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Many tax subsidies help new businesses, especially those financed with borrowed money and organized to avoid the corporate income tax . However, large numbers of start-ups may not benefit from this largess, according to a new study by my Tax Policy Center colleagues Joe Rosenberg and Donald Marron.
Startups and those that lose money in their early years often pay higher marginal effective tax rates than established businesses. In addition, the benefits of tax subsidies vary widely by industry.
For decades, policymakers have enthusiastically supported special tax breaks for small businesses, including start-ups. This week, the House is expected to easily approve a measure that would permanently extend to $500,000 (indexed for inflation) the annual cost of property that small firms could deduct immediately under Sec. 179. In his 2016 budget, President Obama proposed increasing that limit to $1 million after 2015.
But Joe and Donald, using TPC’s new Investment and Capital tax model, as well as data from the Kauffman Firm Survey (a project that has been sampling start-ups since 2004), find that these subsidies fall very unevenly. Full disclosure: This paper was partially supported by the Ewing Marion Kauffman Foundation, which also funds that survey.
For example, subsidies such as Sec. 179 are aimed at cutting taxes for equipment-heavy small firms. Not surprisingly, the biggest beneficiaries are companies in industries such as mining, telecom, and transportation. Retail and service firms, software and IT businesses, or small bio-tech firms get much more modest benefits.
But even these advantages can be washed out depending on how a firm is financed and how long it takes to become profitable.
Other research findings from the Kauffman firm survey found that fast-growing and R&D-based firms rely more heavily on equity while businesses that invest in tangible assets are more likely to finance with debt. That’s no surprise since banks are often reluctant to lend to a business with nothing but an idea, no matter how good. Because the revenue code generally favors debt financing, new firms in R&D intensive industries that rely on equity face higher tax rates than you’d think.
But the biggest reason startups may be unable to take advantage of tax subsidies is that they often lose money in their early years. In theory, generous preferences such as Sec. 179, the research and experimentation credit, or even the ability to deduct interest costs are all available to startups. In reality, many cannot use them because they make no profit and, thus, pay no tax.
Firms can carry net operating losses forward for up to 20 years but these NOLs are far less valuable than immediate deductions for three reasons—money loses value over time, some firms never generate enough income to take full advantage of their unused losses, and some lose their NOLs when they are acquired. A 2006 Treasury study found that at least one-quarter of these losses are never used and others lose substantial value.
Joe and Donald consider three hypothetical scenarios to measure the impact of delayed or lost deductions and credits on METRs. While they vary depending on how long it takes a firm to make positive returns on its investment, the tax increases are significant.
A profitable, and thus taxable, start-up faces an average effective rate of 23 percent. But if a firm, say, invests for five years before successfully bringing a product to market, its METR will increase to 34 percent. For software or IT firms, effective rates would average 41 percent.
This study, the first of a new series TPC is doing on taxation and investment, is strong evidence that lawmakers should look closely at what their tax reform plans will mean for new businesses. It turns out that there is a wide gap between their professed support for these firms and what the tax code does for (and to) start-ups in the real world.
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