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A Better Way to Change Payroll Taxes

Payroll taxes are in the news. For weeks, President Donald Trump said he wanted to defer the collection of employee portion of the Social Security portion of the payroll tax in order to provide pandemic-related economic relief to workers. The Congress didn’t agree, so he issued an executive order to do just that on August 13. Much is unclear about how his order is supposed to work, and there are questions about whether it is legal. The Washington Post reports a “torrent of top employers [have]…joined the U.S. Chamber of Commerce in calling the president’s plan ‘unworkable’.”

All this prompts me to reprise an article I wrote in May 2017, Reduced Employer Payroll Taxes: A Direct Path to Job Creation. At the time, Trump had been in office a few months, both houses of Congress was controlled by Republicans, and income tax cuts were on the agenda.

The G.O.P. was arguing that one would spur job creation, and enough growth to pay for itself. That is, the drop in tax collections resulting from lower tax rates would be offset by an increase in collections due to greater economic activity. Treasury Secretary Stephen Mnuchin went further, suggesting that this could happen enough to reduce the deficit.

When Trump signed the Tax Cuts and Jobs Act into law, he predicted it would cause the economy to grow 6 percent per year, but growth was merely 2.2% in 2017, 3.2% in 2018, and 2.3% in 2019. Larry Kudlow, Director of the National Economic Council, envisioned an “investment boom,” but business investment grew modestly for just two quarters, then it dropped below what it had been before the tax cut.

The new law was proved to be a bad bet; it provided little benefit to most people, and substantially increased the deficit. The Congressional Budget Office projects debt held by the public will rise from 81% of GDP in 2020 to 98% of GDP by 2030—higher than any point since just after World War II.

In my 2017 article (and now), I argue that if the goal was job creation, it makes more sense to reduce the employer share of payroll taxes than to reduce income taxes. [Note: A 12.4% federal payroll tax funds Social Security and Medicare. About half the tax is paid by employees via payroll withholdings—the employer pays the rest. Self-employed individuals pay both portions.]

Trump’s executive order provides temporary benefit for employees; it defers their payment of their post-order 2020 payroll taxes until 2021. In contrast, I propose a permanent reduction in taxes employers pay when they employ someone.

Here is how they compare.

In 2019, $1.2 trillion was collected in total payroll taxes. Half of that—$600 billion—was paid by employers. https://www.statista.com/statistics/216928/us-government-revenues-by-category/ How do I propose to pay for a reduction in employer payroll taxes?

A combination of two new taxes:

A transaction tax on the non-original sale of equity securities—the transfer of stock from one shareholder to another. To be clear, that excludes new stock sold by a company. That is, no tax when a company raises capital, only when the subsequent ownership of its stock changes. The World Bank reports that $60 trillion in equity securities were traded in 2019, and that 38 percent of that—$23 trillion—was traded in the U.S. That indicates that a 1 percent transaction tax in would have generated $230 billion in 2019, enough to cut the employer payroll tax by 38 percent.
A 1% tariff on imported goods could paydown the employer payroll tax by another 4%. The Department of Commerce estimates the value of imported goods in 2019 at $2.5 trillion; a 1% tariff would have generated $25 billion.

The World Bank figure on stock trading excludes private market sales between investors, as well as acquisitions. A one percent tax on the value shareholders receive on those transactions by U.S. shareholders could reduce the employer payroll tax further than 42.5 percent. Alternatively, it could be used to reduce the burden of Social Security obligations on the future workforce, or to help reduce student loan debt.

The overarching rationale for my proposal is that the U.S. economy is transitioning from a world in which it was the unquestionable dominant player, to one where it is less so. By making it less expensive for companies to create or preserve domestic jobs, my proposal makes U.S. labor more competitive without reducing pay or benefits.

That buffers the effect of three trends that have eroded the prospects for U.S. workers over recent decades:

TECHNOLOGY It has made it easier to move work. Initially, within a workplace, then outside a company; eventually, to anywhere in the world.
ECONOMIC THEORY The idea that management’s principal job is to maximize shareholder wealth emerged in the 1970s and gained traction in the 1980s. A derivative economic theory is that companies should focus on their core competencies and outsource the rest. Together, they led work to be moved to lower cost locations; first from the Rust Belt to the Sun Belt, then to other countries.
LARGER SUPPLY OF LABOR. The end of the Cold War encouraged inward-looking countries to adopt an export mentality. That enlarged the supply of labor available to perform work that might have otherwise been performed in developed economies.

These trends bolstered returns on investment and so, those whose wealth is largely derived from the return on capital have done well. On the other hand, these trends weaken the return on labor—the existence of good jobs, with appealing prospects for advancement. The result is that people who rely on the return on labor are increasingly anxious, and less optimistic about the future.

How can the U.S. improve the return on labor? It will take time to develop and implement ideas. Absent progress, pressure will mount on the economic theories that guide corporate decisions.

That’s the situation we are in.

One thing, however, is clear today. The payroll tax structure creates disincentive for employers to have U.S. workers. For labor-intensive companies that are unprofitable or marginally profitable, it makes it harder to survive, let alone thrive. For all companies, it makes it tempting to offshore work or automate it, and to import goods rather than build them, or buy them from domestic manufacturers.

A lower employer payroll tax can abate that.

A tariff reduces the advantage of workforces with low wage rates, and/or weak labor and environmental standards. From a competitive standpoint, it might only be sustainable for a decade. Nonetheless, it can help ease pressing needs while the economy is in transition.

A transaction tax on the resale of securities is more controversial. It will cause some to gag—but it makes sense because:

The U.S. has competitive advantage in capital markets. It is due to investor confidence, which largely flows from respected and enforced legal and accounting practices, as well as established institutions. A transaction tax contributes a return on the societal investment that maintains that investor-friendly environment.
The risk that a de minimis transaction tax will lead much stock trading to move offshore seems slight. A parallel may be the “sin taxes”—high taxes on tobacco and alcohol products; they have less effect on sales than one might expect.
Stock trading does not create value—a stock that changes ownership multiple times a month is not inherently worth more than one that does not. Value creation comes from the design, manufacture, and distribution of products and services—the type of activity that a reduction in employer payroll taxes encourages.
A tax on stock trades help ease a real problem—the relative cost of U.S. employees—without creating a comparable problem in the capital markets.

The Stanford Social Innovation Review publishes excerpts from The Fairshare Model

The mission of The Stanford Social Innovation Review is “Informing and inspiring leaders of social change.” As part of that effort it publishes excerpts for the top books on social innovation https://ssir.org/book_reviews.

And I’m pleased to report it decided to include The Fairshare Model with the heading “Reimagine Capitalism at the DNA Level.”

What is Venture Capital, really?

Venture capital investing is popularly construed to be the exclusive province of institutions and wealthy individuals who invest in private offerings. Some define it more granularly, as an investment by a VC fund, and call investments before that “seed capital.” I’ve seen references to “pre-seed capital,” which refers to capital provided before that.

The apparent reason for such distinctions may be the idea that an investment by a VC firm “legitimizes” a startup. I think it has more to do with valuation—until a “Big Dog” establishes one, no one really knows where to set it. The fact is that no one knows how to reliably set a valuation for a startup, but that’s a different matter. The question I focus on here is “Is venture capital raised in initial public offerings?”

Recently, I spoke at the Global Capital Summit put on by F50 at Stanford University, which focused on the changing nature of venture capital.

Speakers reported that companies were raising larger amounts of money at a given stage than before.

Also, that VC funds were increasingly investing after a company was generating revenue—so angel investors are providing a larger proportion of funding for startups that are at a pre-revenue stage.

These developments inspired observations like “pre-seed is the new seed” and “series A is the new series B.” No one said that investments made by angels wasn’t “venture capital,” but I’ve heard it suggested elsewhere.

One thing that hasn’t changed is the view—in Silicon Valley, on Wall Street, and elsewhere—that an IPO does not constitute another raise of venture capital. Indeed, an IPO is commonly seen as an “exit”—a way for pre-IPO investors to liquidate their position by selling shares in the secondary market to public investors.

To me, this traditional point of view is narrow. I define venture capital broadly—as an investment in a venture-stage company. A venture-stage company has these risk factors:

Market for its products/services is new or uncertain.
Unproven business model.
Uncertain timeline to profitable operations.
Negative cash flow from operations; which means it requires new money from investors to sustain itself.
It expects to continue to have negative cash flow from operations; its future depends on its ability to raise more money later.
Little or no sustainable competitive advantage.
Execution risk; the team may not build value for investors.

These characteristics sound familiar, don’t they?

That’s because they routinely appear as risk factors in IPO prospectuses.

A foundational concept for the Fairshare Model is that capital provided to a venture-stage company is venture capital regardless of its source; it doesn’t matter if it is supplied by wealthy or average investors. Ergo, it doesn’t matter whether the money is raised in a private or public offering.

Put another way, whether or not an investment is venture capital ought to be a question of “What”, not “Who.” That is, the question should be decided based on whether a company presents venture-stage risks, not by who invests.

The difference between these two views of venture capital is depicted below.

One could argue that this diagram should include investors who invest in a venture-stage company in the secondary market. It doesn’t because they buy stock from existing shareholders, not from the company itself. To me, a venture capital investor provides capital directly to a venture-stage company.

The Big Idea behind the Fairshare Model is to adapt the ideas behind a modified conventional capital structure—the VC Model—to an IPO. [The three types of capital structures for equity are described in articles listed below.]

Without price protection, the financial returns posted by VC and private equity funds over past decades would not have been as impressive as they have been. By adapting the price protection concept to venture-stage IPOs, the Fairshare Model reduces valuation risk for public investors. That makes it more likely that they will make money when they invest in a company with high failure risk.

Making it more attractive for public investors to invest in companies with high failure risk is not as crazy as it sounds. Since the 1980’s, venture-stage companies have contributed more to economic growth and job creation than those who were in the Fortune 500.

A New Way to Structure Ownership in a Venture-Stage IPO—The Fairshare Model

Several startups will raise venture capital via a public offering this year. My new book presents a idea for how to structure an IPO for a startup—be it a highly-valued “unicorn,” a less-anticipated “horse,” or a new “pony.” It is called The Fairshare Model: A Performance-Based Capital Structure for a Venture-Stage Initial Public Offerings.

In a Fairshare Model IPO, there are two classes of stock—both vote but only can trade. IPO and pre-IPO investors get the tradable stock. Employees get too, for performance-delivered as of the IPO. For future performance, employees get a non-tradable stock that converts to the tradable stock based on milestones described in the company’s offering document. It protects IPO investors from overpaying for a stock.

Traditionally, IPOs use a “conventional capital structure,” while private offerings with valuation-savvy investors use a “modified conventional capital structure.” Both are conventional in the sense that each sets a value for company’s future performance when the stock is sold. The modifications are deal terms like price-ratchets and liquidation preferences that protect investors from overpaying for a position. Thus, such terms provide investors in a company that uses a modified conventional capital structure with “price protection.”

Price protection is a terrific idea—without it, venture capital and private equity funds would not be nearly as profitable as they have. The problem is that price protection is not provided to IPO investors.

The Fairshare Model changes that with an unconventional approach—it places no value on future performance when an IPO occurs. Rather than pay upfront for potential, investors pay for actual performance via dilution of their percentage ownership of the outstanding tradable stock.

Valuation risk is the risk that new investors overpay for a company’s future performance. The following chart illustrates how valuation risk varies based on the capital structure used.

Valuation risk is highest for investors with a conventional capital structure, the type routinely used in IPOs and in some private offerings.
It is considerably less with a modified conventional capital structure—which is why VC and private equity firms require one when they invest in a private offering.
Remarkably, valuation risk is near zero for IPO investors when the Fairshare Model is used.

To be clear, the Fairshare Model is just an idea at this point—companies will not use it for their IPOs until a critical mass of investors express interest in it.

The next five charts drill-down on these assertions about valuation risk. The first one presents four basic characteristics about how companies raise capital.

It indicates that:

Investors provide two kinds of capital—debt or equity.

2. There are two ways for a company to raise capital—a private offering or a public one.

Note: only accredited—that is, wealthy—investors may invest in a private offering, but anyone may invest in a public one.

3. Companies that raise capital are either established, or venture-stage.

Established companies have an operational track-record and profitable.
Venture-stage companies are startups or companies in a turnaround situation—they are rarely profitable, and need infusions of fresh capital always hard to reliably value when an equity investment is made.

4. Deal structures either provide price protection or don’t.

The second chart shows how a conventional capital structure is positioned. On occasion, it is used to raise equity capital in a private offering—usually when the investors are unsophisticated. It is routinely used in public offerings, however. Also, it is used by both established and venture-stage companies and—significantly—it offers investors no price protection.

The third chart shows how a modified conventional capital structure is positioned. It is used to raise equity capital in a private offering for venture-stage companies using deal structures that provide price protection. I sometimes refer to it as the “VC Model” because VC funds use it when they invest in a company.

The fourth chart has the Fairshare Model—it is for raising equity capital in a public offering for venture-stage companies, using deal terms that provide price protection.

The fifth and final chart has the key point—the Fairshare Model applies the VC Model to an IPO.

Here are ways to defer valuation risk in an equity investment that do not deserve to be listed above:

Convertible note: When the investment is made, it is structured as debt, not equity. Should a promissory note convert to stock, it is structured in one of the forms above.
“Simple Agreement for Future Equity”: A SAFE is not listed because the investment is structured as debt or as a deposit—it is not equity.
“Keep It Simple Security”: A KISS is not listed above for the same reason a SAFE isn’t.
Digital token (ICO, STO, etc.): Tokens are not listed because they rarely convey an equity interest—they typically represent a contribution or a deposit. Also, they don’t provide a way to deal with valuation that isn’t addressed a conventional capital structure, a modified conventional capital structure, or the Fairshare Model.