Taxes and Entrepreneurship
Policy Dialogue on Entrepreneurship, PDE
The primary goal of tax policy is to raise public revenues, but policy makers also recognize that the structure of taxation shapes incentives and should be crafted to enhance economic growth. Tax policy should foster new business creation and create a supportive climate for innovative firms.
The theory of externalities implies taxes should be highest where activity has negative social costs (e.g. pollution) and lowest where the activity has positive social benefits (e.g. innovation). In practice, the tax code is a thicket of anti-entrepreneurial incentives and a source of red tape compliance burden. Taxes influence ownership structure, job creation, financing structure, and often the very decision to start a business. Simply put, incentives matter.
Why Taxes Matter
- Higher marginal tax rates lower incentives by reducing profits,1 but also increase tax avoidance creating a mixed impact on self-employment. Complexity and compliance costs also rise with higher tax rates and higher tax progressivity.
- Unequal corporate and individual income taxes can create distortions. When the personal income tax rate exceeds the corporate rate, entrepreneurs may prefer premature incorporation2 which can diminish startup risk-taking.
- Replacing the corporate income tax with a Business Activity Tax (BAT), which is consumption-based, is expected to increase economic output by 2 to 2.5% in the long-run.3
- The U.S. has the second-highest statutory corporate tax rate among developed nations.4 High corporate taxes deter foreign investment,5 and in theory lowers the valuation of U.S. based companies.
- Both the federal and state government collect unemployment taxes from all employers, constituting a perverse incentive against hiring, and a burden on small businesses.6
- Federal Unemployment Taxes (FUTA) raised $6.1 billion in 2002, but only $3.5 billion was spent on FUTA-related expenses. The rest was used for non-related government programs.7
- Taxes on capital gains (i.e. successful startups) raise the cost of capital, hindering the formation and expansion of businesses8 and also hindering productivity (and wage) enhancing investments.
Unfair Health Care Tax Treatment
- The federal income tax does not count employer-based health benefits as income, which biases the code against small businesses and both poorer and self-employed workers.9
- 60% of Americans who do not have health insurance belong to families with a head of household that is self employed or works for a small business.10
Taxation and Technology
- By banning taxes on Internet access in the U.S., Congress has enhanced America’s online competitiveness.11
- By reducing a mature firm’s value, the corporate tax diminishes the incentives for effort and advice among VC investors in a start-up.12
- The U.S. VC industry evolved in response to key changes in the tax system, such as the 1981 stock option legislation which allowed deferment of tax liability to the time when stocks are sold rather than when they are exercised.13
Pro-Growth Policy Action
Federal tax policy should encourage the growth of entrepreneurial firms in order to accelerate productivity growth and job creation. The U.S. should reform the existing tax code, cease making temporary changes, and make permanent pro-growth provisions.
- Reduce corporate tax rates.
- Reduce tax complexity and close loopholes for special interests.
- Flatten the rate structure on personal income taxes, allowing generous exemptions.
- Minimize the taxation of capital gains.
1 Garrett, Thomas A., and Howard J. Wall. “Creating a Policy Environment for Entrepreneurs.” Federal Reserve Board of St. Louis. 2006.
2 Cohen, Julie Berry and Roger H. Gordon, “Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S.” National Bureau of Economic Research (NBER). 2002.
3 United States Department of Treasury. “Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century.” 2007.
4 Organisation for Economic Cooperation and Development. Tax Database. 2008.
5 Bénassy-Quéré, Agnès, Lionel Fontagné, and Amina Lahrèche-Révil. “How Does FDI React to Corporate Taxation?” Organisation for Economic Cooperation and Development. 2004.
6 National Federation of Independent Businesses. Unemployment Insurance Reform. 2003.
8 Michel, Norbert J. and Ralph A. Rector. “A Research Program on the Interplay between Entrepreneurial Activity and Tax Policy.” The Heritage Foundation. 2004.
9 National Federation of Independent Businesses. Deductibility of Health-Care Costs. 2007.
11 National Federation of Independent Businesses. NFIB Talking Points: Internet Tax. 2007.
12 Keuschnigg, Christian. “Tax Policy for Venture Capital Backed Entrepreneurship.” University of St. Gallen. 2008.
13 Henrekson, Magnus and Dan Johansson. “Competencies and Institutions Fostering High-growth Firms.” Research Institute of Industrial Economics (IFN). 2008.