A Very Taxing Process

Previously, I have talked about how policymakers can design specific incentives that effectively encourage the type of innovative activity for which entrepreneurs are known. The thought is that policymakers ought to encourage investment in and innovative behavior by the firms that take the creative, ground-breaking risks that increase the quality of life for all. This is not a new idea, and it is a way policymakers can actively support an environment conducive to entrepreneurship. In this post, I want to explore the consequential aspects of taxation that aren’t related to explicit tax rates. While the amount of taxes paid is the most commonly discussed tax policy issue and does matter, policymakers can design a more effective, efficient and fairer tax system by reducing the administrative, compliance, and overall complexity costs that trip up many young businesses.

The conversation on taxes is often centered on the rate of taxation. Yet, the evidence suggests that the more pressing concern for the founders is the complexity of taxation: the burden of complying with a hard-to-navigate, disorganized tax system. In a three-year survey of small businesses, Thumbtack (a consumer service organization) found that the level of tax complexity and compliance costs better determined how friendly business owners believed a state was to small businesses more than overall tax rates.  A survey from the National Small Business Association found that small business owners spend as much as 150 hours per year completing both the administrative and actual taxation forms required. And that survey was focused only on the federal taxation burden, meaning that business owners spend additional man-hours completing state and local taxes. The amount of lost productivity that results from increased tax complexity is staggering.

These burdens of a complex taxation regime are particularly injurious to the owners of the young and small businesses that drive economic growth. Part of the complexity hurdle that business owners face, in addition to navigating the multitude of different taxes and credits, is compliance with a tax code that is significantly more burdensome for a small firm than a large firm. Small Business Administration research claims that the cost of tax compliance is 206 percent higher for small firms than large firms. So not only is the tax code a burden for entrepreneurs and the owners of small firms, but it is even more of a burden to them than it is to large firms who possess greater resources to comply with a cumbersome tax code. When policymakers consider tax reform, it is vital that effects like this are accounted for in analysis of welfare effects.

There are significant changes that policymakers can make to simplify tax compliance. A more uniform system of taxation at the state and local level, especially in sales taxes, can reduce unnecessary complexities that frustrate entrepreneurs. Online resources to understand what taxes exist and how to comply are a low-cost way to educate business owners in proper tax compliance. Explicit changes in tax rates, as opposed to simplification of the procedures and ease in complying, are typically a political pipe dream. Yet these policy options that ease the burden on businesses offer low-hanging gains in efficiency and productivity, as more companies spend time producing goods and services and less time studying tax code.

Taxes are perhaps the most obvious connection to government that entrepreneurs have. When making any sort of business decision, whether expanding to a new location, hiring more workers, or even just starting their business, different kinds of taxes contribute to the entrepreneur’s cost-benefit analysis. Income taxes, unemployment taxes, payroll taxes, the costs of business registration, and the multitude of narrowly targeted tax credits; all of these and more comprise the labyrinthine American tax code. The messy and disorganized system of local, state, and federal taxes hurt entrepreneurs who don’t have the resources to wade through the tax code and comply optimally. Fixing the excessive complexity that exists in the tax code provides policymakers with a politically feasible opportunity to create a fairer, more effective tax system.

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chris jackson

Chris Jackson

Chris Jackson is a research assistant in Research and Policy for the Ewing Marion Kauffman Foundation, assisting in the understanding of what policies and environments best promote entrepreneurship and education in the pursuit of economic growth.