A recent USA Today (NYSE:GCI) headline, “Weakest start-ups since early ‘90s”, probably didn’t surprise economist Bruce Bartlett, assuming he saw it. He wrote about a similarly soft entrepreneurial environment in the 1970s.
Indeed, while the modern Bartlett has seemingly moved to the dark side, his 1981 book, Reaganomics, written before Ronald Reagan reached office, remains essential reading for anyone who wants to understand economic policy. In his classic book, Bartlett not only explained why entrepreneurialism is essential for economic growth, but also the barriers governments erect to it that must be reduced in order to get a nation’s restless minds producing.
First up is the loss of innovation that results from reduced startups. Though Reaganomics is 30 years old, Bartlett made a point that likely remains true today that “the largest proportion of important new inventions are still the result of individuals working virtually alone, rather than by big corporate laboratories.”
At first glance we can see that a reduction in the formation of companies formed in the proverbial garage means less exciting inventions down the line. Reduced startups mean less innovation. Simple as that.
Sarbanes-Oxley also comes to mind here in that an ill-conceived law that turned public company CEOs into accountants has surely poured gasoline on the above fire. To put it very simply, Sarbanes-Oxley has made going public far less attractive to smaller, innovative companies lacking the infrastructure to comply with the law.
As a result, some have chosen to be purchased by larger companies over floating their shares to investors. Given a first pass we can see that what we’ve all lost here is the ability to put our savings into exciting companies, only to watch them hopefully grow.
Secondly, big companies, by virtue of being large, are more bureaucratic, and they’re understandably more careful given how much they stand to lose if they fund egregious errors. So in swallowing existing startups that are less eager to navigate the jungle of being public, we as individuals lose for the larger acquirers to varying degrees snuffing out the risky dynamism that characterizes startups, along with startups that eventually go public.
Bartlett confirms the previous narrative. As he wrote 30 years ago, “the individual entrepreneur is still the basic motivating force in the economy, not just in terms of new inventions, as noted earlier, but in terms of meeting all of the consumer’s wants. Any measures which suppress entrepreneurship will ultimately cause the economy to stagnate.” Sarbanes-Oxley is the picture definition of stagnation for making it more difficult for companies to grow, and eventually raise serious growth capital in the public markets.
Moving beyond Sarbanes-Oxley which is a modern mistake, we can then look at taxation, specifically the taxation of capital gains. Here Bartlett provides further clues as to the lagging startup environment, though not in the way most would assume.
As Bartlett put it in 1981, a “capital gain (or loss) is the difference between the purchase price of an asset and its sale price.” Paraphrasing Schumpeter for a moment, startups can’t be startups without capital, so it’s important that the cost (meaning the tax) imposed on savers be light so that exciting concepts can attract investment.
Bartlett was of course writing about the 1970s, but his analysis remains instructive today. As he noted, until 1969 the top capital gains tax on long-term capital was 25%, but in the same year, the aforementioned rate was increased to 50%. The impact on IPOs was profoundly negative.
Whereas there were 1,298 IPOs in 1969, Bartlett revealed that by 1970 the number had been reduced to 566, and by 1978 new public offerings had declined to 18. Taxes are nothing more than a price, and if you raise the price of delaying consumption in favor of investment, you necessarily get less of it.
How this applies to startups is simple. Rarely does an idea get taken public on the first day. Instead, more lightly funded ideas begin as startups, and if successful, they’ll go public in a correctly taxed and regulated environment.
Notably, capital gains taxes were reduced in 1978, and Bartlett reported that new issuances immediately increased. In the second half of 1978 40 new companies were taken public, and then in 1979 144 companies floated their shares. Lower the cost of investment, get more of it.
To his own numbers, Bartlett may well reply today that tax rates can no longer be explained away as the reason for a reduction in startups, and subsequent IPOs (46 in 2010 versus 210 in 2000). The reply would of course be valid in that the capital gains rate is now 15%, quite a bit lower than it was after the reduction in 1978, not to mention the ‘80s.
Happily, Bartlett’s essential book explains this seeming oddity too. As most know now, the falling dollar in the ‘70s tautologically made the decade an inflationary one, and this eroded profits. As Bartlett put it, “Inflation gives the firm ‘paper’ profits on the sale of inventory stock which was accumulated when prices were lower. But since a firm must maintain a given level of inventories, such ‘profits’ are immediately eaten up by inventory replacement. Hence, such profits are not ‘real.’”Inflation always steals the benefits of devaluation.
Furthermore, inflation itself is a certain tax because capital invested is returned to investors (if they’re lucky) reduced in value. Basically you can tax capital gains in two ways; first through a higher rate that erodes returns, and second through devaluation which achieves the same. High capital gains rates surely dampened the ‘70s IPO market (and startups before IPOs), but the falling dollar’s role can’t be minimized.
Bartlett might reply today that inflation is non-existent, but if we measured inflation the way we did in the ‘70s when Bartlett knew it to be real, the admittedly faulty numbers calculated by our federal government would be very similar. Inflation was a problem then, it is today, and even though capital gains rates are historically low, the weak dollar has made the cost of investing very high on the way to a depressed market for startups.
To make simple what already is, the nature of startup companies means they account for a great deal of innovation that improves our lives, all the while creating jobs and great wealth. Sadly, company formation today is at the lowest point since the BLS began measuring it, and the answers for why are all in Bruce Bartlett’s excellent book, Reaganomics.
John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.