A new look at how current law and proposed reforms tax entrepreneurs

Tax policy debates often focus on entrepreneurs, those risk-takers who build businesses from scratch. In an effort to better understand how  innovators who create new products, introduce technologies, and expand markets are taxed, my Tax Policy Center colleague Eric Toder has taken a new look at the effects of the current revenue code and various alternatives, including proposals by President-elect Donald Trump and House Republicans.

The effects of these changes on entrepreneurs’ effective tax burdens are very sensitive to a wide range of assumptions, including the rate of return required for venture capital investments, and the time it takes before a new firm turns a profit. But using mid-range estimates, Eric calculates that the House GOP tax blueprint would significantly reduce effective tax rates on these entrepreneurs, while Trump’s most recent plan would only modestly lower their effective tax rates.

Unlike many other researchers, Eric distinguishes entrepreneurs from other small business owners. His focus is not on owners of dry cleaners or a fast food franchises, but on innovators whose firms may generate large returns over a long period of time (or may crash and burn).

He looks at the taxation of an entrepreneur’s income in two pieces: First, the tax rate on the work she puts in to build the business plus the increase in its value from the time it is created until it is sold; second, the tax on the price the entrepreneur receives when she finally sells her firm. The latter depends on taxes applied to the large businesses that an entrepreneur’s efforts create.

In this model, a firm’s assets are not its tangible capital, such as equipment or software, but the business itself—including the owner’s knowhow and creativity and its brand. In this way, Eric’s analysis differs from these estimates of effective tax rates by my TPC colleagues Joe Rosenberg and Donald Marron, and these by Samuel Brown and Bill Gale, which examine how the taxation of returns to physical assets differs between mature and emerging firms.

Using the two-part frame, Eric estimates that under current law, an entrepreneur in the top tax bracket would pay a mid-range effective tax rate of about 29 percent, assuming she faces a 44.6 percent marginal income tax (including the effects of phase-outs and the Affordable Care Act’s investment income surtax).

By contrast, the House GOP plan, which would lower rates on individual and business income and capital gains, and allow businesses to expense all new investments, would reduce her effective rate to about 12 percent. 

A stylized Trump proposal would trim the overall tax rate on entrepreneurs to about 22 percent. Eric assumed this plan would retain interest deductions but not allow full expensing; reduce individual and business income taxes; and cut the capital gains rate and the effective tax rate on new investments by mature corporations but by a smaller amount than the House plan.

Eric also looked at two theoretical tax reforms—a flat 20 percent income tax, and a 25 percent consumption tax. Eric found that a flat income tax would tax entrepreneurial income at roughly the same 29 percent rate as current law. By contrast, a flat 25 percent consumption tax would reduce the rate on entrepreneurs to 11.5 percent.

The details of the proposals, such as  capital recovery rules, interest deductibility, and marginal tax rates on both ordinary income and capital gains are critical. But Eric’s key message is this: The  effective tax rate on entrepreneurs depends on  the taxes they pay during both the growth phase of their business and on the market value of the more mature business they create.

Eric makes no judgment about whether these incentives to business creation are appropriate.  But keep his analysis in mind the next time you hear politicians promote their ideas for tax cuts aimed at entrepreneurs.      

This story originally appeared on TaxVox.