Editor’s note: This post was republished with permission from the Ewing Marion Kauffman Foundation’s Growthology blog.
Each year in mid-April, Americans experience the truth of Benjamin Franklin’s oft-quoted observation that taxes are one of only two things certain in life. Beyond their certainty, taxes are often a point of confusion at both the individual level, as well as for emerging businesses.
By understanding the welfare effects of different systems and aspects of proposed and existing tax policy, scholars, policymakers, and citizens can make more informed decisions about how taxation can be efficient, fair, and useful.
Consider analysis from three studies:
One of the frequently discussed difficulties that entrepreneurs face is the sheer complexity of paying taxes. A complex tax system requires every firm to understand what taxes they owe and their eligibility for credits. Large businesses have the advantage of scale to dedicate more resources and institutional knowledge to comply. Small firms, especially new businesses without experience navigating the tax system, must spend proportionally more to get to the same level of tax compliance.
Here, Burman and Iselin take a comprehensive look at the research of tax compliance on young and small businesses and conclude that federal tax compliance is more costly for small firms, and that state and local taxes can play a role in contributing to compliance costs.
Because the costs of compliance can act as a barrier to entrepreneurial entry, Burman and Iselin see the virtue in reforming taxation to reduce the burden of compliance costs for small businesses. A simplification of the tax system, including a reduction in tax expenditures, is an ideal solution. Burman and Iselin also offer a system where “firms can signal a willingness to comply in exchange for a simplified compliance regime”, as well as recommend that states design income taxes to match federal definitions.
Tax Incentives? See Kansas
States have used tax incentives to attract existing businesses for decades. By offering tax credit and incentive packages to more-often-than-not large, old firms, states are hoping that the relocation of a factory or headquarters will be the job creation force that their city or region needs.
But Nathan Jensen, professor at George Washington University, dove into one of these incentive programs and failed to find supporting evidence for this fantastic line of thinking.
Jensen linked data from the Kansas PEAK (Promoting Employment Across Kansas) program to establishment-level data from NETS (National Establishment Time Series) to examine whether these firms that moved really created the promised employment. He found no evidence the firms that moved to Kansas (to take advantage of the tax incentives offered) were more effective in creating jobs than a control group of firms. This kind of economic development strategy also neglects the entrepreneurs in favor of established businesses, when it is precisely those entrepreneurial companies that are the engine of job creation.
Read: Evaluating Firm-Specific Location Incentives: An Application to the Kansas PEAK Program by Nathan Jensen
Laboratories for democracy
Gale, Krupkin, and Rueben took advantage of the diversity in how states design their tax systems to see how changes in state taxes affect real income. They found that higher state taxes were correlated with lower real income growth, and that this effect was relatively large and statistically significant. This result held when the authors substituted marginal tax rates and included controls for government spending. This analysis extended the tax analysis methodology of a recent paper and reached a near-replication of the study’s original results, although finding issues with the robustness checks.
The authors also presented an interesting finding about the effect of these state-level taxes on the rate of firm formation. They studied marginal tax rates and found that a small and negative, but statistically insignificant effect on the rate of new firm formation. In line with this result, the authors failed to find an impact on employment from these state marginal tax rates.
Everyone wants a fair tax system. While definitions of fairness vary person to person, research like these three papers are valuable in that they give us the ability to understand the far-reaching effects on startups, incomes, jobs, and beyond.
Read: The Relationship Between Taxes and Growth at the State Level by William Gale, Aaron Krupkin and Kim Reuben
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.
Find Jackson on Twitter: @chrisjack_son.