Success of Wall Street and corporate looters will lead to inability of U.S. to support entrepreneurs?

Taxes are being debated this month on Capitol Hill and one factor in the debate is the question of whether the government’s appetite for funds (approximately 45 percent of GDP; why it should require nearly half a country’s GDP to maintain roads, defend against invasion, etc. is a separate issue) can be satisfied by soaking the rich with higher tax rates. Economists generally argue against high tax rates because they reduce the efficiency of an economy. Rising income inequality in the U.S., however, has given a lot of ammunition to those who would ignore conventional economics wisdom.

Let’s look at the source of the increased income inequality, though. A lot of researchers (sample) have found that much can be attributed to a single industry: financial services, i.e., Wall Street. We’ve set up a system where a lot of money managers place bets on behalf of pension funds and other large investors. The winners get to keep 20 percent of the winnings on these multi-billion-dollar bets. The losers get paid 2 percent of the total fund size (actually so do the winners, as whipped cream on top of the 20 percent ice cream!). If the bets are placed randomly and there is a reasonable amount of volatility in the market, basic probability ensures that this system will result in enormous salaries for tens of thousands of workers.

Corporate management for public companies is set up the same way. Managers place bets on behalf of the shareholders. If the bets work out well, the manager takes home hundreds of millions of dollars. If the bets don’t pay off, the manager sticks the shareholders with the losses and contents him or herself with merely tens of millions of dollars in compensation (see Carly Fiorina, for example, or Robert Nardelli, who took approximately $500 million from Home Depot shareholders, or Stan O’Neal, who bankrupted Merrill Lynch after siphoning off hundreds of millions for himself). [Shareholders have little control over public company boards or management, due to SEC regulations and are more or less powerless to stop a CEO and board from looting out the enterprise that they nominally own.]

Voters and politicians look at Carly Fiorina, Robert Nardelli, and Stan O’Neal and say “these folks didn’t create anything, but benefited from a system set up by the government; they should pay more taxes to support the government that enabled them to become rich at shareholder expense.” The most direct example of this comes from England, where the government installed a 50 percent tax on financial industry bonuses (story).

Unfortunately, the clamor for higher taxes on these folks who took no personal risk, destroyed a lot of jobs, and shrunk the U.S. economy inevitably ensnares America’s entrepreneurs. Just as the TSA cannot distinguish between an 85-year-old Minnesota-born grandmother and a 23-year-old Islamic Jihadist whose own father had ratted him out to the CIA, the IRS has no way of charging Stan O’Neal, a guy who came into a 100-year-old company and destroyed it, a different tax rate from Ken Olsen, who founded Digital Equipment and created tens of thousands of jobs and a massive stream of exports that helped the U.S. economy grow from 1957 through the early 1990s when minicomputers succumbed to the PC.

The U.S. political system moves very slowly, especially now that Congress and the White House are no longer both controlled by one party. So we don’t yet know what changes to the tax code and other policies will ensue from the average voter watching his own wealth shrink while Wall Streeters and public company executives get richer. But I’m wondering if the result will be that the U.S. becomes uncompetitive as a place to set up new companies. Given a democracy, could it be that having a very successful financial services sector inevitably means a poisoned environment for entrepreneurs? England provides us with an example of a mature economy in which it is great to be a banker, but entrepreneurs are better off emigrating. (I compared the U.S. to the U.K. on October 1, 2008 and January 28, 2009, supplemented by a Mancur Olson piece on March 16, 2009.)

15 Comments

  1. Attikus Robinson

    December 1, 2010 @ 5:00 pm

    1

    I’ve been told (and believe) the most important factor for determining entrepreneurship are the laws (read: red tape) that surround business creation. It’s my understanding is that THIS is the main limiting factor for creating businesses in Europe, while it’s relatively easy to do so in the US.

    As for the financial sector, it’s a massive brain drain for smart people being unproductive. I don’t know how you protect against the smartest guys from MIT/Stanford/etc taking jobs there and creating fluffy financial constructs that don’t actually mean anything at the end of the day, and lose a lot of people money. If you have a PhD in physics or math, what sounds more attractive — scrounging for professorship somewhere or getting paid hundreds of thousands (if not millions) on wall street spinning BS.

  2. philg

    December 1, 2010 @ 5:07 pm

    2

    Attikus: While it may once have been true that the U.S. had an advantage in reduced bureaucracy, it is no longer true according to the data in http://www.heritage.org/index/explore (rank by “business freedom”; go to the FAQ if you want to see the definition). The U.S. does not rank especially high, e.g., negligibly better than the notoriously bureaucratic Germany and much lower than “socialist” Sweden and Denmark. Here in Massachusetts, at least, the employment of a single person plunges the new business into a bureaucratic hell that never ends (e.g., five checks per month to pay taxes to various agencies).

  3. Kato

    December 1, 2010 @ 5:48 pm

    3

    Phil,

    That fifth paragraph nails the issue perfectly. It is so hard to convince my friends that higher tax rates and new laws inevitably produce a net punishment for honest businessman that are really trying to create something. In their fervor to support punishment of corporate looters, they forget about the honest people that get hurt by many of the govt’s rules and soon to be new rules.

  4. Matt

    December 1, 2010 @ 5:57 pm

    4

    “why it should require nearly half a country’s GDP to maintain roads, defend against invasion, etc. is a separate issue”

    Except that it’s not, because it doesn’t. What requires nearly half the country’s GDP is the insane array of transfer payments, by which Alice lives at the expense of Bob, who lives at the expense of Carol, who lives at the expense of Dave, who in turn lives at the expense of Alice.

    It’s a wonderful scheme for the bureaucrats, who get to take a cut of the action every time money changes hands in this shell game. It’s a wonderful scheme for the politicians, who can ensure continuing support for the programs (and thus for themselves) by threatening to cut any dissenters out of the “benefits” while keeping them intimately involved with paying the costs.

    For everybody else? Not so much.

  5. Attikus Robinson

    December 1, 2010 @ 6:12 pm

    5

    True, while the US isn’t at the top of the “business freedom” category, in absolute numbers, it’s still only about 8% worse than the “best” (assuming such a thing can really be determined). Given the US’s size, resources, etc it probably only really needs to be near the top and not at the top.

    A huge part of entrepreneurship is getting workers, who ultimately drive the business. In this category (“Labor Freedom”), the heritage.org data ranks the US very high (#3 on the list). Perhaps this is a dominating factor in entrepreneurship too? Note: the influence of this as a factor is probably somewhat limited. We share a top 10 ranking with several countries that are much less well off than the US (Georgia, Tonga, Rwanda, etc).

  6. philg

    December 1, 2010 @ 6:17 pm

    6

    Attikus: My point was that it isn’t safe to assume that there is something so great about intangible factors in the U.S. that entrepreneurs will thrive and choose to stay here in the face of higher tax rates than in other countries.

  7. thrill

    December 1, 2010 @ 8:57 pm

    7

    Philip, you’ve oversimplified your complaints about the financial sector to the point that it is misleading. The 2%/20% number is certainly the rule of thumb for hedge funds and venture capital funds, but it’s critical to note that participation in such funds is, first of all, restricted, and second, voluntary, and third, in regards to pension fund participation, limited.

    First, hedge fund managers only accept participants that have a certain high level of wealth. This is mostly because of the SEC not allowing the average Joe to either enjoy the aggressive investment style and historically well above average returns, for their own good of course. The government does not treat adults like adults. That said, most hedge fund managers have little interest in managing 1000 tiny investments – it’s too much work.

    Second, no one requires anyone to participate in any alternative investment. People used to recognize that reward for risk was a good thing, but now it seems easier to whine that some people get rich by taking risk. Those participating in financial investment are free to put their money elsewhere if they think the fund manager takes too much for himself, or if they think they can do it better themselves then they can invest themselves.

    Third, pension funds that place capital with hedge funds are not placing their entire portfolio with them, but an amount that the pension fund manager and other controlling authorities have deemed acceptable.

  8. philg

    December 1, 2010 @ 9:08 pm

    8

    thrill: I’m not “complaining” about the financial sector. Some of my best friends are hedge fund managers! (well, one is anyway, and I think he does a good job for his investors) The point of my original posting was that, regardless of whether you think the financial services sector adds value to the economy, there are a lot of voters who don’t think that it does. Therefore the obvious wealth of individuals in financial services makes confiscatory taxes seem like a great idea to folks who don’t understand how the hypertrophied investment banks are building a brighter future for all Americans.

    [Separately, I don’t understand the relevance of your pointing out that pension funds don’t put 100 percent of their assets into one hedge fund or that participation in hedge funds is voluntary. The structure of most Wall Street institutions, hedge funds included, is such that random choices plus volatility will lead to extreme wealth for a lot of individuals, even if those individuals all did nothing more than throw darts at a list of possible investments in order to choose. It is this extreme wealth that makes average voters irate and gets them into a “we need higher tax rates” mood.]

  9. Vince

    December 2, 2010 @ 9:47 am

    9

    It’s interesting that you mention DEC, Ken Olsen and 1957. According to this Wikipedia page – http://en.wikipedia.org/wiki/Income_tax_in_the_United_States – the top tax income tax bracket in 1957 was 91%.

    Regarding the politics of the era, there is some interesting information on this page: http://en.wikipedia.org/wiki/Presidency_of_Dwight_D._Eisenhower.

    While his 1952 landslide gave the Republicans control of both houses of the Congress, Eisenhower believed that taxes could not be cut until the budget was balanced. “We cannot afford to reduce taxes, [and] reduce income,” he said, “until we have in sight a program of expenditure that shows that the factors of income and outgo will be balanced.” Eisenhower kept the national debt low and inflation near zero.

  10. philg

    December 2, 2010 @ 10:23 am

    10

    Vince: Ken Olsen and his investors were never subject to a 91 percent tax on their primary sources of income. They would have paid long-term capital gains tax (http://www.data360.org/dsg.aspx?Data_Set_Group_Id=475 shows that the top rate was 25 percent in 1957). Things that worked in the more or less closed economy of the 1950s do not necessarily work in the globalized economy of 2010. In 1957, for example, it was not possible to start a business in China. Most people in India did not have telephones, much less Internet. The U.S. no longer has the luxury of being the only game in town.

    [And even when we thought we were the only game in town, our growth in the 1950s, 60s, and 70s was anemic compared to other industrialized nations; see my reference to Mancur Olson’s data in http://blogs.law.harvard.edu/philg/2009/03/16/how-rich-countries-die/ ]

  11. Stephen

    December 2, 2010 @ 10:27 am

    11

    I don’t think it’s a coincidence that the financial services sector is one of the most highly regulated, and also one of the most profitable, sectors. Much of the brainpower hired by Wall Street goes towards finding the holes in the regulations, while the thicket of regs themselves impose huge barriers to entry for new participants.

    And I think it’s beyond question that the SEC have completely failed to regulate corporate America. Corporate law should be radically simplified around the principle that the shareholders own the company, and should therefore have absolute power over the directors whom they hire to run the company for them. The law should also greatly encourage shareholder activism and activist fund management.

  12. philg

    December 2, 2010 @ 10:40 am

    12

    Stephen: http://online.wsj.com/article/SB10001424052702303864404575572394191997292.html is a good example of what you’re talking about. A town in Florida issues municipal bonds, which are tax-exempt, to fund a private company’s construction of airplane hangars in other states. This kind of activity accounts for 30 percent of the muni bond market, according to the WSJ. Of course, enormous fees can be collected by financial services firms smart enough to turn a taxable bond into a tax-free bond.

  13. david

    December 3, 2010 @ 9:56 pm

    13

    … It is a pity that although Patterson gives us a broad survey of quant finance, he devotes little space to the bigger question: are developments such as the mathematization of markets and the flow of top brains to financial activities good for society?

    http://infoproc.blogspot.com/2010/12/how-other-half-lives-quants.html

    Personally, I don’t have much to add to the argument other than this link from one of my favorite RSS feeds.

  14. Jim

    December 4, 2010 @ 11:19 pm

    14

    Is a flat tax without deductions the answer? If it’s not, who stands to lose?

  15. Phil Sugar

    December 28, 2010 @ 6:37 pm

    15

    Catching up on reading.

    You bring up a great point….one that I’ve been talking about for a while.

    Things have really gotten out of control at public company compensation (at the top). With technology, it really should be going the other way. It should be possible for me to vote through an internet portal on my mutual fund for the compensation of the companies that I own. Instead you have grossly overpaid money managers not caring about the compensation of top management.

    Did Bob Nardelli’s half a billion dollars help the shareholders? Could it have been given out as a dividend or better yet gone to make employees not bitter (I can tell you because I do a ton of projects, there were some bitter people under his regime serving customers as cost cutting translated into making sure you cut employee hours)

    If you owned 50% of my business, there is no way you would let me take grossly outsized pay and leave you with nothing. We would have a vote and see what I got paid. But the collective of people that own Home Depot Stock certainly got screwed.

    I don’t begrudge the Bill Gates of the world one bit of their fortune.

    I have tons of classmates/roomates/fraternity brothers on Wall Street. They are some of the smartest book smart guys I know. During the boom their pay was unbelievable more than I want to ever have in a lifetime, during the bust they were hired to clean up their own mess. Again I don’t mind if you are in a partnership and you make a ton of money when times are good, but own the losses when times were bad. If you don’t own the losses when you write a letter telling me the American Taxpayer you made $100M for AIG that is a big fat lie. AIG shareholders made $100M because of the risk they took.

    This was really impressed on me when I called up a former roomate to talk about the whole housing bubble right in the mist of the boom He was in charge the bundling, securitizing, and selling of mortgages for a world wide top ten bank. He was fortunate enough to be doing it for the S&L crisis of the late 80’s and had risen to the top.

    I had just sold a house and nearly threw up at the closing table when I saw the buyer’s financing. She was stretched to the limit, in hoc on everything and in no way could afford the house I just sold her. She was a single mom that was a school teacher and I thought when I sold her the house she must have had a mother-loving big down-payment from somewhere. Literally, she got a check on closing and was going to use that to buy some furniture and “maybe pay down some of that credit card debt”. I asked to get up from the closing table….the two brokers, the lawyer, and the Closing Company rep, came out to talk. What was the problem? I said I can’t watch a train wreck. They said she was great, better than most. I said you see worse than this? All the time, no issue, bundle it, resell it, its all good. I went along.

    I asked him….you bundle this stuff up and call it AAA??? Better than most companies? Yup, that’s what the models say. WTF??? Seriously? There is no way this thing isn’t going to blow up, no way. He said, yup we bundle it up, slice and dice it into tranches and sell it. I remember telling him….that is like me going around the neighborhood picking up all the different dog shit into a bag and selling it as roses, just because it wasn’t only my dog didn’t make it not stink.

    He said oh well, and we hung up. I know his bonus that year was in the high eight if not low nine figures.

    Here is another quote from the NYTimes I can’t figure out….if I did this wouldn’t it be called gambling, how is this a derivative?

    Pershing also owns an additional 14.9 percent interest in Landry’s through cash-settled derivatives. These derivatives track the shares of Landry’s, but Pershing never owns the actual shares. Instead, if the shares go up, the banks that sold them simply will pay out the gain to Pershing. If the shares go down, Pershing will pay the loss to the banks.

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