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Targeted tax benefits outside the lab

January 16, 2012

Tax Analysts in-house economist Martin Sullivan boldy calls for government to pick winners in business ($link). (Update, 1/17/12: free link now available via the TaxProf.)

Tax incentives for venture capital. Firms receiving financing from venture capital funds grow far more quickly and are far more innovative than other small businesses. Positive externalities from innovation are enough to justify preferential tax treatment for venture capital funding. Financial market imperfections provide additional justification. Venture capital funding suffers from a double moral hazard problem. Venture capitalists provide funding and experience to companies they fund. Companies funded by venture capital have imperfect knowledge of the effort venture capitalists will provide. That leads to low levels of venture capital that could be remedied by a reduction in capital gains taxes on venture capital investment. (See Keuschnigg and Nielsen.)

So there is a good economic case for extending tax benefits to venture capital...

...Tax incentives should be targeted to the subset of small businesses that are fast-growing and innovative.

Unfortunately, "targeted" tax benefits don't work well outside the classroom. Iowa has tax incentives for start-up businesses, and a Cedar Rapids example, via Gongol, is instructive:

When he came to Cedar Rapids last year, Walter “Skip” Emig said he and his corporate team at AgSugar International thought they had landed on a gizmo or two that would revolutionize the ethanol industry and make them, and investors, a lot of money.

They believed the biotechnology machines of Missouri inventor Ted Lewis would help run America without foreign oil....

By July, the local backing had secured AgSugar International a package of state assistance worth about $600,000.

About two months later though, Emig and his team lost faith in Lewis and his machines. They have changed their business plan from an assembly plant for those inventions to an assembly plant for LED office lights.

And taxpayers are now invested in a new dream.

While targeting worthy startups sounds good, the government has no skill in selecting "targets" for targeted breaks. As a practical matter, these things target local wire-pullers who know how to play the system and big companies who can hire lobbyists and consultants to milk the programs. An article over the weekend in the Des Moines Register illustrates this:

State leaders gave the lion’s share of Iowa’s economic development tax breaks from 2003 to 2010 to some of the most profitable businesses in the country, awarding 50 companies more than $809 million in seven years.

The three companies that received the most in incentives from the state are all linked to Iowa’s biofuels industry. They’re followed on the list by Swedish steelmaker SSAB, which has operations in Muscatine County; Rockwell Collins in Cedar Rapids; and Deere & Co., which has plants in the Quad Cities, Waterloo, Ankeny and elsewhere in Iowa.

As Nobel economist James Buchanan and his underappreciated colleague Gordon Tullock illustrated, political manipulation of government benefits is inevitable outside the laboratory. That's why "targeted" benefits are bad policy. The government can help best by staying out of the way. Mr. Sullivan has one suggestion that is an excellent thought:

If Congress really wants to help all small businesses, its best course of action would be to reduce compliance costs.

In Iowa, that would mean The Tax Update's Quick and Dirty Iowa Tax Reform Plan.

Related: Most small business don't create many jobs. Because once they do, they're not small.

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