Despite all that has been written about the proposed tax restructuring being considered by Congress, there has not been much discussion about how it will affect the D.C. region’s technology community. This restructuring will dramatically affect our technology economy and we will need to adjust. Let me explain.
As things stand now, if the tax restructuring is adopted as proposed, a corporation’s income from operations will be treated much more favorably than individual income derived from a well-paying job. In addition, income from a passive investment in a business will be treated much more favorably than the current income derived from the owner who works in the very same business.
These changes will put many of our existing businesses and most talented individuals at a comparative disadvantage. As I have pointed out in other columns, our technology community currently skews very strongly towards owner-managed businesses that are structured to provide current income.
Simply reorganizing as a corporation will not be suitable for many of these owner-operated businesses. Many provide current income to owners, many of them running small businesses, that is used to support families. Some must be structured to provide current income to investors as well. In certain instances, licensing and government rules require that these businesses be structured as owner operated. For all of these businesses, their effective tax rates will be higher than a corporation would pay. Depending upon the size of the businesses and its profitability, this will create a tax disadvantage that could amount to hundreds of thousands if not millions of dollars of taxes.
On the other hand, the changes in corporate tax rates, and the favorable tax treatment for passive investing will be a huge opportunity for investors. They will benefit from better tax treatment on current income from investments as well on long-term capital gains. This favorable treatment will have two important effects. First, it will give passive investors a large new pool of capital to invest derived from the large tax subsidies they will be provided. Second, it will encourage business owners who have the option to trade current income for longer-term business value, since the tax rate on a sale of an interest in a business will be much lower than the rate on current income paid by the owner.
Another area where the proposed tax changes will have a big effect will be our universities. Changes in the tax benefits to be gained from research and development may shrink funds available for sponsored research. Changes in the tax treatment of research fellowships will discourage students who don’t otherwise have the ability to pay for their graduate degrees.
Our highly paid workforce will also see changes in their tax bills, due to changes in the tax deductibility of local and state taxes and mortgage interest. These changes will adversely affect our region’s ability to attract and retain highly paid technical talent when compared to competing regions. The higher pay our region’s employers can offer will become less appealing, if it results in higher taxes and participation in a housing market where valuations are constrained or falling due to the loss of current tax benefits for owners. Transportation, education and infrastructure challenges in our region will also become more expensive to solve, if they require additional local taxes to finance improvements that are doubly taxed.
Taken as a whole, our region is facing a large adjustment if the tax restructuring occurs. How adversely we are affected will be driven by whether we can make up for the negative aspects by creating enough new businesses that will be attractive to investors and corporate buyers. For many years, I have argued that our region’s future requires that we change the model we use for technology-based business creation. That need is now even more immediate.
It is ironic that many of the people who most avidly support these likely tax changes are the same people who have consistently stated that “government shouldn’t pick winners or losers.” Hard to see the revision of the tax code as anything other than that.
But that doesn’t mean we can’t adapt to the new rulebook and make our own future.