Tax Policy Should Consider New Business, Not Small Business

Small businesses occupy an iconic place in the public policy debate and benefit from a broad range of tax and spending subsidies. But the economic issues surrounding small businesses and innovation are complex and nuanced, and not well understood.  We are learning, however, that  if Congress wants to encourage risk-taking, it may be better off focusing on new firms, not small ones.

In an effort to better understand the nature of small businesses and the government subsidies that support them, my Brookings colleague Sam Brown and I have reviewed decades of research  in a new paper for the Kauffman Foundation. What we’ve found suggests Congress should tread very carefully as it thinks about  how the tax code drives decisions by entrepreneurs  to start and expand companies.

Being small, in and of itself, does not confer a special advantage to businesses in job creation or innovation. Rather it is young firms, which by definition start as small businesses, that serve these critical roles. Policies that aim to stimulate young and innovative firms may be very different than those that subsidize small businesses.  

Sometimes, the very tax policies and other public programs that are aimed at helping small businesses may discourage their growth. For instance, when pro-small business subsidies or policies are phased out as firm size expands, they may unintentionally discourage businesses from expanding because expansion will lead to loss of those subsidies.

The tax treatment of small business, innovation and entrepreneurship will continue to be a front-line issue in tax reform.  For instance, House Ways & Means Committee Chairman Dave Camp (R-MI) has proposed a package of potential changes in the way small business and other firms whose owners report their business income on their 1040s are taxed.

These reforms deserve a careful review. But Sam and I found that there is often a vast gap between the rhetoric that surrounds the tax treatment of small business and the reality.