Taxes create a wedge between what a new venture earns and what investors receive, boosting the hurdle rate that must be met in order to attract funding.
In a recent study, we examined how big this effect is, how it varies across industries, and how it differs between startups and established businesses. To do so, we combined all of the features of the federal tax code - rates, deductions, credits, special provisions, etc. - into a single measure known as a marginal effective tax rate (METR). The METR measures how much taxes raise (or, in rare cases, lower) the hurdle rate on a new investment. A METR of 20 percent, for example, means that an investment must generate $1.25 in pre-tax profit in order to return $1.00 to investors.
Our analysis quantified the impact of several familiar aspects of the tax code and also revealed some surprises. In particular:
Structure matters. C corporations face two layers of tax, one on the company and one on owners; partnerships, LLCs, sole-proprietorships, and other "pass-throughs" face only the owner layer. Pass-throughs thus enjoy a significant advantage: a 19 percent METR on new investments, on average, versus the 26 percent on C corporations.
The tax code favors debt over equity. Corporations can deduct the cost of any interest they pay on bank loans, debt, etc. But they can't deduct dividends or other payments to owners. That tilts the playing field sharply in favor of debt. In C corporations, for example, a (hypothetical) investment financed completely by debt is actually subsidized by the tax code, with an METR of -6 percent, while investments completely financed by equity face a rate of 33 percent.
The tax code plays favorites. Uncle Sam favors investments in equipment, software, and intellectual property over those in structures and inventories. That's good news if your venture is in R&D- and equipment-heavy industries; chemical and pharmaceutical firms, for example, face a METR on their investments of only 11 percent. If you are launching a wholesale or retail business, however, the news isn't so good; investments in those industries face average METRs of 31 percent.
Startups often can't make full use of tax breaks. The figures we've mentioned thus far are for companies that are profitable and thus pay full taxes on their profits and get full credit for any expenses or deductions. Startups often make losses, however, and thus cannot make immediate use of the R&D tax credit, accelerated depreciation, and other tax benefits. The value of those tax breaks declines the longer companies have to wait to use them. (Existing companies can often get credit for losses against prior taxes paid.) In addition, companies often lose unused tax deductions and credits if they get acquired or do a big equity financing. These limits can drive up the METR facing new businesses sharply. The impact is most pronounced in R&D-heavy industries, where METRs can easily double.
Our results illustrate the need for thoughtful tax reform. There is no reason to favor debt over equity, for example, and many differences across assets and industries appear difficult to justify. In addition, the inconsistent value of tax incentives for investment and R&D, especially among startups and fast-growing young firms, deserves a close look.
Tax reform must inevitably balance competing goals. But its impact on future investment and R&D decisions should be a top priority.