Are High Taxes About to Make Silicon Valley Pack Up and Leave?

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California Governor Jerry Brown is at it again.

He's cut a deal with the teachers' unions that would take the top rate of state income tax from 10.3% to 13.3%.

If passed on the November ballot, that would increase taxes on the top tier by a hefty 29%.

Since that would be the highest rate in the nation, it begs the question: How high would taxes have to go before Silicon Valley's zillionaires decided to make the great escape?

It's a very important question considering the condition of California's state budget.

After all, the Facebook IPO alone is expected to produce $2.5 billion in state tax revenue over the next five years. What if high tax rates set in motion the law of unintended consequences?

Like in the late 1990s when dot-com revenues enabled the state to go on a massive spending spree.

Not long after the tech bubble burst, the sudden budget crunch that followed in 2001-02 caused Governor Gray Davis to be recalled in a referendum.

It's a different set up this time, but the results could be the same.

Higher Taxes Create Capital Flight

Silicon Valley's tech sector provides both capital gains taxes from tech giants selling their stakes after companies go public and massive income tax revenues from their salaries and bonuses in the interim.

Faced with higher taxes the threat of relocation is very real - even among large, well-established companies. For instance, Boeing (NYSE: BA) relocated from Seattle to Chicago in 2001.

California's taxes and other living costs are already large enough to cause flight; in 2007-10 an annual average of 135,000 more people left California than arrived there.

However, the largest generators of California's tax base are not established companies, they are the young, brilliant entrepreneurs, venture capitalists and engineers involved in Silicon Valley enterprises.

These people are exceptionally footloose, with few family ties.

On the plus side, Silicon Valley is very tightly networked, so at least the more junior members of the tech sector would be tied there by their colleagues, competitors and mentors.

Still, the corollary of the Valley's networked nature is that the departure of a small number of key people could cause a mass exodus, with junior employees following their bosses and mentors.

Needless to say, almost all those key people will pay California's new top rate of income tax, if it is introduced.

What is a One-Percenter to Do?

The questions are: What tax differential would make a critical mass of Silicon Valley zillionaires leave, and where would they go?

Just because California now has the highest state income tax, other high tax states need not jump for joy and hope for a huge influx of business.

New Jersey, with its 8.97% top income tax rate and New York, with its 8.82% top income tax rate (12.6% in New York City) should not expect to get much of the business, since it's not worth schlepping across the continent and putting up with winters for a mere 4% differential.

On the West Coast, Oregon's 9.9% top marginal rate would not generate much business either.

Relocating California zillionaires would presumably head for one of the nine states that don't impose a state income tax.

Of these, Wyoming, South Dakota and Texas would suit fine, but are probably culturally unthinkable.

That leaves two alternatives: Washington state and Nevada.

Washington state has no state income tax, but has a business and occupations tax, which levies a rate of about 0.5% on gross receipts - probably not a problem for high-tech companies with high margins. That's an alternative if you don't mind the rain.

Then finally there's Nevada, which makes most of its state revenues from casinos, and is fine if you're young, hip, not so bright, and like casinos and showgirls. Personally I'd choose the rainfall and scenery of Seattle over Nevada (or indeed over California) but I'm 25 years too old to be a tech zillionaire and nowhere near rich enough.

The Real Threat Created By Higher Taxes

Then there's the possibility that some California zillionaires could decide the chances of rising federal tax rates make relocation overseas attractive.

As for domestically, high-tax countries like Europe and Japan, they shouldn't hold their breath. However, even without relocating to true tax havens like the Cayman Islands, there are some other possibilities.

Singapore, notably, has a top income tax rate of only 20% and a substantial tech sector of its own, making it a very attractive destination. It even has a casino now, for those considering Nevada as an alternative.

For venture capitalists, Switzerland is also attractive, with a tax burden in a favorable canton such as Zug that also runs about 20%.

Personally, were I a zillionaire venture capitalist, I would ignore Switzerland and head for the more exclusive Liechtenstein, which also taxes you at about 20% but you get a population of only 35,000, beautiful mountain scenery and the joy of being the world's only citizens still ruled by a Hapsburg, Prince Hans-Adam II.

But all jest aside, the chance of a Silicon Valley exodus is very real.

The extra 3% on the top rate of state income tax makes California even more onerous than in Manhattan.

That might well be just enough to trigger one.

California citizens should be very afraid. The unintended consequences of higher taxes are quite real.

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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