Tax Policy and Investment by Startups and Innovative Firms

We examine how tax policies alter investment incentives, with a particular focus on startup and innovative businesses. Consistent with prior work, we find that existing policies impose widely varying effective tax rates on investments in different industries and activities, favor debt over equity, and favor pass-through entities over corporations. Targeted tax incentives lower the cost of capital for small businesses, startups, and those that invest in intellectual property. Those advantages are weakened, and in some cases reversed, however, by two factors. First, businesses that invest heavily in new ideas rely more on higher-taxed equity than do firms that focus on tangible investment. Second, startups that initially make losses face limits on their ability to realize the full value of tax deductions and credits. These limits can more than offset the advantage provided by tax incentives. We also examine the effects of potential tax reforms that would reduce the corporate income tax rate and achieve more equal tax treatment across the various forms of business investment.