As Congress works to provide another round of emergency relief for individuals and businesses impacted by the pandemic and pass a bill funding the government for FY 2021, it is a good time to step back and consider how taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy affects entrepreneurs and small businesses. In addition to short- and long-term tax policy issues, public health restrictions and the related economic downturn have had an outsized effect on entrepreneurs and small businesses this year.
In normal times for entrepreneurs, the complexity and barriers created by the tax code are hardly abstract concepts. The real-world experience of entrepreneurs shows that tax considerations play a critical role when they establish their ventures. Tax planning, preparation, and compliance activities in coordination with practitioners such as accountants and tax lawyers can become a major distraction for entrepreneurs, who have a high opportunity cost for their time.
These challenges become even more challenging when dealing with an economic downturn and service restrictions. Tax authorities at the federal and state levels did the right thing this year by delaying important tax filing and payment deadlines and providing flexibility for businesses navigating the many new tax provisions created in the CARES Act, the original economic relief package passed by Congress in March.
The CARES Act helped entrepreneurs keep their businesses running by providing forgivable loans through the Paycheck Protection Program (PPP) and tax provisions like the Employee Retention Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (ERTC), which reduced payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. liability for firms retaining payroll. However, they are still navigating several sources of uncertainty, including whether they will be able to deduct PPP expenses when PPP loans are forgiven, and whether the many expiring CARES Act provisions will be extended by the end of the year. Some of the tax credits provided in the CARES Act were used less than expected, partly because of administrative delays and an outdated process for receiving tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s. s.
At the state level, there is plenty that can be done to improve the tax environment for entrepreneurs and small businesses. For example, many states levy taxes on tangible personal property (TPP) and inventory, which may create a tax bill even if a new business has yet to make a profit.
A brewery, for example, may pay property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. not just on any real property the business owns, but also on the equipment the brewery uses to produce its beer. Not only does this increase costs for the business and potentially increase prices consumers face, but TPP taxes are “taxpayer active,” meaning that entrepreneurs must calculate their tax liability themselves rather than get a tax bill from the state.
Other state taxes that are assessed regardless of profitability, such as gross receipts taxes, are also particularly harmful for entrepreneurs who have yet to make a profit. As my colleagues argued in our recommendations to create a lasting economic recovery, “states should prioritize reducing reliance on these taxes, particularly those that discourage capital investment, and shift toward more neutral forms of business taxation.”
In addition to poorly structured tax bases, tax uncertainty, and complexity issues, unusually high tax rates can deter individuals from pursuing entrepreneurial ideas, opting instead to pursue lucrative but less risky occupations. Not only does this reduce economic dynamism, but high tax rates can increase the chance that businesses fail, which is a particularly high risk in the current economic climate. This should be kept in mind if policymakers consider raising business and individual tax rates next year to raise revenue and cover budget shortfalls.
Not all is looking gloomy for entrepreneurs and start-ups heading into 2021. The number of new businesses forming has surged during the pandemic, partly driven by the increase in savings Americans have after the CARES Act was enacted and potentially due to more Americans seeking creative ways to earn a living during the pandemic.
These “green shoots” in business formation are a hopeful sign that America can begin reviving the economic dynamism we have lost over the last couple of decades. It will be important for policymakers to clear the way for a strong economic recovery by improving tax policy for entrepreneurs and small businesses.
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