In 2017 I wrote a column proposing that the Bay Area should levy a 5% equity tax on new companies and create a sovereign wealth fund for the region. The idea was to effectively create a municipal or state version of Y Combinator in order to align the incentives of the region with those of the startups it hosts.
In 2020, witnessing California’s enormous budget crisis, I strongly believe that the time for this idea has come.
Having the state or region as one of the equity holders from the outset in new businesses is far more aligned with value creation, will help raise funds for the state faster and should be broadly preferable to the alternative of spiraling taxes on income and, very probably, wealth. Such taxes in 2020 are likely to cause serious unintended consequences in ways that historically might have been less true.
The Challenge of Increasing Traditional Income Taxes
The challenges associated with raising income taxes in California are widely known. The first stems from the belief that if income taxes get too high, high earners will simply leave the state. While this risk is often cited, it generally hasn’t proven to be true during earlier tax increases. The vast majority of people do stay in the state and keep paying taxes.
But it is possible that this time, things will be different.
The Covid-19 pandemic has prompted an exodus of high-income workers from cities and has gotten many people comfortable with working remotely. Faced with higher taxes today, and the possibility of even higher taxes in the future, there is a strong incentive—and potentially a newfound ability—for people to simply not return.
We are going to see an interesting real-time test of this thesis play out in 2020 state tax returns. If many high earners left the state and paid portions of their state income tax elsewhere in 2020, that will have a serious impact on California’s tax receipts. (The state will have to issue vouchers or refunds for days worked in other states.)
Just as important, with especially low interest rates, very high earners have a lot of control over when they claim income today. Many might be inclined to borrow against the value of their equity to gain access to funds, rather than selling holdings outright. That would allow them to stay in the state, while recognizing as little income as possible for as long as possible.
This strategy also isn’t a new one. But where it used to only apply to the ultrarich, in our current very low interest rate environment, and with stock an increasingly important form of wealth generation, it now affects many more people and can have broad implications on to what degree incremental income tax increases will result in actual increased revenue.
A third issue is that since state income taxes are much harder to deduct from federal taxes (which arguably makes sense at a national level), any state or local tax increase would be more widely felt.
The upshot is that I really worry about the state’s ability to raise income taxes much without creating a series of cascading—and unwanted—effects.
Even if people don’t leave the state over these issues, it is very possible that the next generation of young, ambitious people—whom we need to come to the state and the San Francisco Bay Area—won’t show up.
In a world where major technology companies can hire anywhere, programs like Y Combinator’s startup accelerator have gone online, and even seed investors look globally for deals, why would a young, ambitious person come to California, where taxes are already meaningfully higher?
The Challenge of New Wealth Taxes
Given the challenges facing continued increases in income taxes, it is understandable that adding a wealth tax to the California state taxation regime now seems to be on the table.
In theory, I prefer wealth taxes to income taxes. I have written before about how I think a wealth tax should be implemented and why it would be a better framework for society overall.
But in practice there are two big problems with a wealth tax. The first is that it is nearly impossible to calculate and enforce accurately or fairly, and the second is that it will cause very challenging market distortions.
In terms of measurability of wealth, and therefore the feasibility of levying a wealth tax, consider that today, when people die and estate taxes are levied, it can take armies of accountants and lawyers (and frequently lengthy negotiations) to figure out how to value and pay taxes on an estate. Now, imagine trying to do that every year! It would be a bonanza for accounting and law firms, but an unmitigated disaster for everyone else involved.
Outside of a few company founders, affluent people store the bulk of their wealth in complicated and hard-to-assess assets. Trying to continuously account for their value and calculate taxes seems nearly impossible to do in a way that wouldn’t lead to all sorts of wild gaming.
Beyond the feasibility of measurement, adding a wealth tax—even a small one—would start massively distorting all sorts of existing markets in ways that are hard to predict. Here are a few examples of how this might play out:
On the VC side, a wealth tax would make high-price private rounds expensive to undertake, especially when liquidity events are far away, and drive a bias toward debt financing. Rather than giving companies high valuations, investors would simply write loans with theoretical future conversion terms to avoid taxation. As already happens at the seed stage with successive rounds of securities known as SAFEs (simple agreements for future equity) and notes, these structures can have unintended consequences and can leave founders and employees owning less of companies than they realized.
A wealth tax also could cause venture capitalists to rapidly write off all sorts of investments they currently hold at cost on their books. It is hard to figure out where to mark illiquid investments, and different firms take different approaches to how they mark the valuations of companies in their portfolio. If, all of a sudden, the valuation has serious tax implications for limited partners, there will be a huge incentive to write down or write off all investments after making them.
Beyond the narrow world of venture capital, a wealth tax would make it harder for companies to stay private for long periods of time. It would also be more difficult for people to found, own and operate businesses with no liquidity events on the horizon.
For employees at early-stage companies, it might force them to take out annual loans to cover taxes. If these loans were personally guaranteed, that would, over time, cause many people who had paper millions that never panned out to go bankrupt (as happened in the first tech wave). Securing these loans only with stock would lead to higher interest rates, which could be a bonanza for lenders and speculators, but would cost employees far more than the initial 0.5% annual wealth tax. Any way you slice it, a wealth tax would induce employees to take fewer chances and would shut off the startup ecosystem in California to anyone without the personal means to bear the risk.
Beyond economics, it is also worth considering how a wealth tax would distort other things. For instance, some people might get married faster to obtain more exemptions (with strong prenuptial agreements, of course), and others might pass on their wealth to their children more quickly if they have the means to do so.
In the end, I don’t think wealth taxes are in theory a bad idea, and the 0.5% proposed rate on individuals with an ultrahigh net worth isn’t crazy (especially when the government is lending money at nearly zero, effectively giving a handout to anyone with the means to borrow who can make more than 1% investing).
The devil is, unfortunately, in the deeply complicated details of how to implement a wealth tax efficiently and how to manage the broad and deep economic and social implications of such a shift.
I actually do expect some form of wealth taxation to come in our lifetime, but it seems like something that will have to happen at the federal level, and very slowly, rather than something California can implement alone anytime soon.
The Startup Equity Tax Solution
If it is going to be hard to keep raising income taxes, and even harder to implement a wealth tax practically and fairly, it’s worth revisiting my proposal of a startup equity tax.
At a high level, the way it could work is that any new company that has more than X employees in the Bay Area, or that has raised more than Y dollars of capital, would have to grant upfront to the state of California 5% of its equity, with certain traditional rights attached. The state would require pro-rata rights, giving it the ability to invest as the company grows to maintain the state’s ownership level.
The state would then immediately raise a large fund from outside investors, where presumably it could start to charge fees as a VC firm would do for access to investing in its pro rata slices of companies down the line. With around $300 billion of global venture capital every year, it isn’t hard to imagine the California state fund deploying $10 billion a year, which, given investment time horizons, could easily build to $1 billion a year in fees charged to investors just for access to the fund.
Any California-based company that went public,—assuming the state paid to maintain its 5% ownership throughout—would be on the cap table along with every other investor. If Airbnb were to go public at $30 billion this year, that would be a $1.5 billion position for the state. Uber, at today’s prices, would add up to a $2.8 billion stake. Of course, had this strategy been applied for the last 20 years, the stakes in such companies as Facebook, Apple and Google today would be worth hundreds of billions of dollars.
Starting from scratch, these positions in startups would take time to build, but in the meantime it would be easy enough for the state to borrow against their future value. The thing I like about this plan is that it highly aligns incentives between the startup ecosystem and the state.
Ultimately, as I wrote in 2017, the real thing that California has in 2020 is a talent and brain trust. People want to live and work in the state, and much as New York is the center of the financial world, San Francisco is the hub for technology. As long as crazy policies don’t mess it up, it’s a self-fulfilling prophecy that San Francisco will continue to be that hub.
My theory is that most founders would be more than happy to give up 5% of their initial equity for access to the region, just as people would give up more than that to Y Combinator for access to the accelerator’s network. If you disagree, just consider this: San Francisco–based startups get far more than a 5% valuation bump from investors compared with others not in the region. It would be economically rational for new founders to make this trade-off.
A Better Policy for California
Many people believe that California is run very inefficiently, and that the budget challenges the state faces are largely of its own making. That might be true, but the question about whether the state is spending money well is, in my mind, a separate issue.
For now, we face a reality that running California is expensive, and we are today grappling with an unprecedented public finance crisis.
The most obvious solution, raising income taxes, wouldn’t be effective today. Imposing a wealth tax isn’t something that a single state should do quickly or off the cuff, even if in the long term, and on a national level, it probably makes sense.
But a startup equity tax, while it would be the first of its kind, seems relatively easy to implement, a great way to align the state with the interests of its economic engine, and very, very lucrative for California.
Were there to be a startup equity tax, I could imagine that in time the alignment between the state and the innovation community would, despite the tax burden, draw more ambitious startups to California. Other proposals might have them running for the exits.