Tax reform must do more to encourage technology startups

When it comes to providing tax reform for small businesses, Congress needs to be careful not to put too much money on the wrong kind of horse. As things now stand in the House and Senate, lawmakers plan to target tax reductions toward individually owned “pass-through” companies (think: dry cleaners, pizza parlors, and the like), which are important mainly insofar as they provide vehicles for their owners to make a good living for themselves — not because they do much for net new job creation or overall economic growth. If Congress is really concerned about generating growth, then it should turn the tax-reform spotlight toward a different kind of small business — the technology-based startup firms that are engines of innovation and tend to have much more long-term growth potential.

According to new research from the Information Technology and Innovation Foundation (ITIF), young firms in technology-based industries make up slightly less than three percent of all U.S. businesses, but they punch significantly above their weight. In fact, the ones that catch fire and grow rapidly account for one-eighth of all new jobs created in any given year. These are good jobs, paying more than double the U.S. median wage — and for every job these dynamic companies create themselves, they spur the creation of five more in the rest of the economy. ITIF’s research shows that the number of these tech-based startup firms in the economy has increased a robust 47 percent in the last decade. But the right kind of tax reform could encourage even more. 

The emphasis in the tax reform debate so far has been on corporate tax reform — which few dispute is desperately needed to boost America’s global competitiveness—and individual tax reform, which makes more sense politically than economically, because it boosts consumer demand, not productive business investment. The same goes for the fabled “mom-and-pop” small business and individual entrepreneur — they may be heroic archetypes, but they aren’t the ones that do the most to grow  the economy. Tech-based startups are the real heroes. And as Congress finalizes tax legislation, lawmakers should take note: These companies are in every congressional district in the country — an average of more than 400 in each — ranging from 26 of them in Texas 33 to more than 2,700 in California 17. Some of these companies have the potential to become the next Amgen, Apple, or Google in a decade or two. 

{mosads}But these firms face unique challenges. Unlike other companies, they often have to make large initial investments for many years before they realize any significant revenues, let alone profits. In fact, many of these companies have net operating losses. As a result, they do not immediately benefit from a reduction in the corporate tax rate. Many must compensate their workers through stock options since their revenues are limited. Moreover, like more mature technology-based companies, they are dependent on investing in risky research and development (R&D) to succeed. Any business tax reform effort should ensure that it helps these kinds of firms succeed on those terms. 

Unfortunately, the House and Senate proposals try to hold down the cost of tax reform by reducing many of the tax provisions that help support high-tech startups. For instance, the Senate bill originally included language that would have taxed stock options when they are exercised rather than when the owner realizes a profit by selling the stock. Both the Senate and the House versions limit the ability to subtract net operating losses in one year against income in other years. The House bill eliminates the orphan drug credit while the Senate bill cuts it in half. This provision is especially important because an increased share of early work in drug development is being done by small companies that have large expenses but few revenues until the government approves their drugs. Finally, both chambers would eventually make companies deduct research expenditures that are not eligible for the R&D credit over five years rather than letting them expense the costs immediately.

Most people agree on the need to eliminate some special tax provisions in order to reduce the cost of tax reform and increase economic efficiency. However, these provisions raise relatively little revenue, and they have a profoundly negative effect on some of our most innovative and fastest-growing companies.

For a relatively low cost, Congress could make changes that would support and encourage new businesses with high growth potential. First, lawmakers should retain first-year expensing for investments in R&D, so companies can deduct those costs right away. Congress also should expand the incentive for companies to conduct more research in the future by raising the R&D tax credit from 14 percent to at least 20 percent. This would make companies more globally competitive, because the United States currently ranks only 25th among OECD countries in R&D tax credit generosity. Second, for the particularly R&D-intensive biopharmaceutical sector, lawmakers should retain the original orphan drug tax credit rate. Finally, Congress should amend current law to let companies carry forward net operating losses even when they have experienced a change in ownership. Doing so would make small companies with long-term potential more valuable to both the companies that might purchase them and the venture capitalists that provide their initial funding.

Congress needs to ensure that tax reform spurs investment. Lowering the corporate tax rate, especially on firms that must compete internationally, will help a lot. But Congress also needs to preserve and even expand incentives that help early-stage innovative companies start and grow. These companies go on to generate high-paying jobs, increase innovation and productivity, and improve the global competitiveness of the U.S. economy — all major wins for any tax reform effort.

Joe Kennedy (@JV_Kennedy) is a senior fellow at the Information Technology and Innovation Foundation, a leading science and tech-policy think tank, where he focuses on tax and regulatory policy.