Zero Capital Gains on Start-ups – A Not So Good Idea

According to today’s Wall Street Journal (June 17, 2008), Barack Obama “proposes eliminating capital gains taxes on start-up companies ….” While the Journal points out the obvious problem with this policy idea – that the tax lawyers will have every company in America defined as a start-up – it missed the subtler problem.

Cutting taxes on start-up companies will encourage people to create more new businesses. But do we want more of the average start-up to be formed?

I don’t think so. We’d want more start-ups if new companies were more productive than existing companies. But they’re not. A study by John Haltiwanger, Julia Lane, and James Speltzer, in the American Economic Review: Papers and Proceedings, showed that firm productivity increases with firm age. So if we encourage people to start new firms instead of working for existing firms, we are creating an incentive to decrease productivity.

The negative effect of stimulating firm formation can be seen in aggregate economic statistics. In an article published in Labour Economics, economist Danny Blanchflower showed that the correlation between self-employment rates and economic growth in the 19 OECD countries from 1975 to 1996 was negative. And when differences between countries are controlled, the data from the Global Entrepreneurship Monitor indicate that increases in total entrepreneurial activity are associated with decreases in GDP growth.

I’m not sure we’d be doing the entrepreneurs themselves any favors either. When governments intervene to encourage the creation of new businesses, they stimulate people to start new companies disproportionately in competitive industries with lower barriers to entry and high rates of failure. And the entrepreneurs who run those businesses typically earn less money and have worse benefits than they would have earned had they remained working for someone else.

So perhaps we would be better off letting the market work and not provide extra incentives for people to start businesses.

* * * * *

About the Author Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of eight books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By; Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures; Technology Strategy for Managers and Entrepreneurs; and From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company.


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

20 Reactions
  1. Eliminating capital gains on start ups is the removal of a penalty for successful businesses, not, as you suggest, providing an incentive for people to start unsuccessful businesses.

    Unsuccessful and inefficient businesses are an equally important part of a healthy market. They provide competition that makes the successful businesses more efficient. They also will, at times, stumble upon revolutionary breakthroughs in their struggle for survival.

    While there will always be people who attempt to game the system, entrepreneurship is hard enough without being penalized by the government for being successful.

  2. If a startup fails there are no capital gains, just losses. Do you have any idea of what you are talking about?

  3. Bobmanc,

    I believe Professor Shane is talking about the “lure” of no or low capital gains as unduly encouraging investment in startups, even bad startups.

    When people start businesses or invest in startups, they go into it thinking that the business will be successful. They might be tempted to get involved in a startup they shouldn’t, if they THINK they won’t have to pay capital gains on all that money they anticipate they’re going to rake in — even if that money never materializes.

  4. In order to “let the market work” accordingly to its natural law of supply and demand, you have to deregulate, get rid of red tape, lower the taxes, etc. Say after me: “Laissez-faire”… Government employees shouldn’t intervene at all. Instead the state should protect our individual rights and let us conduct business in a free and voluntary way. The small business owners don’t need special favors our hand outs, please use the “hands off” (laissez-faire) method instead.

  5. Ant,

    The problem with the capital gains tax cut on start-ups is not that taxes are good. It’s that the difference between taxes paid as an entrepreneur and taxes paid as an employee distort behavior. They give people an incentive to start businesses that they otherwise shouldn’t start.

    Your house could be painted by someone who works for a company that paints houses or the same guy can start his own business to paint your house. If you give him zero taxes from painting your house by running a business but make him pay taxes as an employee, he would rather paint your house by running his own business.

    Why do we want to encourage him to paint the house by running his own company rather than by working for someone else? If he starts his own company to do it, he will have to spend time running the business. That takes time. So he will paint fewer houses than if he worked for someone else.

    Unless we have evidence that he will do a better job painting or paint the houses faster by working for himself – so much so that it makes up for the administrative costs of running a business and then some – we aren’t getting any benefit by motivating him to start a business. And the evidence isn’t there to show that we get this higher productivity from people when they run their own businesses.

    So if we cut capital gains taxes on entrepreneurs, we should also cut taxes on employees. That way we help people with lower taxes without distorting behavior towards starting companies we don’t need.

  6. I’m a little out of my league here, but that makes sense. At least you’ve given me something to talk with my brother-in-law the economist this weekend…

  7. First, how long would a start up be a start up and therefore be exempt from capital gains? Truthfully, most start ups don’t worry about capital gains because no one is coming along to buy them anyway. This is a pointless proposal with no real economic benefit. Just politics talking.

  8. Are you talking about tech startups or all small-business in general? The data you use to support this conclusion is for all small businesses in general. Your first evidence of productivity versus firm age is a journal article from 1999, and the historical correlation may have changed.

    Also, if you are just talking about tech startups (as your title suggests), then you need to isolate that sector and see the correlation with that data.

    The barbershop on the corner does not have the same behavior as a consultant doing FPGA design.

  9. Steve,

    I am repsonding to Obama’s point to the Wall Street Journal reporters which refers to “start-ups”. The article implied that he was talking about “start-ups” in general. Since tech start-ups make up only a very small portion of all start-ups, the effect of any general policy will be driven by its influence on the typical start-up.

    I don’t know if new firms are more or less productive than established firms in technology. But the data show that new firms in manufacturing in general are less productive than established firms in manufacturing. So the point would hold for manufacturing.

    It’s always possible that the relationship between firm age and productivity was negative in the 1990s and is positive now. But I haven’t seen any data that says that this relationship has changed. And it’s unclear why this relationship would have changed.

  10. This is a bad idea. It will encourage people to start businesses that they otherwise would have not, just because of the tax incentives, which only come into fruition if the business succeeds. Start-ups are difficult and the failure rate is high – and that makes sense.

    Mr. Obama wants to eliminate the cap gains on start ups and hike the cap gains tax on established businesses? People in the US have a tough time saving and investing as it is, this sort of thinking will keep people from wanting to invest in companies that could more likely provide them investment gains. You’re more likely to lose your shirt in a start up. This sort of thinking just does not make sense to me.

  11. Professor Shane, I am not an economist, so I need some help understanding your premise. Where does most startup money come from? Is the common loss coming from individual assets like mortgages and retirement savings? Banks? I am trying to figure out who really gets hurt besides the folks that are working it.

    Also, what businesses do well around startups?

    What does OECD mean?

    I imagine that a flood of new startups would be tough for some established business and good for others – in the short run. There are other trends that could make a big difference. The younger generation is re-defining what a startup is and what success means. Networks of alliances at the startup level may be the start of a sea change. There are many new trends emerging that will have profound effects on our ideas of who is benefited by what – that goes beyond simple GDP numbers.

    There is also another scenario possible: Mid and large Business decide to fund startups by employees and build the pool of outsourced services. Which they have more influence over with less responsibility.

    I doubt Senator Obama is proposing a sound bite without some practical structural ideas behind it.

    Out of the gate, it is hard for me to buy into the notion that lowering the entry barrier for startups is going to hurt our country is pretty hard to swallow. GDP and startup failure doesn’t strike me a cause and effect relationship. More likely that the economic conditions that reduced the GDP also caused alot more startups to fail.

    But your article is good for blogging – you got a rise out me:)

  12. I agree with Andertoons, this is a little out of my league. But once I read your comment responses, I now understand a little better. Good food for thought.

  13. If people would be encouraged to start a business if the tax is taken away, are you assuming the currently people are discouraged to start up because of the capital gains taxes? That sounds silly. Almost no one I know of who has started a company has thought twice about capital gains, they do it for other reasons. So why would it make a difference if the rules changed? Put another way, capital gains or no capital gains, people don’t care about those things when starting a business. I think it’s so far down on the list of worries/cares/importance, it would make absolutely no difference if the rules changed.

  14. Scott,
    There are already significant tax advantages for entrepreneurs, because society benefits from the inefficiency of small business. The reason these tax advantages are offered is because in being inefficient it creates other business opportunities as well as creating employment.

    In the example of the house painter guy, he has a business problem if he can’t paint as many houses as he could as an employee. He can chose to leave this business problem unsolved and in doing so he will create demand which will either attract other painters to fill that need, or the scarcity of painters will drive the price up incenting him to be more efficient or others to fill that need. On the other hand, he can chose to solve the business problem by outsourcing some administrative task which in turn is new business for the person or business that he uses or he can hire an employee to increase his house painting capacity.

    Just because being an entrepreneur is difficult doesn’t mean that it shouldn’t be attempted. Entrepreneurs build wealth for themselves, as opposed to large companies where most of the wealth is siphoned off and hoarded by the executives leaving less for the shareholders/owners of the business. This is a natural and healthy distribution of wealth that benefits the nation because a smaller percentage of the wealth is hoarded due to the percentage of the distributed wealth being required for living expenses. While this is less efficient from the entrepreneur’s perspective, this lack of efficiency returns more of this wealth to perpetuate fiscal growth from the community level up to GDP.

    I agree that with regard to the tax issue, income tax should be lowered, if not eliminated. From a matter of economic incentive/disincentive, people shouldn’t be penalised for either working a job or starting a business.

  15. Although this is a topic that’s a bit “foreign” to me. . .it doesn’t sound like a very good idea and it also sounds like the companies that will come out of this are doomed for failure. Just doesn’t sound wise at all. I think simplistic, logical thinking is lost to many these days. . .

  16. A great post! Some great comments and discussion.

    Having complimented you on a great post…I disagree.

    You are correct in saying large, more established businesses do run more efficiently. Growth companies eat cash. Established companies produce cash. That’s why they’re sometimes referred to as cash cows.

    Established companies are known as much for their size and established systems as they are for being successful in established markets. And their future success comes not from gaining increasing market share, which would eat cash, but in maximizing their efficiencies of scale, Six Sigma, Lean manufacturing, streamlining, cutting costs…and jobs. Established companies generate cash because they’re no longer investing in innovation. they’re not looking for the next market. They’re looking to defend their turf, (sorry) milk this cow, ie, market for as long as possible. At best they’re investing in cutting costs, too often that’s in the form of cutting jobs.

    Growth companies do eat cash. They eat cash while they’re in startup phase before they have products to bring to market. They eat cash for each new job they create. There’s a huge upfront cost small businesses and startups incur with each new hire: a new computer, training, GS&A, FICA/FUTA. These are investments. These are expenses not incurred with an established company in an established market.

    In May 60,000+ jobs were generated by companies with under 50 employees. A negative number of jobs were created by companies over 50 employees.

    Think about it. Smaller companies have more expenses, have a higher risk, face richer competition. And here they are the ones driving job creation in a very tough economy. Their larger brethren, the ones with access to many forms of capital, the ones with established positions in mature markets, the ones with the additional tax credits…are the ones cutting jobs.

    You mention a zero capital gains tax on startups would incentivize the wrong people. Really? How so? Wouldn’t it incentivize the right people? Wouldn’t it incentivize the ones most likely to add jobs to our economy?

    The current capital gains tax/credits and returns are available only for investments in mature companies. Small, startup, companies …the ones adding jobs to our economy don’t have that advantage. They offer higher risk…but no support in the tax code at least compared to their more established brethren. Their larger companies offer lower risk, and higher returns.

    So, which tax is more conducive for growing our economy through the tried and true method of adding jobs from innovative, startup companies with the courage to take a greater risk and with less support than their larger, better-finance companies?

    One last thought…the growth of our economy and our ability to compete globally won’t be sustained or even possible by established companies in established markets. Growth and global competition will be sustained by innovative companies. These usually fall into the small, startup category of companies. When’s the last time you heard ‘innovation’ and ‘large-established company’ used in the same sentence?

  17. As some above have said that most small businesses don’t think about the tax before they start. This is part of the problem. Making it seem easier to start up with no capital gain tax, or starting in an unfavourable industry etc as you mentioned in another post means that some small businesses don’t think through all the issues before they leap and later suffer the financial and other consequences when they struggle or fail.

    Your posts give good food for thought.

  18. This is in response to what Tom said on June 18th. Please correct me if I am wrong, but this capital gains waiver is not only for those who start the business but also to those who join startups (for stock options). This will incentivize people to join startups and make it a success.

  19. Do you think blogging just has to be about writing? Reason I ask is I want to start a photography blog, but I feel I am better at expressing myself with photos rather than write. Should I even start it? With your experience could it work, more pictures, less words?

  20. Any thoughts on the new Start-Up Visa proposal that Congressman Polis is introducing?