William Gentry (Williams College, Department of Economics) presents Capital Gains Taxation and Entrepreneurship at Northwestern today as part of its Advanced Topics in Taxation Series organized by Tom Brennan and Charlotte Crane.  Here is the Conclusion:

Entrepreneurial assets are an important part of the aggregate net worth of U.S. households. These investments play a vital role in the creation of jobs and new products. Data from the Federal Reserve Board’s Survey of Consumer Finances indicates that investment in entrepreneurial ventures has generated a large stock of unrealized capital gains, considerably larger than the stock of unrealized capital gains on corporate equities. In contrast, tax return data suggests that the realized capital gains on entrepreneurial assets may be smaller than the realized capital gains on corporate equities. The magnitude of these unrealized capital gains suggests a shift in focus in considering the effects of capital gains taxation. While typical analyses of capital gains consider households’ portfolio investments in stock, the distortions created by the capital gains tax for entrepreneurial assets may prove to be considerably more important than those created by taxing capital gains associated with investing in public companies.

The magnitude of unrealized capital gains on entrepreneurial investments suggests that the capital gains tax could distort a number of important decisions of entrepreneurs. These decisions include starting a new business, expanding the business, and obtaining outside financing; the capital gains tax can also affect whether and when an entrepreneur sells his or her business. The possibility that the capital gains tax is asymmetric with respect to gains and losses, with gains being taxed more heavily than losses, magnifies the importance of these distortions.

The tax policy response to these potential distortions could take several different forms. One approach is to reduce the capital gains tax rate that applies to most types of assets. A benefit of such an approach is that it does not discriminate against types of investments. An alternative approach is targeted tax relief for capital gains on entrepreneurial assets. One example of targeted capital gains tax relief is the exclusion of 50% of the gains for qualified small business stock that is obtained when a qualified firm has an initial public offering (Section 1202 of the Internal Revenue Code). Guenther and Willenborg (1999) conclude that this tax treatment has increased the prices at which entrepreneurs have sold their firms, consistent with the objectives of the policy. While targeted approaches focus attention on a class of assets for which the distortions of the capital gains tax may be the largest, targeted approaches often carry administrative challenges. Defining which assets qualify for special treatment is an exercise in line drawing that inevitably creates some distortions between types of investment that are quite similar but fall on different sides of where the qualifying line is drawn.