Download Taxation and Public Policy Towards Small Firms: A Review

Taxation and Public Policy Towards Small Firms: A Review
Francis Chittenden & Brian Sloan
Abstract
The favourable tax treatment of the self-employed and SMEs can only be justified on
efficiency grounds if there is evidence that they provide spillover (external) effects to
the rest of the economy that are not fully captured by these small “firms”. However,
many countries have incomplete integration between personal and corporate tax
systems. The resulting non-neutral tax structures are often inefficient, distorting the
allocation of resources. Consequently, policy makers need to design tax policies for
entrepreneurship to remedy market failures, while avoiding adverse side-effects. The
paper concludes with suggestions about the characteristics of an optimal small
business tax system.
Background
In the broad area of tax policy there is a range of literature from internationally
respected authors that is relevant to small firms in advanced economies, including
evaluations of policy designed to improve access to finance and also other tax policies
such as R&D tax credits, capital allowances and the effect of taxation on the rate of
business formation and growth. The objective of this article is to assemble the
findings of this diverse literature into a coherent review that presents arguments about
the relevance of taxation to small business policy and the ways in which taxation
 Francis Chittenden is ACCA Professor of Small Business Finance at Manchester Business School;
Brian Sloan is a Doctoral Researcher at Manchester Business School.
might be used as part of public policy towards smaller firms in mature economic
environments, whilst avoiding undesirable effects that distort commercial decision
making.
As a starting point the findings of two papers are presented. Chen Lee and Mintz have
argued that small firms in a number of OECD countries are subject to sub-optimal tax
systems that do not address market failures that hamper the growth of small firms.1
These market failures are generally taken to include2: rewards for the externalities
provided by small firms to the benefit of the wider economy that are not fully
captured by small firms (e.g. with R&D expenditure); the need to provide tax breaks
for small firms, on the basis of equity, i.e. fairness vis a vis other firms (for example
because of the regressive costs of regulations); the need to stop the tax system from
influencing business decisions, i.e. to make tax more economically efficient (for
example to neutralize the tax advantages associated with debt financing; if there was
evidence that capital market imperfections were leading to under-investment in small
firms (because of the equity gap and the problem of credit rationing for entrepreneurs
lacking collateral or a track record); if the level of taxation were constraining the
willingness of entrepreneurs to take risks (for example because a very high proportion
of their wealth is invested in just one venture). Chen Lee and Mintz conclude that
governments should re-examine their tax systems and seek to remove the biases
against small firms, providing doing so does not lead to the inefficient allocation of
resources elsewhere in the economies concerned. However, these conclusions are
contested. For example, Holtz-Eakin2, discusses the market failures that would justify
1 D. Chen, F.C. Lee and J. Mintz, “Taxation, SMEs and Entrepreneurship” (2002) Working Paper
Series, OECD Directorate for Science, Technology and Industry.
2 D. Holtz-Eakin, “Public Policy Towards Entrepreneurship” (2000) 15 Small Business Economics at
283.
public policies that favour small firms, as noted above, but concludes in every case
that the tax system in the USA is an inappropriate mechanism for addressing these
disadvantages. These arguments are examined here in some detail, drawing upon a
range of literature relevant to the taxation of small firms.
The next section discusses general issues relating to the tax system that, despite their
broad relevance, are important to public policy towards small firms. The taxation of
business profits section reviews the literature on the efficiency and desirability of the
profits base for taxation observed in most advanced economies and the implications of
this tax base for small firms. The following section then considers public policy
towards small firms, from a fiscal perspective, and examines a number of specific
public policy issues concerning small firms. A discussion section brings together the
diverse literature reviewed, particularly highlighting whether there is any justification
for using the taxation system as a means to support public policy towards small firms.
Finally the main arguments are drawn together into a conclusion and suggestions are
made for a theoretically sound fiscal stance towards small firms.
General issues
A fundamental issue recognised in the literature is that the effectiveness of tax policy
is dependent upon a broad base of support from citizens. As a consequence fiscal
policy cannot be determined in isolation from the socio-political climate of the day.3
Whilst this statement may seem trite, in the literature relating to tax compliance and
evasion research indicates the importance of broad political support to the successful
3 E. Engen and J. Skinner, “Taxation and Economic Growth” (1996) 49 National Tax Journal at 617.
working of the tax system, because it is dependent upon very high levels of voluntary
compliance by citizens, including business owners.4 Consequently taxpayers, the vast
majority of whom are compliant, should be treated with respect by the tax
authorities.5 Operating a tax system without that support would be very expensive, if
not impossible. Conversely, when policies enjoy broad political support a wide range
of tax rates and structures may be workable, e.g. in relatively low tax economies, such
as the US, and high tax countries, such as Sweden.6
A second fundamental point is that, despite the popular appeal of the notion of Laffer
curves7 where reductions in tax rates result in increased tax revenues, the literature
shows that, from a historical perspective, tax incentives and reductions in tax rates
have generally not been self-financing.8 However, it should be noted that Griffith et al
predict that the R&D tax credit in the UK could be self-financing over the long term,
because of the positive externalities associated with this form of investment
expenditure.9
Proposals for major reforms to the structure of business taxes are made by a number
of researchers. The pro-genitor of these ideas is the argument (now several decades
old) that the most economically efficient tax base for businesses would be cash4 See for example B. Erard and J.S. Feinstein, “Honesty and Evasion in the Tax Compliance Game”
(1994) 25 RAND Journal of Economics at 1; J. Andreoni, B. Erard and J. Feinstein, “Tax Compliance”
(1998) 36 Journal of Economic Literature at 818; R.E. Brown and M.J. Mazur, “IRS’s Comprehensive
Approach to Compliance Risk Management” (2003) 56 National Tax Journal at 689.
5 K. Murphy, “Moving Towards a More Effective Model of Regulatory Enforcement in the Australian
Tax Office” [2004] BTR at 603.
6
See
OECD,
‘Tax
Database’,
(2004)
website
resource,
available
at
http://www.oecd.org/document/60/0,2340,en_2649_201185_1942460_1_1_1_1,00.html, accessed 20th
April 2007.
7 The Laffer Curve is concerned with the effect of marginal rates on incentives to work, i.e. lower tax
rates may stimulate people to work harder and earn more income, so tax revenues rise.
8 See for example E. Engen and J. Skinner, see fn.3 and J.H. Branson and C.A. Knox-Lovell, “A
Growth Maximising Tax Structure for NZ” (2001) 8 International Tax and Public Finance at 129.
9 R. Griffith, S. Redding and J. van Reenen, “Measuring the Cost-Effectiveness of an R&D Tax Credit
for the UK”, (2001) 22 Fiscal Studies at 375.
flow.10 The more recent proposals are for a flat tax system in the US and the Ralph
Committee proposals in Australia.11 Whilst governments may recognise the
theoretical attraction of these tax systems, there is reluctance to engage in such radical
reform. There appear to be two reasons for this. First, in practice the proposed taxes
may be less straightforward than initially anticipated12 and secondly concerns exist
about the level of tax revenues that might result13, partly because changes to the tax
code may yield unanticipated opportunities for tax planning. The tax code should be
designed to minimise tax planning activity by reducing opportunities and incentives to
switch incomes from high to low taxable sources; alter the timing at which incomes
are recognised or tax is payable; or move incomes from high to low tax bands, e.g. by
avoiding thresholds.
Within these boundaries this paper attempts to synthesise findings from the literature
on taxation relevant to public policy towards small firms, and to assemble this in a
way that explores the possibility that an optimal system of taxation for small firms
could be designed that is consistent with the broad theoretical underpinnings evident
in the literature.
The taxation of business profits
Despite the lack of theoretical attraction referred to above, in advanced economies
direct business taxes are presently levied on profits, in some cases adjusted in
10 J.E. Meade, The Structure and Reform of Direct Taxation (George Allen & Unwin, 1978).
11 For details of the flat tax see R.E. Hall and A. Rabushka, Low Tax, Simple Tax, Flat Tax (McGraw
Hill, New York, 1983) and The Flat Tax (Hoover Institution Press, Stanford, 1995). For the Ralph
Committee proposals see J. Pope and P. Fernandez, “Current Tax Reform in Australia: An Ambitious
Programme” [2001] BTR at 135.
12 M. Calgari, “Flat Taxes and Effective Tax Planning” (1998) 51 National Tax Journal at 689.
13 See J. Pope and P. Fernandez, see fn.11.
accordance with the tax code. One such adjustment relates to adding back accounting
depreciation and then deducting “capital allowances” calculated in accordance with
the rules of the tax authority. Bond, Devereux and Gammie are critical of the capital
allowances system and argue that it does not offer adequate incentives to encourage
investment, particularly in the presence of tax incentives to utilise debt as opposed to
equity.14 The most elegant response to this has been the proposal of an “Allowance
for Corporate Equity” (ACE).15 The ACE seeks to remove the tax incentives to use
debt by allowing a deduction from taxable profits equivalent to an imputed interest
charge based upon the value of equity in the balance sheet. Despite the theoretical
attraction of this proposal only one reference to the adoption of an ACE in practice
can be found in academic literature, and this was subsequently withdrawn by the
Croatian government in 2001, some six years after its introduction. However, the
reasons for abolition appear to have been driven primarily by political factors rather
than valid criticisms of the economic efficiency of the ACE.16
In the context of small firms the distortion caused by the tax deductibility of interest
(referred to above) may be of relatively less importance than for large firms because
of the well-known fact that business owners wish to grow their enterprises from
retained profits. This was first articulated by Bolton:17
“…what is required for the health of the (small firms) sector is an
economic and taxation system which will enable individuals to acquire
14 S.R. Bond, M.P. Devereux and M.J. Gammie, “Tax Reform to Promote Investment” (1996) 12
Oxford Review of Economic Policy at 109.
15 See discussions by M.P. Devereux and H. Freeman, “A General Neutral Profits Tax” (1991) 12
Fiscal Studies at 1 and S.R. Bond, M.P. Devereux and M.J. Gammie, see fn.14.
16 M. Keen and J. King, “The Croatian Profit Tax: An ACE in Practice” (2002) 23 Fiscal Studies at
401.
17 At 192, J.E. Bolton, Small Firms: Report of the Committee of Inquiry on Small Firm Cmnd.4811
(1971).
or establish new businesses out of personal resources and to develop
these on the base of retained profits. Without this no institutional
financing arrangement can preserve the small firms sector.”
It might be expected that this conclusion, reached over 30 years ago, would no longer
be valid. However, more recent studies have confirmed that for the majority of (small)
businesses retained profits remains the preferred source of finance.18
There are other pressures for change on the corporation tax system in particular, and
these relate to international tax competition. Tax competition is probably a zero sum
game because states suffering a loss of economic activities may have little choice
other than to respond19, although there may be a time delay. However, there is little
doubt that if countries can adopt a policy of low corporate taxes, at the same time as
maintaining fiscal prudence, orderly labour policies and access to sophisticated
industrial and consumer markets, there may be opportunities to attract foreign direct
investment to the benefit of the economy as a whole, including the small business
sector. The low corporate tax policies adopted by Ireland in the 1990’s is an example
of such an approach.20
The prospect of tax competition21 together with the mobility of international capital
has led some authors to suggest that taxes on business profits should be abolished
18 See for example S.C. Myers, “The Capital Structure Puzzle” (1984) 39 Journal of Finance at 575
and N. Michaelas, F. Chittenden and P. Poutziouris, “Evidence on the Tax and Investment Affairs of
Small Firms” (1999) 6 Journal of Small Business and Enterprise Development at 7.
19 T.C. Omer and M.K. Shelley, “Competitive, Political, and Economic Factors Influencing State Tax
Policy Changes” (2004) 26 The Journal of the American Taxation Association at 103.
20 B. Walsh, “The Role of Tax Policy in Ireland’s Economic Renaissance” (2000) 48 Canadian Tax
Journal at 658.
21 See OECD “Harmful Tax Competition – An Emerging Global Issue” (1998) available at
http://www.oecd.org/dataoecd/33/0/1904176.pdf, accessed 20th April, 2007.
altogether22 and replaced by consumption taxes.23 Indeed it is generally accepted that
taxes on production, e.g. corporate taxes, are less economically efficient than taxes on
consumption, i.e. indirect taxes.24 However the size differential of these effects is less
clear. Engen and Skinner argue that tax structures are important to economic growth,
whilst Branson and Knox-Lovell state that tax rates are six times more influential than
tax structures.8 In practice it seems unlikely that taxes on business (especially
corporate taxes) will be abolished unless the US were to adopt such a radical policy
and, if they were, other avoidance measures would need to be put in place to cope
with the tax planning opportunities arising from the wide tax differential between
personal and business taxes.20, 22 The high rate of new business incorporations evident
in the UK as a consequence of the introduction in 2002 of the zero per cent rate of
corporation tax on profits up to £10,000, is an example of the behavioural response to
such a tax differential that caused the measure to be withdrawn in April 2006.25
Public policy towards small firms
Do taxes restrain entrepreneurial activity?
Consideration of this issue is important for economic prospects as there is general
agreement that tax policies do affect profits growth and the size of economies in a
variety of ways26, for instance through the impact on incentives to create wealth, on
22 R. Citron, “The Future of Tax in the 21st Century: A Practitioner’s Perspective” [2002] BTR at 161.
23 S. Fazzari, R.G. Hubbard and B. Petersen, “Investment, Financing Decisions, and Tax Policy”
(1988) 78 American Economic Review at 200.
24 Such taxes impact on investment in human and physical capital as well as the allocation of labour
and capital. They are therefore considered to be economically inefficient. See for example discussions
in E. Engen and J. Skinner (see fn.3) and J.H. Branson and C.A. Knox-Lovell (see fn.8).
25 See Pre-Budget statement 2005 available at www.hm-treasury.gov.uk, accessed 20th April 2007.
26 J.H. Branson and C.A. Knox-Lovell, see fn.8.
tax planning efforts, on compliance and evasion and on the allocation of resources
between the public and private sectors. A number of articles explore the extent to
which entrepreneurship is constrained and whether tax policy has a role to play in
minimising any adverse effects.
Some opening comments are appropriate to this discussion. First, entrepreneurial
behaviour is difficult to monitor, as a consequence most studies use self-employment
as a surrogate measure. This is unsatisfactory as it is acknowledged that selfemployment encompasses a variety of forms of economic activity, including lifestyle
businesses and “quasi-employment”.27 In addition it should be noted that the form of
“entrepreneurship” considered here is that identified by Knight, where the
entrepreneur is also the provider of capital.28 This contrasts with the Schumpeterian
view where investors other than the entrepreneur provide the resources.29 Today the
Schumpetereian entrepreneur is perhaps an intrapreneur. This form of economic
activity is not considered here, indeed relatively little is known about its scale or
impact.
Gentry and Hubbard conclude that the tax system influences the numbers of people
adopting self-employment, and in a study of the US these authors argue that tax
differentials could either encourage or discourage the adoption of self-employed
27 D. Holtz-Eakin, D. Joulfaian and H.S. Rosen, “Entrepreneurial Decisions and Liquidity Constraints”
(1994) 25 RAND Journal of Economics at 334; R.C. Kloosterman, “Creating Opportunities. Policies
Aimed at Increasing Openings for Immigrant Entrepreneurs in Holland” (2003) 15 Entrepreneurship
and Regional Development at 167; B. Sloan and F. Chittenden, “Fiscal Policy and Self-Employment:
Targeting Business Growth” (2006) 24 Environment and Planning C: Government and Policy at 83.
28 D.S. Evans and B. Jovanovic, “An Estimated Model of Entrepreneurial Choice Under Liquidity
Constraints” (1989) 97 Journal of Political Economy at 808.
29 J.A. Schumpeter, “The Theory of Economic Development”, 1967 Reprint, Oxford University Press,
New York.
status.30 However, taxation is only one of a series of influencing factors affecting this
choice. Other relevant issues include the desire to be “your own boss”31, the
availability of a safety-net, such as alternative job opportunities, and the presence (or
absence) of a sense of financial security.32
Do taxes exacerbate the financial constraints on entrepreneurship?
Turning to the financial constraints on “entrepreneurship”. There is considerable
debate about whether these financial constraints exist. Many academics argue that
financial constraints on entrepreneurship do not exist; however there is also a strong
body of literature that opposes this view.33 With regard to the argument that they do
not exist, the argument follows that because it is impossible for banks to differentiate
between businesses with good or poor prospects, some poor proposals are funded and
some strong ones rejected. If banks have to rely upon collateral security, because they
lack evidence on which to judge the commercial prospects and acumen of business
founders, they may either over or under invest. Parker’s recent work is telling33, as he
is the first economist to present a theoretical proposition that both credit rationing and
under-investment can occur simultaneously. Previously it was thought that because it
30 W.M. Gentry and R.G. Hubbard, “Tax policy and Entrepreneurial Entry” (2000) 90 American
Economic Review at 283.
31 B.H. Hamilton, “Does Entrepreneurship Pay? An Empirical Analysis of the Returns of SelfEmployment” (2000) 108 Journal of Political Economy at 604.
32 M. Taylor, “Earnings, Independence or Unemployment: Why Become Self-Employed?” (1996) 58
Oxford Bulletin of Economics and Statistics at 253.
33 Examples of literature that argue liquid constrains do not exist include J.E. Stiglitz and A. Weiss,
“Credit Rationing in Markets with Imperfect Information” (1981) 71 American Economic Review at
393; D. DeMeza and D. Webb, “Too Much Investment: A Problem of Asymmetric Information”
(1987) 102 Quarterly Journal of Economics at 281; R. Cressy, “Are Business Start-Ups DebtRationed?” (1996) 106 Economic Journal at 1253. Those that suggest liquidity constrains do exist
include D.S. Evans and B. Jovanovic, see fn.28; D. Holtz-Eakin, D. Joulfaian and H.S. Rosen, see
fn.27; A.E. Burke, F.R. FitzRoy, and M.A. Nolan, “When Less is More: Distinguishing Between
Entrepreneurial Choice and Performance” (2000) 62 Oxford Bulletin of Economics and Statistics at
565; S.C. Parker, “Asymmetric Information, Occupational Choice and Government Policy” (2003) 113
Economic Journal at 861.
is impossible to differentiate between new business proposals that will be successful
and those that will not, even in the presence of credit rationing, over-investment
occurs. However, recognising that entrepreneurs are liquidity constrained is not the
same as arguing that there is market failure in the provision of debt finance or that the
tax system is necessarily the best mechanism by which to address these liquidity
constraints.
On this latter point researchers are once again divided with Bolton17 and Parker33
arguing that the tax regime may be an appropriate policy vehicle to alleviate the
financial constraints on entrepreneurship. Bolton advocates incentives for business
owners to grow their businesses from retained profits and Parker suggests using the
tax system to improve individual’s choices between employment and selfemployment and thus, indirectly raising the quality of business propositions seeking
finance. In contrast Holtz-Eakin acknowledges the existence of capital market
imperfections but concludes that the tax system is not an appropriate policy
instrument as, in this case, market failure results from lack of information about
business prospects.2
However, none of these arguments are entirely satisfactory from a policy perspective.
Bolton17 reported at a time when levels of personal wealth and the fiscal environment
were very different, possibly reducing the strength of his arguments today, and Parker
acknowledges that his work is novel and requires further development33. Holtz-Eakin
argues that the tax regime is likely to prove ineffective in addressing liquidity
constraints even though he acknowledges that business owners are in the best position
to judge the commercial prospects of their businesses.2 Keuschnigg also considers that
tax reliefs could be offered to hands-on venture capitalists to enable the expansion of
their managerial resources and so increase the volume of investments made.34
However, this proposal appears to assume that there are few constraints on the supply
of experienced venture capital managers, a condition that some would find difficult to
accept, at least in the short-term.
The authors conclude that in the literature the issue of whether new businesses are
liquidity constrained remains unresolved. However, this is a somewhat different issue
from whether the tax regime reduces the availability of finance for the expansion of
established businesses. On this the evidence is more clear cut, with examples of both
theoretical support and empirical evidence being found in the literature.35 Whilst these
studies do not quantify the extent to which the availability of business finance is
reduced by taxes, Poutziouris et al find that 45 per cent of business owners claim they
would seek to earn additional profits to take advantage of a £5,000 tax free allowance
for business profits and 29 per cent claimed that they would, if necessary, reduce their
personal drawings from the business in order to utilise such an allowance.36
Poutziouris et al provide a theoretical framework that explains recent UK experience
that the tax system strongly influences the behaviour of business owners in terms of
the profits that they declare for tax purposes.
34 C. Keuschnigg, “Taxation of a Venture Capitalists with a Portfolio of Firms” (2004) 56 Oxford
Economic Papers at 285.
35 Theoretical evidence can be found in J.E. Meade, see fn.10 and S. Fazzari, R.G. Hubbard and B.
Petersen, see fn.23; empirical evidence is provided in J.E. Bolton, see fn.17 and N. Michaelas, F.
Chittenden and P. Poutziouris, see fn. 18.
36 P. Poutziouris, F. Chittenden and N. Michaelas, “Evidence on the Tax and Investment Affairs of
Small Firms” (1999) 6 Small Business and Enterprise Development at 7.
Taxes and the choice between employment and self-employment
With the issue of the role of the tax system in helping to alleviate the financial
constraints on entrepreneurship partially unresolved, the discussion turns now to a
consideration of the dynamics that influence the choice of employment or selfemployment. Here a number of co-incidental factors appear to be at work. Chen et al
find that in a survey of OECD countries the self-employed face lower levels of
taxation than employees and that this influences the employment / self-employment
decision.1 In the UK Redston discusses the combined effects of the favourable tax
treatment of the self-employed, particularly with regard to lower levels of social
security taxes, and the rising levels of employment regulation.37 As a consequence in
the UK incentives have increased for both individuals and businesses to contract on
the basis of self-employment rather than employment. These conditions were
probably exacerbated in recent years by the zero per cent rate of corporation tax
making self-employment through a company even more attractive. The resulting
growth in the numbers of newly incorporated businesses has now resulted in the zero
per cent rate of corporation tax being withdrawn, as referred to earlier.38 Her
Majesty’s Revenue and Customs (HMRC) also appear reluctant to apply IR3539 in a
significant number of cases.40 In addition the widening gap between National
Insurance Contributions (NICs) paid by both employees and employers compared
with the self-employed is reducing the attractiveness of employment.37
37 A. Redston, “Small Business in the Eye of the Storm” [2004] BTR at 566.
38 At 112, Pre-Budget Statement 2005, see fn.25.
39 IR35 is the name given to intermediaries legislation introduced on April 6, 2000. It is named IR35
after the Budget press release that announced its introduction. The aim of the legislation is to eliminate
the avoidance of tax and NICs through the use of intermediaries, such as service companies or
partnerships.
40 B. Sloan and F. Chittenden, see fn27.
In some OECD countries, such as France and Germany, over the last few years the
push factors towards self-employment have been operating at relatively high levels
because of sluggish economic growth and strong employment regulation, in others
such as the US and UK the pull factors associated with independence, financial
security in the form of rising housing equity or life partners in secure employment
have probably increased the incentives to become self-employed.41
Taxpayer compliance
Moving now to compliance issues, a number of papers make it clear that the tax
system is heavily dependent upon the voluntary compliance of tax-payers. Andreoni,
Erard and Feinstein show that in the US actual compliance levels are far higher than
economists can explain. Voluntary compliance results in excess of 83 per cent of
taxes being declared and paid on time, with enforcement activities contributing only
another 3 per cent to total gross receipts. Enforcement tactics are relatively
ineffective, with audits thought only to detect about 50 per cent of unreported income
and having an uncertain impact on ongoing compliance levels. However, the threat of
audit, coupled with citizens’ generally weak knowledge of the (low) probability of
investigation, are seen as effective motivations for compliance.42
41 Push factors are described by N. Meager, “From Unemployment to Self-Employment in the
European Community” Chapter 3 in F.C. Chittenden, M. Robertson, M. and D. Watkins, “Small Firms:
Recession and Recovery” (Paul Chapman 1993); pull factors associated with independence are
discussed in B.H. Hamilton, see fn.31; financial security factors are described in M. Taylor, see fn.32.
42 J. Andreoni, B. Erard and J. Feinstein, see fn.4.
Secondly, it is recognised that a very high proportion (84 per cent) of those who have
the opportunity to evade do so, to some extent43, making industry sector agreements
and deductions of tax at source particularly effective in promoting compliance.44
People whose incomes cannot readily be checked, such as some types of selfemployed individuals and small businesses, are particularly likely to evade.37 This is a
tricky issue that is influenced by conformity to social norms, that are usually assumed
to support honest behaviour. However once the decision to evade is taken, the extent
of evasion jumps to its optimal level bearing in mind the risk and perceived
consequences of discovery.45 From a public policy perspective a balance of
approaches is probably required, including sustaining uncertainty in the minds of
taxpayers about the threat of audit, whilst promoting honest reporting through the tax
system being seen to be equitable and fair across different social groups. Voluntary
compliance is also promoted if the taxpayer reacts favourably to government policies
and activities46 and taxpayer compliance costs are minimised.47
Where professional advisers are involved tax compliance for checkable items is
higher, but perceived as more aggressive where incomes cannot be checked.
Investigations of the clients of professionals detect less evasion than where no advisor
is involved.48 The role of professionals is recognised to be influential both in reducing
43 J.C. Young, “Factors Associated with Non-Compliance: Evidence from the Michigan Tax Amnesty
Program” (1994) 16 The Journal of the American Taxation Association at 82.
44 P. Brand, “Compliance a 21st Century Approach” (1996) 49 National Tax Journal at 413.
45 G.D. Myles and Naylor, “A model of tax evasion with group conformity and social customs” (1996)
12 European Journal of Political Economy at 49.
46 B. Erard and J.S. Feinstein, see fn.4.
47 See discussions in C. Sandford, M. Godwin, P. Hardwick and I. Butterworth, “Costs and Benefits of
VAT” (Heinemann Educational Books 1981); M. Godwin, “The VAT Registration Threshold’ [1998]
BTR at 541; K. Murphy, see fn.5.
48 J. Andreoni, B. Erard and J. Feinstein, see fn.4.
detectable evasion and informing clients of relevant tax policies that should influence
their decisions.49
Discussion
The purpose of this section is to consider whether there is an economic case for the
preferential tax treatment of small businesses. It is argued that the points presented
below would provide valid reasons for the favourable policy treatment of small
firms.50 However, on balance, Holtz-Eakin concludes that in the US, at least at the
time of his analysis, the features that would justify favourable tax treatment for small
firms are either not present, or that the tax system is an inappropriate means to address
those particular market failures. The alternative view, that in some cases argues for
the favourable tax treatment of small firms (for example in respect of retained profits
used to fund growth) and in others through raising taxes to improve the neutrality of
the tax system with respect to business decisions (i.e. by reducing the differential in
social security taxes between the self-employed and employees) is presented here.
First, it is argued that public policy support for small firms would be justified if the
presence of externalities provided by small firms bring benefits to the wider economy,
but the rewards are not fully captured by small firms, e.g. if small firms were highly
innovative, but the majority of the advantages accrued to other businesses who,
49 A. Hansford, J. Hasseldine and C. Howorth “Factors Affecting the Costs of U.K. VAT Compliance
for Small and Medium Sized Enterprises” (2003) 21 Environment and Planning C: Government and
Policy at 479.
50 See the work of S. Johnson “Small Firms Policies: An Agenda for the 1990s” at 12 in M. Robertson,
E. Chell and C. Mason, “Towards the 21st Century: the Challenge for Small Business” (Nadamal
Books, Maccelsfield 1990) and D. Holtz-Eakin, see fn.2
because of their market power, were able to buy small firms or acquire their
technology for less than its true worth.
The academic evidence reviewed here has shown that taxation affects the size of the
economy and the number of new and small firms8 and deters risk taking.51 Perhaps,
the question is not whether tax policies could address these issues, but whether
policies in support of small firm formation and growth can be effective without
adversely distorting the workings of the wider market? The answer would appear to
be that policy makers and some academics believe that, in certain specific
circumstances, tax measures that favour small firms in a modest way are justified. For
example, a number of countries including the US and the UK currently offer enhanced
tax incentives for R&D investment, including both new and small firms, and it is
believed these will be self-financing in the long-term.9
Second, public policy support for small firms would be justified if there were a need
to provide policy support for small firms on the basis of equity, i.e. fairness vis a vis
other firms. There could be a variety of causes52 but, one particular argument is that
government places small businesses at a disadvantage because of the effects of
regulations. It is known and generally accepted that the vast majority of the costs of
regulation on business fall upon small firms.53 Indeed it can be argued that many
forms of regulation observed in the UK and EU involve the transfer of resources from
51 See fn.30 and F. Chittenden, P. Poutziouris, N. Michaelas and T. Watts, “Taxation and Small Firms:
Creating Incentives for the Reinvestment of Profits” (1999) 17 Environment and Planning C:
Government and Policy at 271.
52 For details refer to S. Johnson, see fn.50.
53 F. Chittenden, S. Kauser and P. Poutziouris, “Tax Regulation and Small Business in the USA, UK,
Australia & New Zealand” (2003) 21 International Small Business Journal at 93.
businesses to consumers, in a similar manner to direct taxation.54 Even experts
sceptical of the economic contribution of small firms acknowledge that the
disproportionate burden of regulation would be an appropriate justification for
compensating tax allowances for SMEs.55
Third, support for small firms would be justified if there were a need to stop the tax
system from influencing business decisions, i.e. to make tax more economically
efficient. It is acknowledged, both in the UK and US, that decisions about legal form
are influenced by tax rules.56 It appears that the tax system is not neutral in its impact
on small business decisions and there is scope for improvements to the tax code in
this respect. However, this would be unlikely to involve favouring small firms.
Rather, as Chen et al and Sloan and Chittenden argue neutrality could be improved by
raising taxes, especially social security contributions payable by the self-employed,
bringing these closer to the levels payable by employees, taking account of the higher
levels of risk faced by workers who do not enjoy the social protections offered by
employment legislation. As far as possible the choice of employment or selfemployment should be tax neutral.57
Fourth, support for small firms would be justified if there was evidence that capital
market imperfections were leading to under-investment in small firms, e.g. because
lenders were restricting the amount of finance provided to small firms. The existence
54 T. Ambler, F. Chittenden and C. Hwang, “Regulation: another form of taxation? UK Regulatory
Impact Assessments in 2003/4” (British Chambers of Commerce London 2005); P. Minford, V.
Mahambare and E. Nowell, “Should Britain Leave the EU?” (Institute for Economic Affairs London
2005).
55 See the Institute for Fiscal Studies Green Budget 2005, available at www.ifs.org.uk, accessed 20th
April, 2007. Specifically at 145.
56 P.J. Wilkie, “Discussion of Organizational Form and Taxes: An Empirical Analysis of Small
Businesses” (1996) 18 The Journal of the American Taxation Association: Taxes and Business Strategy
at 68.
57 D. Chen, F.C. Lee and J. Mintz, see fn.1; B. Sloan and F. Chittenden, see fn.27.
of capital market imperfections is acknowledged, on balance, by the literature covered
in this review. These imperfections are not caused by the lending policies of providers
of debt finance but are the result of information asymmetries between entrepreneurs
and investors or lenders.58 It is acknowledged that the best judges of a business’s
prospects are the entrepreneurs themselves2; it is also well known that business
owners wish to grow their businesses from retained profits17,
producers are themselves economically inefficient.22,
30
18
; and that taxes on
The authors conclude that
there is scope for the tax system to address this issue.
Fifthly, policy support for small firms could be justified if the level of taxation was
constraining the willingness of entrepreneurs to take risks. It is acknowledged that
owning a single business as the dominant investment in a person’s portfolio deters
risk-taking.2 Given that new business formations are in any case running at high levels
the tax system does not need to encourage start-ups, indeed some economists argue
that the quality of the business stock would rise if new firm formations were
restrained.59 However, whilst business formation thrives on the risk-seeking or
“skewness loving”60 predisposition of business founders, it is business growth that is
particularly constrained because profits retained for re-investment are subject to
taxation.
Put simply, internally generated resources are the preferred choice of
funding for established privately owned businesses and the tax system can directly
influence the incentives facing business owners when deciding to retain profits for
58 J.E. Stiglitz and A. Weiss, “Credit Rationing in Markets with Imperfect Information” (1981) 71
American Economic Review at 393.
59 D. DeMeza and D. Webb, “Too Much Investment: A Problem of Asymmetric Information” (1987)
102 Quarterly Journal of Economics at 281.
60 T. Astebro, “The Return to Independent Invention: Evidence of Unrealistic Optimism, Risk Seeking
or Skewness-Loving?” (2003) 113 Economic Journal at 26.
growth or to extract funds to enhance their personal lifestyles or diversify their risk
position.61
Conclusions
Overall the authors concur with Chen, Lee and Mintz who conclude that many of the
OECD countries reviewed in their analysis have incomplete integration between
personal and corporate tax systems.1 Consequently, especially where special tax
provisions for the self-employed and SMEs exist, tax systems are not neutral and
affect decisions regarding organisational form, corporate capital structure and
dividend distributions. The resulting non-neutral tax systems are often inefficient,
distorting the allocation of resources. The favourable tax treatment of the selfemployed and SMEs can be justified on efficiency grounds where there are spillover
(external) effects to the rest of the economy. Consequently, governments need to
review the tax biases influencing the levels of entrepreneurship and favouring the selfemployed and to design tax policies for smaller firms to remedy market failures, while
avoiding adverse side-effects. Some of these policies will probably lead to increases
in the taxation of certain business types, such as the self-employed, but others will
lead to policies that favour small firms, e.g. in recognition of the regressive costs of
regulation and in order to support risky (R&D) investments.
In reviewing tax policies towards small firms policy makers may find it useful to
consider some theoretically sound features of optimal tax policies towards small
businesses:
61 R. Watson, “Employment Change, Profits and Directors’ Remuneration in Small and Closely-Held
UK Companies” (1990) 37 Scottish Journal of Political Economy at 259.
1. Policies should be formed taking cognisance of the political context and public
aspirations of the day.3 For the tax system to operate effectively both fiscal
policies and to some extent wider government policies must earn and sustain
the respect of tax payers, in this case the small business community.62 Ideally
such policies should also be stable, with little or no annual change.
2. Tax rates should be as low as possible, consistent with revenue needs.63 This is
probably best achieved with a broad tax base, and a mix of direct / indirect
taxes.3 Production should be taxed as little as possible, since it is generally
more economically efficient to tax consumption.22, 23
3. The tax code should be neutral to the choice of legal form that should be
adopted for commercial reasons.56 Similarly the choice between employment
and self-employment should be made for business or personal rather than tax
reasons, taking account of employment law and other regulations impacting
employers, i.e. the tax and regulatory system should not encourage “quasiemployment”.37
4. The retention of business profits should be encouraged, since this is the most
“efficient” source of
small
business
finance, avoiding information
asymmetries and the costs of investigation and monitoring associated with
“external” sources of finance.18
5. The tax authorities should be supportive of tax payers who want to pay the
minimum correct amount of tax on time. Tax administration within
government should be efficient; fiscal rules should be as simple as practicable
62 J. Andreoni, B. Erard and J. Feinstein, see fn.4.
63 J.H. Branson and C.A. Knox-Lovell, see fn.8.
and offer clarity and certainty. Business people, the vast majority of whom are
voluntarily compliant62, should be treated with respect.5
6. The tax code should be designed to minimise tax planning activity. The
requirement on business to conduct administration on behalf of government or
other taxpayers should be minimised, tax compliance costs should be as low as
possible.64 There should be a single point of contact and payment of taxes for
businesses, and the amount of time taken up in interaction with the authorities
should be reduced as much as possible.5
7. The tax system should be designed to minimise evasion, by offering strong
incentives to declare income, including making transactions as visible as
possible and where appropriate taxing incomes at source.44 Economic activity
should not be driven “underground” by seeking to tax the “untaxable” i.e.
revenues that are not visible and not checkable.43 Voluntary compliance
should be maximised by making business people aware of the risk of audit.62
The principles enunciated above are drawn from the literature on taxation and fiscal
policy towards small firms. Whilst the theories need to be “translated” into the context
of national tax codes, in order to be directly relevant to policy, it is argued that
reviewing emerging policies as well as existing tax codes in the light of the extensive
theory relating to taxation might lead to enhancements in public welfare or, at least a
more holistic view of the role of taxation in public policy towards small firms.
64 C. Sandford, M. Godwin, P. Hardwick and I. Butterworth, see fn.47; M. Godwin, see fn.47.