Commentary

Economic Stimulus Proposals

Mr. Chairman and members of the Committee, thank you for inviting me to testify today on proposals for economic stimulus. In compliance with the Truth in Testimony Act, I note that the Cato Institute receives no federal grants, loans, or subsidies.

The U.S. economy is now in recession. The right tax policy can speed up the economy’s return to growth. As large businesses are cutting jobs by the thousands right now, we need small businesses and entrepreneurs to take up the slack by starting new businesses and investing. Let’s make these risky decisions easier for them by cutting their tax burden.

Tax reforms can aid entrepreneurs in three ways - the decision to launch a new business, the ease of finding financing, and the decision to expand. Let me discuss each of these.

First, Congress can make the decision to start a business more attractive by accelerating the already enacted income tax rate cuts. This will boost after-tax returns for sole proprietors, partnerships, and S corporations. Treasury figures show that 63% of tax filers in the top 39% tax bracket have small business income, so cutting the top rate targets exactly the people who can get the economy moving again.

The capital gains tax rate is also very important to encouraging start-ups. This country has scores of so-called serial entrepreneurs, as we’ve seen in high-tech in recent years. They start a new business which they grow for a few years, and then if successful sell their business realizing a capital gain, then they turn around and invest in another start-up. Cutting the gains rate make successful start-ups more valuable, and allows entrepreneurs to keep more funds for reinvestment in new businesses.

As a side note on start-ups, there is quirk in the tax code that would be very timely to fix right now. That is the requirement that new businesses write-off start-up costs over 5 years, rather than allowing immediate deduction. These start-up costs include such items as market research and employee training. So I recommend that the Committee look into this disincentive and lower this tax hurdle to new businesses.

The second way that tax reforms can help is easing business financing. The Committee is aware of the important role played by venture capital in the economy. So-called angel investment in start-ups is maybe even more important and thought to be about twice as large. Angel investors are usually wealthy individuals who are fully taxable. Microsoft billionaire Paul Allen, for example, has put his own money into over 100 new companies. The return these investors receive is capital gains on start-ups that succeed. By the way, during the 1990s many large corporations became venture investors in new growth companies, particularly in high-tech. Corporate capital gains are taxed at 35%, so cutting corporate capital gains may also increase investment flows to small companies.

Some have questioned what lowering the capital gains rate would do right now with the stock market down. But angel and venture capital investors know that the market will rise again, and they are looking to realize gains in new investments perhaps 2 years or more down the road. So cutting the gains rate permanently will drawn in more investment to new high-growth firms right now.

Thirdly, accelerating the individual income tax rate cuts will stimulate existing small businesses to expand. A series of studies by four top tax economists examined the effect of the 1986 tax rate cuts on sole proprietors. Their results indicate that a 5 percentage point cut in rates would increase capital investment by about 10 percent. And they found, for example, that dropping the top tax rate from 40% to 33% would increase hiring by about 12 percent. These are substantial effects.

Other than tax rate cuts, liberalizing depreciation will lower overall or effective tax rates on new investment. The depreciation provision in the House bill is a step forward, but we need to do much more, and make it permanent. The small business expensing limit, now at $24,000, should be raised substantially, and ultimately we should move to full capital expensing for all businesses. The Tax Executives Institute testified before Congress this year that depreciation rules are “hopelessly outdated and needlessly complex.” We should scrap them then and move to expensing which would eliminate many investment distortions. Workers would be the beneficiaries as more capital investment would raise worker productivity and produce higher wages.

Let me make a final note on the issue of broader tax reform. In the 1980s, the U.S. was a leader in tax rate cuts in the world. But the 1990s was a lost decade for tax reform in this country, while other countries have been moving ahead. The average corporate tax rate for national governments in 25 OECD countries fell from 41 percent in 1986 to 31 percent today. Therefore, our corporate rate is now 4 percentage points higher than the average of our trading partners. The average top individual tax rate for national governments in OECD countries fell from 55 percent in 1986 to 41 percent today. Regarding capital gains, a number of countries, such as the Netherlands, exclude it from individual taxation altogether.

A new study by Arthur Anderson compared 9 major countries as to how good their business environment is for entrepreneurial growth companies, based on various tax and regulatory factors. As it turned out, the US was not number one, as we would usually expect. We finished second behind Britain. Let’s not fall any further behind, we should pursue further tax reforms and create the best tax environment in the world for business and entrepreneurs.

Thank you for holding these important hearings, and I look forward to working with the Committee on these issues.

Chris Edwards is director of fiscal policy studies at the Cato Institute. Following is his Dec. 6 testimony before the House Committee on Small Business, Subcommittee on Tax, Finance, and Exports regarding economic stimulus proposals.