Tax policy is one of the most obvious policy levers that policymakers control to alter the incentives of firms and entrepreneurs. One of the most important aspects of tax policy is the way taxes encourage (or discourage) investment and innovation. Young firms need capital to grow and take advantage of opportunities that arise. When business tax structures are well-designed, government facilitates investment in the emerging firms that create jobs and innovations. Entrepreneurs can enter markets and compete without being too heavily burdened. On the other hand, poorly designed taxes make it harder for an entrepreneur to enter a market and firms encounter barriers to research, innovation, and investment. Here government achieves neither efficiency nor fairness. Policymakers should aim to create a holistic tax structure that accounts for the existing tax environment and precisely choose policies that promote economic growth.
One of the more targeted government efforts to support innovative companies and business investment are the group of tax credits associated with research and development and investment. Policymakers ought to design taxes to encourage this behavior because businesses tend to underinvest on their own. More investment that leads to more innovation makes society richer. It is these kinds of tax credits that can actually increase efficiency.
However, government needs to properly develop such tax credits so that entrepreneurs and innovative companies have the ability to take advantage of them. For example, some of the tax credits that firms are allowed to claim require that the firm be operating with a positive profit level. This requirement can be difficult for a young entrepreneurial firm. Most businesses are not profitable for at least the first year of existence. When these young firms report their net loss to the government, they are ineligible for many of the tax credits that allow them to invest in their business. Unprofitable firms are allowed to record losses in the current period to offset future profitable activity. But this option is less valuable to these firms, as they cannot take advantage of the investment subsidies when they need them most. While we don’t want to subsidize firms that are wasting resources, there are firms at the margin of profitability for whom this sort of change in an investment or innovation tax credit would be the difference between positive and negative profit. Also, because of the time value of money, a tax credit in the present year is worth more, especially to these cash-starved young firms, than a credit in the future. Thus the credit as designed may not even reach the new firms that would be the most likely to be the innovators that the subsidy is trying to encourage.
It is this kind of misallocation of resources that shows that just because a tax policy is aimed to support entrepreneurs, does not mean that it actually supports them as intended. Policymakers must understand the business and policy environment the entrepreneurs face and then design tax policies to successfully engage them.
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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.