TAXES AND ENTREPRENEURSHIP

What taxes mean for capital and investment.

In discussions about money and entrepreneurship, capital tends to get all the attention. But what about taxes? What role do they play in the startup scene?

A significant one, according to a new study, “Tax Policy and Investment by Startups and Innovative Firms,” by the Tax Policy Center, a collaboration between the Urban Institute and the Brookings Institution. The study looks at how various government tax incentives try to encourage investment in R&D and by small businesses.

One of the findings is that many startups are unable to take advantage of thosee incentives. We’ve reprinted the report conclusion below, but suggest you take a look at the whole thing:

CONCLUSION

Financing costs are an important factor influencing business investment decisions. To raise capital, whether from equity investors or lenders, a business needs to put forward a compelling case that the investment will return enough to provide those investors an adequate return. Tax policies have a significant effect on that hurdle rate. At the margin, tax policies can thus determine which investments get undertaken and which do not, whether firms finance investment through equity or debt, and whether firms structure themselves as corporations or as pass-throughs.

Our results are only illustrative. An individual firm or opportunity involves unique circumstances. Moreover, further work is needed to more precisely define important factors. For example, just how much do startups discount the value of tax credits and tax depreciation allowances? What fraction of equity funding comes from tax-favored sources? And what is the mix of investment types in specific industries?

Despite those limitations, our analysis provides new insight about important qualitative implications of the tax code. Today’s tax system treats businesses differently. Both established and new retail businesses face relatively high tax rates on new investment, for example, while R&D intensive industries like pharmaceuticals and professional services face much lower rates. Corporations face higher tax rates than LLCs, partnerships, and other pass-throughs. Equity is taxed more heavily than debt.

In principle, startups and innovative firms benefit from targeted tax breaks, including the R&E tax credit, expensing of R&D, lower capital gains taxes, and more favorable depreciation rules. But those advantages are over-stated in traditional cost of capital analyses.

First, greater reliance on equity financing eats away at the advantages offered to innovative firms and to startups. Second, and potentially more important, limits on the ability to use tax losses can significantly increase the cost of capital and marginal effective tax rates, relative to what they would be if new firms could take full advantage of preferences such as accelerated depreciation, expensing of research, and the research credit. Efforts to reform the tax code, especially those aimed at lowering the corporate tax rate and “leveling” the playing field among different types of investment should pay particular attention to these types of effects on startups and entrepreneurship.

For the full report, click here.

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