With all the attention paid to big corporations like Walmart and Microsoft, it’s easy to forget about the little guys—small, entrepreneurial companies that fill in the less-glamourous contours of the U.S. economy. An excellent memo released by the U.S. Treasury last month reminds us of the long-run importance of these dynamic, experimental small companies—and how our individual income tax discourages their formation: [Small] businesses are often small and entrepreneurial in nature, a source of innovation and risk-taking in the economy, and important contributors to economic growth. They start new businesses or invent new products; try out new technologies, new internal forms of organization, and new locations. Others follow their successes, leading to general increases in productivity, or learn from their mistakes. Small firms are society’s testing ground for new ideas. As a result, you’d think we’d want a tax code that didn’t discourage this sort of dynamic learning. But you’d be wrong. Most small businesses pay tax through the individual income tax code, which imposes higher tax rates as companies grow. Progressive marginal rates on entrepreneurship make social experimentation more costly. And we all know what happens when things get more costly.
