Why Getting Rid of Small-Business Taxes Might Not Be Such a Good Idea

As promised, I'd like to discuss the proposal from the great entrepreneur Mark Cuban that has been flitting around the blogosphere the last week. In case you missed it, here's the beef:

If you want to see an immediate reinvigoration of the economy, open the door back up for individual entrepreneurs to enter the real world without fear and without an immediate financial burden that preempts their ability to be successful.

If we really want to stimulate job creation in this country, take the same approach to [taxing] small business with 25 or fewer employees that we take to Internet taxes. Outlaw them.

No taxes of any kind on small businesses with 25 or fewer employees. No employer payroll tax. No state or local taxes. No taxes on earnings. Nada. The business owners will pay income taxes on their personal income they pay themselves, but not corporate earnings.

Who wants to not pay taxes? It sounds like a question as obvious as "Who wants to be a millionaire?" It's an idea no entrepreneur could ever refuse. Anita Campbell points out one caveat regarding just how many small businesses would be affected, but her bottom line is the same as my initial reaction: "I like the idea of lower taxes in general."

But it's more complicated than that. There actually is good reason for entrepreneurs to oppose Cuban's proposal, or at least call for caution.

Here's the problem: If you own a business, and you have 25 employees, and your business is growing, partially thanks to your low tax liability, what do you do when you want to expand? If going from 25 to 26 employees means that a boatload of taxes is going to come falling on your head, that's going to be a huge disincentive to do what would otherwise make good economic sense. You might say that expanding your business is worthwhile in the long run, but the problem is, you're not going to make economic decisions based on what your business will look like with 100 employees. You're going to look at what will happen with 26, 27, 28, and so on, employees. That's why economists talk about marginal utility—it's that marginal effect of adding each new employee that counts.

Bob Litan over at the Kauffmann Foundation told me that economists also call this "the notch problem." In reference to Cuban's idea, Litan says, "When you're close to the notch, you do everything to stay under the notch. It has very perverse incentives." The proposal also would encourage business owners to avoid taxes in ways that aren't very efficient, such as breaking up what would otherwise be one large company into several separate entities.

So while I'm no fan of taxes, especially those that affect the most innovative and productive people in our economy, I worry about the unintended consequences of lifting taxes on businesses of only a certain size. That being said, I think there are ways to modify Cuban's idea to deal with this problem. Litan told me about one: Base the tax exemption on the age of the business, instead of the size. Your firm doesn't have to pay taxes for its first year. That would encourage more people to become entrepreneurs, but without encouraging them to stay small.

Also, check out Jeff Cornwall's favorable assessment of Cuban's post. I'll have some more thoughts on this next week, but I actually agree with a lot of what Jeff is saying.