The Republicans often argue that capital gains and income taxes discourage the creation of more jobs, especially by small entrepreneurs. They are both right and wrong. The main tax distortion against starting businesses is not where they think it is.

The Republicans are wrong: Entrepreneurs do not decide not to start businesses because they are afraid of not making enough if the business succeeds. Instead, they decide not to start business because they are afraid of failure.

But the Republicans are also correct: The current income tax code is as harmful for entrepreneurial activity as can be. Let me give a small example.

Consider an employee wants to strike out and start a business. Assume she needs to invest $1 million of her savings. If she succeeds, she will earn $2.2 million. If she fails, she shall lose it all. Assume further that success and failure are roughly equally likely. The expected payoff is therefore $1.1 million. Without taxes, this is a good project. It yields a positive NPV of $100 thousand.

Alas, in our current tax code, it is not a good project. If she succeeds, she needs to pay taxes on the $1.2 million gain. Depending on what form the gain comes in, this can easily be more than 50% (federal income tax, state income tax, etc. the times when the USA was a low-tax country and Europe was not are long since over). So, if she succeeds, she is left with about $600 thousand. If she fails, she is left with nothing. Her losses cannot be used to recoup her past tax payments or her future tax payments if she goes back to work for someone else. The tax code has transformed her positive NPV project of $100 thousand into a negative NPV project of (+$600 - $1,000)/2 = $200 thousand. The best advice to our budding entrepreneur can only be that she not start this new business.

This asymmetric treatment, where business losses cannot be used to reduce ordinary income taxes, amounts to a tax that is exclusive to start-up entrepreneurs. If she were a company, she could use any losses to recoup taxes paid in earlier years as well as any taxes paid in future years. Established businesses are not greatly worried about this asymmetric tax treatment—for established businesses, business losses can be offset with business gains elsewhere. Again, the tax code allows this even for past tax payments. Established successful business people rarely expect to go back to work for someone else, earning W-2 wage income if they fail. I am not arguing that their ability to recoup taxes on losses is a bad thing. Established businesses create jobs just like entrepreneurs. I am only arguing that our tax system is uniquely discriminating against entrepreneurs.

Unfortunately, small entrepreneurs do not hire great lobbyists. Only business people that are already wealthy and well-established do. It is therefore unlikely that the situation will change. What can I do? Not much. Here is one small idea: following the Republicans naming of the inheritance tax as a “death tax”, let’s use a catchy name for this distortion caused by our tax system: call it the “Entrepreneur’s Tax.”

Call on Congress to eliminate the Entrepreneur’s Tax.

Final Notes:

Many decades ago, it was possible to reduce one’s wage tax bill by losses incurred elsewhere. This was badly abused by our legal tax-mitigation industry, which invented vehicles that produced quasi-losses to shelter real wage income. There are ways to suppress this. For example, there could be a reasonable limit to the amount that can be deducted. It could be limited to U.S. investments. (Many of the fake vehicles exploited gray zones in International taxation.) It could require active participation of the entrepreneur (as is the case for active investment treatment today).

The best argument for or against taxing the wealthy is not the intrinsic fairness of who should pay what for our joint goods. The best argument is that we are quickly reaching the limits of our ability to tax. Neither capital nor individuals are forced to stay in a particular US state or even in the US itself–and they are certainly not forced to come to the US. The more we tax, the fewer will be the number of successful business people that will come here and the less will be the capital that will come to the USA for investment; if not now, then over the next few decades. In effect, we may well have already reached close to the maximum of what we can tax.