On The Subject of Economic Stimulus Proposals

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

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

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

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

The capital gains tax rate is also very important to encouragingstart-ups. This country has scores of so-called serialentrepreneurs, as we've seen in high-tech in recent years. Theystart a new business which they grow for a few years, and then ifsuccessful sell their business realizing a capital gain, then theyturn around and invest in another start-up. Cutting the gains ratemake successful start-ups more valuable, and allows entrepreneursto keep more funds for reinvestment in new businesses.

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

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

Some have questioned what lowering the capital gains rate woulddo right now with the stock market down. But angel and venturecapital investors know that the market will rise again, and theyare looking to realize gains in new investments perhaps 2 years ormore down the road. So cutting the gains rate permanently willdrawn in more investment to new high-growth firms right now.

Thirdly, accelerating the individual income tax rate cuts willstimulate existing small businesses to expand. A series of studiesby four top tax economists examined the effect of the 1986 tax ratecuts on sole proprietors.1 Their results indicatethat a 5 percentage point cut in rates would increase capitalinvestment by about 10 percent. And they found, for example, thatdropping the top tax rate from 40% to 33% would increase hiring byabout 12 percent.2 These are substantialeffects.

Other than tax rate cuts, liberalizing depreciation will loweroverall or effective tax rates on new investment. The depreciationprovision in the House bill is a step forward, but we need to domuch more, and make it permanent. The small business expensinglimit, now at $24,000, should be raised substantially, andultimately we should move to full capital expensing for allbusinesses. The Tax Executives Institute testified before Congressthis year that depreciation rules are "hopelessly outdated andneedlessly complex."3 We should scrap them thenand move to expensing which would eliminate many investmentdistortions. Workers would be the beneficiaries as more capitalinvestment would raise worker productivity and produce higherwages.

Let me make a final note on the issue of broader tax reform. Inthe 1980s, the U.S. was a leader in tax rate cuts in the world. Butthe 1990s was a lost decade for tax reform in this country, whileother countries have been moving ahead. The average corporate taxrate for national governments in 25 OECD countries fell from 41percent in 1986 to 31 percent today.4 Therefore,our corporate rate is now 4 percentage points higher than theaverage of our trading partners. The average top individual taxrate for national governments in OECD countries fell from 55percent in 1986 to 41 percent today.5 Regardingcapital gains, a number of countries, such as the Netherlands,exclude it from individual taxation altogether.6

A new study by Arthur Anderson compared 9 major countries as tohow good their business environment is for entrepreneurial growthcompanies, based on various tax and regulatory factors.7 As it turned out, the US was not number one, as we wouldusually expect. We finished second behind Britain. Let's not fallany further behind, we should pursue further tax reforms and createthe best tax environment in the world for business andentrepreneurs.

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

Notes

1 "Entrepreneurs, Income Taxes, and Investment,"Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen,in Does Atlas Shrug, Joel Slemrod (editor), 2000. See alsoEconomic Policy and the Start-Up, Survival, and Growth ofEntrepreneurial Ventures, Douglas Holtz-Eakin and HarveyRosen, Submitted to the Small Business Administration, May2001.

2 "Income Taxes and Entrepreneurs' Use ofLabor," Journal of Labor Economics, Robert Carroll,Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen, April 1999.

3 Betty Wilson, Tax Executives Institute,Testimony before the Senate Finance Committee, 107th Congress, 1stsession, April 26, 2001.

4 "Tax Rates Are Falling," OECD inWashington, March-April 2001. And email from OECD Washingtonwith "OECD Tax Database" data.

5 Email from OECD Washington with "OECD TaxDatabase" data. Central government tax rate only.

6 An International Comparison of CapitalGains Tax Rates, Arthur Andersen LLP study completed for theAmerican Council for Capital Formation, August 1998.

7 "Not Just Peanuts 2001," Growth Plus andArthur Andersen, October 2001. www.growthplus.org.

Chris Edwards

Subcommittee on Tax, Finance, and Exports
Committee on Small Business
United States House of Representatives