How Does Capital Gains Taxation Affect Entrepreneurial Activity?

May 5, 2016

Taxing capital gains at lower rates than earned income has raised continuous debate in the tax world. The existing arguments center on whether it is fair to tax capital gains at lower rates than earned income. One new study by Professor William Gentry shed new light on the influence of capital gains taxation on entrepreneurship.

The common perception on capital gains taxation is that it is primarily about taxing corporate stock rather than taxing new firms or entrepreneurial capital. Tax return data from the IRS confirms that realized capital gains are mainly on corporate gains rather than new ventures. By focusing on unrealized capital gains, the paper points out that active business assets have generated large piles of unrealized capital gains in household portfolios, based on data from the Federal Reserve Board’s 2013 Survey of Consumer Finances (SCF). This paper defines the entrepreneurs as the households holding actively-managed business assets. These unrealized capital gains from household portfolios are considerably larger than the unrealized capital gains from holding equity in public companies. The magnitude of unrealized capital gains sitting in entrepreneurial investment warns us of the potential importance of capital gains tax on entrepreneurs’ decisions.

The existing literature on capital gains taxation and entrepreneurship suggests entrepreneurs benefit from the tax rate difference between ordinary income and capital gains by paying capital gains tax rates on what is arguably labor income. This paper, however, argues this simplified depiction may miss an important mechanism by which the capital gains tax can spur entrepreneurial activity. Entrepreneurs can defer paying taxes since capital gains taxes are only collected upon realization. Given the large stock of unrealized capital gains on active business assets, the capital gains tax is at stake and to some extent determines when to sell these business assets with capital gains. The lock-in effect will distort the business decisions made by entrepreneurs. The author also explains how capital gains taxes can affect the financing ability of entrepreneurs.

The paper is worth a read; more attention should be paid to the impact of changing capital gains tax on entrepreneurship activity.

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