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Kickstarter and taxation

18 Jun 2012

Matthew Yglesias says Kickstarter will be disastrous for tax revenues, make it impossible  to fund the welfare state, and lead to a collapse of civilization as we know it. Felix Salmon says that’s not the case because banks pay no taxes anyway:

What Matt misses here is the tax implications of the two models. I deposit money in a bank account, and get some derisory rate of interest on it: I’m not going to be paying any significant taxes on that income. The bank lends the money out to Neal Stephenson or to Pebble — but because these are risky startups, a lot of them fail, and the bank has to write off a lot of those loans. Overall, its profits on that lending are small — and as we all know, banks never pay much in the way of taxes in the first place. … Neal Stephenson and Pebble only have to pay taxes once they’ve paid back the loan and started making profits.

In the crowdfunding model, by contrast, when Kickstarter writes a check to Neal Stephenson, that’s Neal Stephenson’s income, right there, and he has to pay taxes on it. …  And remember that Kickstarter, too, pays income taxes on its own profits.

But a lot of saving happens through pension plans that invest in VC funds, and a lot of investing happens not by banks in the form of loans, but by venture capitalists and other investors through equity investments. It’s true that VC funds may not generate high returns, but that’s probably because the venture capitalists themselves make all the money. Capital still earns a return, even if it’s siphoned off by the money managers, and that return is taxed.

Matt’s larger point is that with the popularity of crowdfunding, investors are more willing to sacrifice a monetary return in exchange for the benefits of supporting awesome projects, and entrepreneurs are more willing sacrifice wages and entrepreneurial rents in exchange for being able to work on projects they love. Since less money changes hands, there is less income to tax. To generate the same tax base, entrepreneurs would have to take on more projects or work harder. But one possible consequence of the crowdfunding future is that you will work less because you are more happy with the projects you do take on.

Here’s a simple model to explain what’s going on: the crowdfunding economy consists of one consumer and one cultural entrepreneur. The consumer has $100 post-tax to save in this period, and will consume it in the next period. The entrepreneur has a boring project that will generate a total return of $40; let’s say the consumer/investor demands a return of 10% and receives $10, while the entrepreneur receives $30.

In the crowdfunded economy, a new awesome project is possible whose value added is $60, but only $30 of that is in the form of consumption good. The rest comes from the general awesomeness of the project and because of a better match between investor and project. Let’s say that the consumer/investor and cultural entrepreneur each capture $15 of the nonpecuniary benefit. Then the consumer/investor may demand a return of 0%, and the entrepreneur is satisfied with wages of $30. Everyone involved in the transaction is better off, but there is less income that can be taxed. (The entrepreneur’s wages of $30 are still taxed, but there is no $10 profit to tax.) Even worse, the consumer/investor may decide to work less because he gets so much enjoyment from funding Kickstarter projects.

We tax value added, and crowdfunding makes less of the value added taxable.

Felix says “I’m just spending money, which is a different thing entirely. It’s consumption, and it’s taxable.” It gets a little tricky here and I’m not certain of the implications of my model. Crowdfunding may cause entrepreneurs to lower their prices (less tax revenue), but lower prices and better matched projects may cause consumers to spend more (more tax revenue). On the other hand, a quick look at the Kickstarter profiles of project sponsors reveals that a lot of the entrepreneurs are themselves backers of other Kickstarter projects, and if monetary entrepreneurial rents fall because non-monetary rents increase, that will in turn reduce investment.

Taking into account all of these factors, you could very well end up in an equilibrium where overall welfare is increased, but there is less taxable income.

(I have a vague recollection that Tyler Cowen explains this much better in the first few chapters of The Great Stagnation. Think of Kickstarter as tending to increase welfare but lower GDP.)