave you with some questions. The “g” is the fraction of the labor force that is entrepreneurs. This part just says that when a large fraction of the labor force is entrepreneurs, a tax on that has a big spill-over effect on wages, and vice versa when it is small.

The term inside the parentheses has an economic interpretation, in that it captures how large a flow of engineers must leave entrepreneurship to re-establish an equilibrium, with larger flows leading to greater reductions in wages. Suppose that the startup success probability was completely inelastic, meaning that a reduction in the number of startups doesn’t “help” the startups that remain succeed. The increase in startup costs drives engineers from entrepreneurship, but because the startup success probability does not change, there is no compensating increase in success probability that would occur if the success probability was elastic. As such, a larger flow out of entrepreneurship is needed to re-establish the equilibrium, which means that employees see a larger fall off in wages. With a highly elastic success probability, a smaller number of exiting entrepreneurs is needed to establish a new equilibrium, and so there is less downward wage pressure and so less pass through of startup costs.

The model says that the overall surplus of the system is proportional to engineer wages in equilibrium. As such, what we would hope, as a social planner, is that the tax does not lower wages much in equilibrium. This happens when the startup success probability is highly elastic. A key feature of the model is that a highly elastic startup success probability is the sign in the model of too much entrepreneurship, in the sense that there are lots of entrepreneurs pursuing more of less the same ideas. In the model, ideas differ in their perceived “quality” and obviously good ideas get lots of entrants pursuing them, while only the marginal ideas get the efficient number of entrepreneurs (perhaps the ideas-that-seem-bad-but-are-actually-good). The figure below is the key figure from the paper:

Screenshot 2017-04-24 11.54.03


To wrap it up, the model says that if you think there is lots of duplicative entrepreneurship right now—too many entrepreneurs pursuing more or less the same idea—the model says that Sam’s tax is very likely to be a good idea, as it will mostly reduce, on the margin, startups pursuing ideas that were already being pursued, and hence the social welfare consequences will be minimal (interestingly, I think this elasticity question probably can be pursued empirically, using booms and busts in startup funding and/or technological shocks). Is my model the right way to model things? I have no idea, but it’s *a* model and we have to make choices. Of course, there are lots of considerations this analysis doesn’t consider, but I think it’s a  starting point for thinking about the issue, and also potentially the impetus for newer, better models.