Throughout history, poverty is the normal condition of man. Advances which permit this norm to be exceeded — here and there, now and then — are the work of an extremely small minority, frequently despised, often condemned, and almost always opposed by all right-thinking people. Whenever this tiny minority is kept from creating, or (as sometimes happens) is driven out of a society, the people then slip back into abject poverty. - Robert Heinlein

The secret sauce of Silicon Valley is the tradition of leaving established companies to start or join new ones, secure funding from venture capitalists, build the company to a suitable size, and then either float or sell the company for a windfall to the founders and early employees. The incentive to continue this practice is the engine that keeps the fire of human technological innovation alive.

Silicon Valley's unique ecosystem has so far been nearly impossible to eclipse. The combination of research universities, the best and brightest immigrants from India and China, a culture of entrepreneurship, and a nearly perfect climate has kept the competitors to Silicon Valley at bay. In the 1990s, the prevalent belief was that the high cost of living in Silicon Valley would enable Austin, Dallas, Seattle, and Phoenix to attract technology workers and cultivate their own tech sectors. This did not happen, as the Silicon Valley ecosystem just had too strong of a gravitational pull.

This, however, should not be an excuse for complacency, or a belief that Silicon Valley is a bottomless supply of tax revenue. There are four steps that would make Silicon Valley prohibitively inhospitable to the formation of new ventures. Any one of these by itself would not be enough to dent the might of the Silicon Valley engine, but all four combined would exceed the breaking point. The first two of these four steps have already happened, and the final two are set to happen, barring direct intervention.

The four steps are :

1) Sarbanes-Oxley : This attempt to reduce the risk of another Enron-style fraud has inflicted a cost on the US economy greater than 100 Enron collapses. In Silicon Valley, the crushing costs of Sarbanes-Oxley compliance (up to $3M a year) have dried up IPOs to a trickle, as the prospect of spending money of compliance that could otherwise be spent on R&D is unappealing. IPOs are less frequent than they were even in the early 1990s, before the bubble, and start-ups can only hope to be acquired by a larger company. In the last 8 years, only two IPOs were large enough to be considered 'blockbuster' : Google and VMWare. This crushes the incentive to leave stable jobs to go work at a new venture.

2) Tortuous Immigration Process : Any list of the most successful people in the history of Silicon Valley will quickly reveal that at least one third of them were born outside of the US. In response, America has chosen to make it much harder for more such people to come here, even as the quality of life in their home countries is rising.

While politicians pander to illegal immigrants with minimal education, they somehow refuse to make immigration easier for legal, highly-skilled immigrants who start new ventures in America. This is significant given the fact that about half of Silicon Valley's skilled workforce is Indian or Chinese. Many are choosing to return to their home countries in exasperation, and are advising their younger relatives that the US immigration process is so tedious that it is better to pursue their careers at home, working for Indian or Chinese branches of HP or Microsoft.

Under current procedures, an engineer from India or China has to be on an H1-B visa for 6 years before he can get a greencard. If he changes employers during that period, he has to start the clock again. The immigrant's spouse cannot work during this period. Even after the greencard, it takes 5 more years to become a US citizen. Unsurprisingly, the best and brightest are deciding that this 11-year limbo is not worth it, and return to their home countries (eventually starting companies there rather than in Silicon Valley). In the 1990s, Americans had not even heard of Bangalore or Suzhou.

I have written up a detailed solution to this problem over here.

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If these two factors weren't bad enough, two more negatives are about to be piled on.

3) California State Income Taxes are Set to Rise : The budget shortfalls and underfunded pensions in California are a ticking time bomb. CalPERS, which invests in many of the top venture capital funds that nurture the growth of start-ups in Silicon Valley, is in a shambolic state, and has to add $80 billion in assets just to meet present obligations. The top income bracket in California is already taxed at 9.3%, and this is set to rise. Sales taxes are also set to rise. Due to this horrendous mismanagement worthy of a banana republic, California will soon reach a tipping point where taxes are so high as to destroy California's private sector, which until now has been the envy of the world. It would, of course, be better to reduce CA state expenditures, but government officials have made it clear that raising taxes is their preferred course of action.

Victor Davis Hanson explains California's black hole in more detail.

4) Federal Income Taxes are Set to Rise : If the Bush tax cuts are allowed to expire, then from 2011 onwards, the top income bracket will be taxed at 39.6% rather than the current 35%. Here, too, the concept of reducing expenditures is not palatable to Washington decision-makers. While this does affect the entire US equally, when this is combined with the increase in California Sate tax, the combined marginal tax rate in California rises several percentage points, and possibly rises well above 50%.

The danger here is that each of these factors by themselves are not life-threatening. But all four of them in cumulative combination are deadly. So on top of the difficulty of conducting an IPO, and the brain drain out of Silicon Valley back to Asia, if the financial windfall that a worker receives after his startup makes a successful exit is taxed at a grand total of 50-55%, fewer and fewer people will aspire to toil away for years in a startup. As a result, fewer startups will form in Silicon Valley, and instead will form in Bangalore, Shanghai, and Taipei.

Furthermore, after these forces have been in effect for a few years a simple reversal of the higher tax rates, dysfunctional immigration policy, and Sarbanes Oxley will not simply restore Silicon Valley to its prior grandeur. The technology centers in Asia will have achieved critical mass by then, and Silicon Valley will have permanently lost its exclusivity. It would never recover the dominance it once had.

Silicon Valley will be reduced to a location that still hosts the headquarters of HP, Intel, Cisco, and Google, but 90% of the employees of these corporations will be overseas, and startups will be rare. Silicon Valley will effectively become like Cleveland or Pittsburgh, which even today host the headquarters of more than 20 Fortune 500 corporations each, but still have a lower population than they each had in 1960, and cannot attract new young people to come and live there. Cleveland and Pittsburgh are still functioning societies, of course, but their economic vibrancy is irretrievably dead.

This bleak outlook can certainly be reversed if prompt action is taken now. Sadly, the current path is one that is set to have a smothering effect on Silicon Valley.

(crossposted on Techsector)