Tax Credits gone Awry?

There no question that the life blood of any business is capital and cash flow; and this is especially true for emerging small businesses. When starting up a new venture there are myriad expenses with little or no revenue coming in, making access to adequate capital essential to getting a venture off the ground. In fact many good ideas never get off the launch pad due to a lack of access to capital. And once the business is launched, cash flow becomes “king”, as expenses inevitably outpace revenues throughout the initial survival stage of the business. It is during this survival stage in the business development cycle where managing the rate in which funds are being expended vs. sales revenue coming in is key to the business’s viability.

When it comes to capitalizing a business there are two types of capital that entrepreneurs rely on: debt capital and equity capital. We are all familiar with debt capital as it is the strategy that most of us use to finance our homes and cars. Banks and other lenders are more than willing to provide us with loans as long as we have sufficient collateral or other demonstrated means to pay back the loan with interest. But obtaining sufficient debt capital is often difficult when a small business is starting out with little equipment, real estate or other forms of tangible collateral that a lender can count on. On the other hand, equity capital is a form of investment where a financier provides outside funding in exchange for a partial stake in the emerging business. Many call this type of investment “patient capital,” as the business owner does not have to begin paying back the funds, but rather as the business grows and prospers, so does that equity stake in the business. Unfortunately, most of the financiers that make such equity investments are not typically interested in very small start-up firms as the risks are often disproportionately high in relation to the reward. Accordingly, those individuals and equity firms that choose to make investments in such start-up or early-stage companies are often called “angel investors.”

In an effort to encourage more angel investments in Minnesota the state legislature passed a bill in 2010 establishing an Angel Investment Tax Credit program. The program, which began in the latter half of 2010, requires qualified investors seeking to make such investments, as well as qualified businesses wishing to receive these investments to register with the Minnesota Department of Employment and Economic Development (DEED). The reward for such compliance with the program is a refundable tax credit to the investor equal to 25 percent of the investment.

According to a recent legislative report it seems that the program is performing as intended. In 2011 there were 623 individual angel investors certified by DEED, of which 563 made an investment in a certified business, along with 21 certified investment funds, all of which made an investment as well. As a result in 2011, 113 qualified businesses received investments totaling $63.1 million through the program and $15.8 million in refundable tax credits were issued.

While most would consider the program a success, others have concerns. As expected, the overwhelming majority of investments were made to businesses located in the 7-county Twin Cities region. In fact of the 113 firms receiving investments in 2011, only 11 were located outside the Twin Cities; 10 in southern Minnesota and 1 in Duluth. As a result of this apparent geographic inequity, a bill was drafted this session increasing the size of the refundable tax credit to 40 percent for investments made to businesses located in greater Minnesota. But is this really a good idea?

While few are more sympathetic to the concerns of rural Minnesota communities and businesses than I, at the same time I have always believed that smart equity investors make their investments in good companies regardless of their location. And while the opportunity to learn about such good companies is certainly easier if they are located in the Twin Cities area, maybe the appropriate response is for DEED to simply work harder at showcasing these investment opportunities in greater Minnesota. But is increasing the tax credit to 40 percent the answer?

Personally, I can’t help but think of a 40 percent refundable tax credit as the taxpayers of Minnesota subsidizing almost half of a private investor’s total investment without receiving any direct return on our investment. Can we even call this private investment anymore? Further, the program does not limit qualified investors to be Minnesotans. So hypothetically, an out-of-state investor who has no tax liability in Minnesota, and who makes a $100,000 equity investment in a rural Minnesota company will simply get a refund check for $40,000. Really?

Recently I was reading the remarks of Mankato’s city manager Pat Hentges in the Mankato Free Press, as he was reflecting on the strong employment growth and business development his city has experienced. Hentges noted, “The days of wielding all these financial incentives for getting companies (to locate here) is past.”

Well … maybe not everywhere.

Spring is a Time for Optimism

It sure felt like spring was in the air when the February jobs report was released showing an increase of 227,000 jobs. While that was a bit higher than most analysts expected, what actually was most impressive was that February was the third consecutive month in which the economy created over 200,000 jobs. As any statistician will tell you, one occurrence is often perceived as an episode; two back-to-back occurrences give you a reason to pause and observe; however three consecutive occurrences is defined as a trend. And while this continuing upward trend in jobs is not that steep, it appears to be spreading a great deal of optimism.

What was equally exciting to see was that in addition to the higher than expected job growth in February, the economy simultaneously witnessed an increase in the employment participation rate. In other words, people who had previously been sitting on the sidelines unable to find a job in the past are now encouraged to once again join the workforce and start looking. The fact that several hundred thousand Americans re-joined the workforce and the overall unemployment rate still remained steady at 8.3 percent is a good sign. And lastly, amid all this optimistic news it was also reported that average weekly wages increased as well. Having all of these indicators trending upward at the same time gives one reasons to hope.

Here in Minnesota the trends and the optimism are equally on display. The January jobs report indicated that our state economy added 15,500 jobs and the state unemployment rate dropped to 5.6 percent; more than 2.5 percentage points lower than the national average. Over the past year the state economy has now added a “net” 29,000 jobs. The strength of the state’s private sector was substantial when you take into account the continuing loss in government jobs during the same period of time. For example, in January the private sector actually created 17,200 new jobs, while government shed 1,700 for an overall net gain of 15,500. These contradictory trends have been quite consistent throughout the year with the private sector actually creating close to 37,000 new jobs in the past year, while government agencies shed a total of 7,900 jobs. And while one could argue that the loss of government jobs seems to be slowing down the overall jobs recovery, one cannot deny the fact that in the fourth quarter of 2011 Minnesota’s private employers reported close to 50,000 job openings; an increase of 47 percent from the same quarter the year before. Without question Minnesota’s private sector is both growing and gaining traction.

The housing market in Minnesota has been weak for years and has created a significant drag on the economy. But now even the housing market seems to be trending in a more positive direction bringing a bit more optimism for 2012. Realtors report that the number of homes receiving offers continues to rise, while the number of new listings entering the market declines. And while the average price of homes has not significantly risen, it is fair to say that the continuing decline in the average price of homes seems to have bottomed out and may be in a position to increase from this point forward.

Locally here in south central Minnesota, the economy actually has been quite robust. While the Mankato/North Mankato metropolitan area typically doesn’t receive much statewide attention, some might be surprised to learn that over the past year the Mankato/N. Mankato area has outpaced the all other metro areas in terms of job growth. In fact in the past year jobs grew at a rate of 3.6 percent in the Mankato area. Not that impressed? Well over the same period of time jobs in the Twin Cities metro grew at 1.1 percent; in Rochester the rate was 0.2 percent; and in Duluth net jobs declined by a rate of -0.9 percent. With that as a reference, how does 3.6 percent seem now?

Let’s remember that spring is the time of year that always brings out the optimist in all of us; but this spring the economic optimism may well be warranted. At the same time one must be careful not to be unrealistically optimistic. The recent February forecast of a $323 million budget surplus is a good example. While a multimillion dollar surplus is always a good thing, let’s remember that this surplus was created as a result of reduced government spending, not because of a fast-growing economy. In fact since the November forecast the combined revenue increase as a result of income, sales and corporate income taxes was a very modest $45 million, or an increase of 0.2 percent.

So while the economic recovery continues in Minnesota and across the nation, let’s remember that the recovery can’t afford any sudden jolts. And while some may imagine jolts such as a natural disaster or unexpected geo-political events, it also includes unwise tax and economic policies designed to speed up the recovery. While it’s hard to admit, sometimes the smartest thing a policymaker can do is to sit back and just let the economy continue its course.

The Myth of the Job Creators

Every decade or so a new a word or phrase becomes so popular and so over-utilized that it is rendered virtually meaningless through its overexposure. In fact, for much of the last decade the word "Entrepreneur" seemed to fall into that category. Captured by the outstanding success of people like Steve Jobs, Jeff Bezos, Bill Gates and Mark Zuckerberg, Americans, led by the popular and business media began to characterize the entrepreneur as a tech-savvy, risk-taking, swash-buckling savant of a business person. As a result of this national obsession on entrepreneurship, colleges and universities began offering degrees in entrepreneurship, policymakers passed legislation to facilitate greater entrepreneurial behavior, and even local communities started looking in the mirror trying to assess how "entrepreneurship-friendly" they were. At the same time it became evident that the young son who put up his capital to purchase and expand his father's local hardware store; the farmer who takes financial risks every day; or the local business person who quietly, but successfully owns and operates a small manufacturing plant are just not sexy enough to wear the label "entrepreneur."

Now the latest phrase being put on a pedestal is the "Job Creator." And not surprisingly, given the deep drop in employment since the beginning of the recession, politicians are trying to do everything they can for this new category of economic hero. In fact, in today's highly-charged political environment, it seems like every single piece of legislation at the state and federal level must be labeled as either beneficial or detrimental to the job creators. But who exactly are these job creators and why are they so important? Similar to the "entrepreneur" is there some special personal attribute that distinguishes "job creators" from the rest of us?

It seems reasonable to me that at its core a job creator is one who creates new jobs in the economy. So maybe the first step in understanding the job creator is to understand how exactly a new job is created. And at the heart of my argument on job creation are two simply economic principles: supply and demand. Simply stated, when the aggregate demand for your goods and/or services increases to the point where you may not be able to adequately supply your customers in a timely manner, you risk losing some of those customers to your competitors. Accordingly, the business owner has a choice: (1) risk losing some customers or (2) create a new job that will allow the business to better meet the increased aggregate demand of its customers. Viewed this way, the decision to create a new job is a simple, rational business decision based upon the increased aggregate demand for the business's goods and services. The more the demand increases and sustains the more jobs the business will create. Likewise, as we saw during the recent recession, the more the demand drops off, the more likely it will force business owners to make the similarly rational business decision to shed jobs to meet this new level of reduced demand. As they say... its just business.

But also bear in mind what this simple explanation doesn't suggest. First, it doesn't suggest that the creation of a job is an act of charity or benevolence. Jobs are not created as a function of kindness or goodwill. Nor does it suggest that providing a tax break or other fiscal incentive to a business will lead to new job creation. Unfortunately, politicians on both sides of the aisle seem to believe that such incentives will work, as that's the only real tool they have in their toolbox. So new incentive programs are proposed all the time for high tech jobs, green technologies, returning veterans, etc...

But if you agree with my simple explanation, the only factor that can truly drive and sustain real job growth is a significant increase in the aggregate demand for goods and services. Accordingly, while policies to lower the cost of business such as the lowering of tax rates, tort reform or regulatory relief may be helpful, they will be disappointing as job creation stimulants. On the other hand, policies designed to put more spending money in the hands of middle-class Americans might be more effective, as that is where true aggregate demand originates.

But what is most disappointing to me is the seemingly accepted view that these simple economic principles are somehow personified as individual attributes of the "job creator." And therefore satisfying or appeasing the job creator is the correct path to employment growth. To me this view is disingenuous, as it simply denies the economic reality of how jobs are actually created.

Another way to look at it is to ask, if the CEO whose business demand picks up and hires 100 new workers is personified as a job creator, what is he or she called when demand weakens and they are similarly forced to shed 100 jobs: a jobs destroyer?

Understanding Rural Business Success

Trying to understand the factors that lead a local start-up company in your community to succeed is never easy. With more than half of all small business ventures never successfully emerging from the survival stage (typically the first five years), it seems like the deck is stacked against them from the start. Yet, from the viewpoint of an economic development practitioner, you want to assist small business owners in your community grow, but clearly you can’t assist them all.

While there is no “secret sauce” that can be identified to easily predict business success, the EDA Center at the University of Minnesota, Crookston wanted to further explore this question. So instead of identifying probable factors that might lead to business success and examining their importance, the EDA Center took an inductive approach and first identified successful rural businesses and then sought to understand what factors they might have in common.

With the help of the Regional Development Commissions across rural Minnesota, we identified close to 70 rural businesses that met our criteria of “success.” First, we wanted businesses that have cleared the survival stage of development and were ready and poised for growth. This meant that we wanted companies that were at least 5 years old, but no older than 15. And second, we wanted to identify companies that were clearly growing in sales and employment. Using these criteria we collected information from 62 successful rural businesses.

Of the 62 companies examined, the average number of years in business was 7. The overwhelming percent (75%) were incorporated or were structured as a limited liability company ( LLC); with only 22 percent reporting being structured as a sole proprietorship. The average annual sales were approximately $1 million, but 12 percent of companies reported sales of $10 million or more. And most importantly, the businesses represented a wide range of industries; from manufacturers to information technology, to construction, to food processors. It was a diverse group of businesses with no specific industry clusters identified. Clearly, if you were trying to identify a specific industry to build your economic development plan around, you would have a difficult time. What was more easily identified were the characteristics of the business owners and founders themselves. Here in many ways the similarities were unmistakable. Below are some of the most salient characteristics:

A Business Pedigree: Two-thirds of our successful business owners reported having other family members/parents who also owned businesses; and half of them reported having previously started a business prior to the one they were currently operating.

Value Experience over Education: More than 80% of these successful business owners had over a decade of experience in their current industry prior to starting their own business. And while they valued education, 52 percent reported having an Associate’s degree or less; and 88 percent reported having no higher education beyond the Bachelor’s degree. Clearly, they valued experience and industry knowledge over formal education.

Be Invested from the Start: More than 90 percent of the business owners reported investing their own capital into the business before their start-up; and more than half indicated that they devoted themselves full-time to the business before even registering it. More than 70 percent reported that they had a formal business plan in place; 75% formed a legal entity and 46 percent even organized a team of employees prior to registering the business. Equally interesting, in a time when it appears that many businesses and business start-ups seek government funds or tax breaks to launch their business, more than two-thirds of these successful owners reported that they never even sought government support in the development of their business.

Look for a Hands-on Owner: It was also equally clear that these successful business owners were not hands-off managers. Rather they were completely invested in the financing, operations and management of their companies. 90 percent reported that the business was either moderately or extremely dependent upon the owners’ technical/operational skills; and 92 percent reported being dependent upon the owners’ managerial skills.

Growth-Oriented and Optimistic: It is also evident that these successful business owners are both growth-oriented and optimistic about the future. Approximately 70% report plans to introduce new products and services in the next 12 months; 48% report plans to increase their number of full-time employees; and two-thirds report plans to purchase additional capital equipment.

And lastly, their while some economic pundits report an atmosphere of economic uncertainty holding back businesses from hiring new employees, these business owners were asked how they would react to a 100 percent increase in their number of employees over the next 5 years? Not surprisingly, 19 percent of owners reported that such rapid employment growth would be looked upon negatively; however, 60 percent reported such a rapid growth scenario as either “positive” or “very positive”.

So what’s the secret sauce to business success? Well I’m not sure if this study sheds enough light to answer that question, but it suggests that it has more to do with the orientation and characteristics of the business owner than the business itself. As some point out, “you don’t put your money on the horse race, you bet on the horse.”

Is Government Too Large?

Few issues have captured the attention of Congress in the past year as much as the national debt; and with the debt now exceeding $14 trillion, who could blame them. In the long run an unsustainable national debt will wreak havoc; not only putting the U.S. in an economically and politically fragile position, but it will draw government resources away from providing important public services to simply servicing this burgeoning debt. At the same time an obsession with the national debt can at times paralyze a government; as we saw when even a simple, noncontroversial appropriation to fund FEMA for routine disaster relief became a battle over debt reduction. With a belief that government has simply grown too large, some are trying to turn every political decision into a referendum on the growth of government.

Here in Minnesota the issue is not exactly debt reduction, as the state is required to have a balanced budget; but in many ways the sentiment is the same. Policymakers are concerned about the growth in state government and last session some even sported penny lapel pins, symbolizing their opposition to spending “one penny more.”

Writing this post near the doorway where we have a growth chart that has tracked the height of our four kids, makes me think about how we actually measure growth. Clearly for many in St. Paul, the simplest way to measure growth in government is by examining the amount of money the government spends. And using that measure, there is no doubt that our state government has significantly grown. For example, in 2000 Minnesota’s annual general fund expenditures was approximately $12 billion and by 2010 it had increased by approximately 40 percent to $17 billion. But is simply looking at expenditures really the best way to measure growth in government? After all, we all know it takes more to build and maintain a mile of road today than it did in the year 2000. So should those added costs be considered growth in government?

Another growth measure tracked by our state is called the overall price of government. This measure views how much our government spends as a percentage of our collective personal incomes. The argument here is that while government expenditures rise, so do our personal wages and incomes. So the real concern should be whether government expenditures grow faster than our personal incomes. Using this measure a different story emerges. According to the Minnesota Department of Management and Budget, in FY 2002 the cost of all state and local governments combined was equal to 15.5 percent. Or put another way, for every dollar of our personal income, 15.5 cents was paid to our state, county, municipal, township and school districts for their services. Comparatively for FY 2012 that amount is now 15.8 cents out of every dollar; far from the 40% growth seen when simply looking at gross expenditures.

Still others suggest that the best measure of growth in any organization is by examining the number of workers it employs. Organizations that continually increase the size of their workforce are clearly growing, right? In fact, a bill submitted this past legislative session was designed to reduce the number of state employees by 15 percent. So I again went to the Minnesota Department of Management and Budget to find out just how large the state’s largest employer actually is. There I learned that at the beginning of the decade in 2001 the State of Minnesota employed 32,608 (full-time equivalent) employees and at the end of the decade in 2010 the employee FTE count was 32,786. This change actually represents less than one percent growth in state employees throughout the decade. Further, it should be recognized that during the decade Minnesota’s population grew from 4,919,479 in 2000 to 5,303,925 in 2010. Looking at it another way, in 2001 Minnesota employed 1 state worker to provide services for every 150.8 Minnesotans and in 2010 one state worker serviced 161.8 Minnesotans. Using this measure, not only has the Minnesota workforce barely grown, but it has increased its efficiency as well.

So how exactly should we measure the growth in government; and is the size Minnesota’s government growing out of control or isn’t it? Well, the simply answer is that you have to use your common sense. For example, it’s important to remember that not only do things cost more today, but a significant percentage of the revenue our government spends gets returned to the private sector through the procurement of contracts to build roads, bridges and buildings. Should these contracts with the private sector employers also be considered growth in government?

After all, politicians, lobbyists and other public officials love to toss numbers and statistics around in an effort to convince you that their interpretation represents the “truth”. But in the end I can’t help remembering the words of my college statistics professor many years ago when he noted, “If you torture the statistics long enough, they will confess to anything!”