With thanks to Sean Murdock

If taxes were sharp and pointy, it’s likely that governments would be always sucking their fingers from playing too dangerously. I don’t mean that they’re too high – let that be a debate for another time – but that they aren’t well thought through in terms of what they seek to promote or discourage. While taxes are governments’ tool of choice for incentives, tax policies that have sought to promote entrepreneurship are, for the most part, complete useless. It needn’t be that way.

I won’t spend much time on the subject of whether government should be in the business of using tax policy to promote corporate development. In an ideal world, it wouldn’t be necessary. Growth companies would borrow or raise capital and develop just like any other commercial enterprise. What makes it necessary for government to tinker is that, despite what you may have heard to the contrary, the world isn’t flat. Many countries use either massive tax incentives (such as Germany’s for wind power) or sovereign wealth and trade policy (see Google’s problems in China) to promote their own agendas. So far the US Government and International trade organizations have either ignored these policies or been ineffective in stopping them. The best answer to a pure capitalist would be for everyone to stop and let the chips fall where they may, but that isn’t realistic. A more liberal mind might suggest that a certain amount of this is appropriate to encourage difficult, expensive but strategically necessary enterprises such green energy. Either way, the US needs to decide how far we’re willing to go to level the playing field. My suggestions are just possible ways to do it.

When diving into the question of tax incentives, it’s easy to rapidly end up in a quagmire of loaded terms and policy wonkiness and find yourself feeling like a camel in quicksand sinking to a slow and very painful demise. In fact, arguably the best single reform to tax policy would be to simplify it, but rather than making an argument that would put legions of tax accountants and lawyers on the streets, I’ll stick to what I know: what motivates entrepreneurs. And I’ll try to stay general. Of course there are minor exceptions and inconsistencies to these ideas, but nothing that can’t be sanded off with a little work.

So let’s start with what doesn’t work at all. By and large, corporate income tax deductions and even credits don’t work. Why? Because most startups positioned for high growth have to spend their first few years investing in developing and commercializing their products. And even once their products are ready to roll, the startups need to raise capital to get them into the market before they become profitable. That means the companies run a loss and don’t have a tax bill to deduct from. Instead, deductions and credits tend to go straight to mid-market and bigger companies or to startups in non-growth market sectors that get to profitability more quickly.

Is there a way to fix these credits so they do work? Sure. The new biotech company incentives in the Healthcare Reform Act are much better thought out if oddly limited to biotech only. They allow not just for a credit, but for direct reimbursement of certain R&D expenses that will cut costs and allow for more rapid expansion of early stage companies. An even better way would be to allow early-stage companies to sell or trade their tax credits to their bigger, profitable corporate brethren. That would stop the government from writing checks to companies, provide some relief to startups and also encourage big companies to take an interest in the startup community relatively early on resulting in more strategic investment and research partnerships.

Unfortunately, Healthcare Reform did more damage than to help to small business tax incentives by imposing onerous 1099 requirements. No good deed goes unpunished, eh?

Another set of programs that really doesn’t help startups is TIFs (Tax Incentive Financing) and property ownership tax deductions and credits. While every program in every region works a little differently, the idea is that either 1) the tax rate on your offices stays the same even if you do massive improvements (which would ordinarily cause your property to appreciate in value and thus in taxation), 2) your taxes are diminished in some way for locating in a challenged zone or region or 3) that you get some kind of tax relief on the mortgage you pay on your building.  To be clear, high growth startups don’t own buildings. If they do, they are mismanaged.  When your company is growing 500-1000% per year and your staff is doubling or tripling is size what you need above all is low cost and flexibility.  You don’t buy – you rent, and that on the shortest term basis you can get while getting enough leasehold improvements to demo the walls and move in a pool table, industrial coffee machine and a server rack.  If you own property you’re like the Ancient Mariner with the albatross dragging him down.

So how can taxes be used effectively? There have been a few good programs. Small employer tax credits that reimburse portions of FICA and other payroll-related tax contributions for new hires are complicated, but align incentives well – every employer pays these taxes and a reduction helps align the interests of government and startups – hiring more people more affordably.  Unfortunately not much more affordably since these programs only reduce the cost of new hires by a couple of percent and only the biggest companies make hiring decision on that kind of basis.

This brings us to the subject of capital gains. Tom Friedman has argued specifically that reducing the capital gains rate for startups would be effective in pushing more entrepreneurs into the race.  At a high level, he’s probably right. Reducing capital gains rates would encourage entrepreneurs to stint their salaries and grow their businesses more quickly. It might also get more people to start businesses, but that’s less clear – people either have the entrepreneurial gene or they don’t.  Taxes aren’t what gets them over the edge.  It might have more impact for investors, but even that’s a bit uncertain.  It would probably be just as effective to raise the capital gains rate on other types of transactions that just make money from money.  That’d push more money towards productive businesses, probably add total tax revenue and help reign in Wall Street with one fell swoop. I’m just saying.

Having said that, the chances of a tax rise on traders are about as high as rainfall in the Sahara. Given that, an informed tax policy would emphasize low capital gains rates for two groups – holders of a company’s common stock (founders and executives – investors always take preferred stock) and those who invest the first $1 million in a new company. The first money is always the hardest to raise and this would help shake loose independent angel investors. Larger venture funds (and many of them are far too large, making money on management fees rather than sound investing) would get less benefit. Similarly, it’s actually the founders and startup execs who take the most risk (unlike investors they can’t diversify) so this would make the currency used to attract talent (stock options) more valuable.

This last point is particularly important. Right now, executives tend to be compensated with options that vest over a period of time. While that vesting schedule may be accelerated under some conditions, for the most part they can’t be exercised until the company sells or IPOs. This means execs pay short term capital gains taxes while investors (who got their shares when they wrote the check) pay long term capital gains taxes. In other words, capital pays half the taxes of talent even though the talent takes more risk. This is an inequity (if you’ll excuse the expression) that could use righting.