Tax Incentives for Entrepreneurship and Innovation

Jonathan Ortmans, President, Public Forum Institute

You might have seen that last week the Money & Investing section of the Wall Street Journal featured an article titled “Entrepreneurs Win Tax Case Versus IRS.” A Tax Court decision would now allow investors in LLC and LLP companies to deduct losses against salary and investment income. The decision could still be repealed and its effects are different for entrepreneurs facing losses and for those that are profitable, but I wanted to mention it because it highlights the relationship between the tax system and entrepreneurial activity. Taxes influence decisions regarding hiring, financing structure, and ownership structure (e.g., LLCs and LLPs have been the preference for most new businesses in part because of the benefits of freedom from double taxation). Taxes also often affect the very decision to launch a business.
Given these incentive effects, yet another important task for this Administration should be to question whether our taxes are helping or hindering entrepreneurially-driven economic growth.

Last Thursday, the House Committee on Small Business held a hearing on the Research and Experimentation Tax Credit, commonly known as the R&D tax credit.  Rep. Glenn Nye explained that roughly 40 percent of the businesses that claim this credit are small firms. However, the witnesses denounced that the constant uncertainty surrounding the credit’s reauthorization and its costs of compliance and administrative burden deter small businesses from using this benefit. There is a clear opportunity for strengthening this incentive for risk-taking and innovation among our small businesses.

Everybody wants lower taxes.  When I was a staffer for a Congressman on the Ways and Means Committee, I learned this was far from simply about paying more or less.  Let’s remind ourselves that the tax code is a policy tool of the government.  Right now, we know that entrepreneurship is key to recovery.  If there was  ever a time when taxes on entrepreneurial activity should be lowered and tax incentives easier to implement for entrepreneurs, it is now. Entrepreneurship offers so many public benefits: jobs, innovation, economic growth. Why deter a beneficial activity with unnecessary barriers?

The Small Business Administration found that lower marginal rates on entrepreneurial income boost survival rates of young firms. Yet, our current tax code contains several anti-entrepreneurial incentives. The U.S. Department of Treasury explained, for example, that replacing the corporate income tax with a Business Activity Tax (BAT), which is consumption-based, is expected to increase economic output by up to 2.5% in the long-run. In fact, the U.S. has the second-highest statutory corporate tax rate among developed nations. This certainly produces negative effects. For example, by reducing a mature firm’s value, the corporate tax diminishes the incentives for effort and advice among VC investors in a start-up.

We are also making the mistake of taxing jobs. Both the federal and state government collect unemployment taxes from all employers. This represents a perverse incentive against hiring, as well as a burden on small businesses seeking to grow. Moreover, Federal Unemployment Taxes (FUTA) raised $6.1 billion in 2002, but only a little more than half ($3.5 billion) was spent on FUTA-related expenses. The rest was used for non-related government programs at the expense of entrepreneurship. 
And there is health care where 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.  Small businesses can treat employer-based health benefits as non-taxable income, but discriminating against the self employed does little to encourage risktaking among bootstrapped entrepreneurs.

Our tax system does contain examples of pro-entrepreneurship thinking about taxes. By banning taxes on Internet access, Congress has enhanced America’s online businesses’ competitiveness. And key changes in the tax system have helped spurr the availability of start up money.

As with so much of the opinion voiced in this blog, I simply argue that all we ask for is that policymakers consider the needs of the entrepreneur.  Being supportive of entrepreneurial firms, is being supportive of advancing American innovation, productivity, economic growth and job creation.  It is supporting the “good capitalism” pioneers that built this nation.  The pundits tell us there simply aren’t the votes to pass a second top down stimulus package to spur growth.  Perhaps this time Washington will consider a bottom up approach by supporting permanent changes to the codes that provide the incentives and make the path easier for those that want to risk their own savings to make jobs and solve problems.

Jonathan Ortmans is a senior fellow at the Kauffman Foundation where he focuses on public policies to promote entrepreneurship in the U.S. and around the world. In addition, he serves as president of the Public Forum Institute, a non-partisan organization dedicated to fostering dialogue on important policy issues.

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