Entrepreneurship and Capital Gains Taxes: A Small Business Week Reminder

By SBE Council at 29 April, 2024, 4:30 pm

by Raymond J. Keating -

It's National Small Business Week, and one is left wondering how many federal elected officials are serious about substantively improving the policy environment so that entrepreneurship and small businesses can flourish.

In addition to ever-mounting regulatory burdens, as noted in this SBE Council analysis, there is the issue of taxes. We've heard a great deal recently about taxes from the Biden administration, and none of it has been good news for entrepreneurship, small business and our economy.

Let's consider the capital gains tax, which is one of the most economically destructive taxes given that it is a direct tax on the returns on entrepreneurship. The capital gains tax reduces the potential returns on investing in new and/or expanding businesses, and therefore serves as a disincentive for starting up, owning and operating, and investing in businesses - which, by the way, are undertakings wrought with risk and uncertainty.

Currently, the top federal tax on capital gains is far too high. The rate is 20 percent, plus the 3.8 percent Obama Medicare income tax.

However, President Biden has proposed jacking up the top individual rate from 20 percent to 39.6 percent, and the Medicare tax to 5.3 percent, for a total top capital gains rate of 44.9 percent.

But the story doesn't end there. Capital gains are not indexed for inflation. That means that the real capital gains tax rate is higher based on the rate of inflation - and we all have been painfully aware of inflation in recent years.

Let's consider an example of a $10,000 investment with a return of $1,000, or 10 percent. Currently, the capital gains tax paid, at 23.8 percent, would be $238. But if inflation registered 4 percent over this period, then the real capital gains tax jumps to 41.4 percent.

At the Biden tax rate of 44.9 percent, the capital gains tax paid would be $449, and the real capital gains tax rate would leap to 77.8 percent.

The higher the inflation rate, the higher the real capital gains tax. But it also must be noted that if inflation runs at a 2 percent rate - considered tame and acceptable by most - the real capital gains tax can still leap quite notably. For example, in our example, the current nominal capital gains tax rate of 23.8 percent would climb to a real rate of 30. 3 percent, and under a Biden capital gains tax of 44.9 percent, the real capital gains tax would jump to 57.2 percent.

Three points should be clear:

● First, the current capital gains tax is too high, never mind Biden's proposal to push it far higher, given the importance of entrepreneurship, and the substantial risks and uncertainties involved with building and investing in businesses.

● Second, inflation pushes the real capital gains tax much higher.

● And third, the volatility of inflation, and the unknowns as to where it's headed, create additional uncertainties for entrepreneurs and investors.

Here's an idea for National Small Business Week, let's see productive bipartisanship in action for a change, and advance a reduction in the capital gains tax, such as cutting the total top rate to 10 percent, and indexing gains for inflation. That would serve as a powerful signal to entrepreneurs and investors domestically and globally that America is open to starting up, investing in, and building businesses.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His latest books on the economy are The Weekly Economist: 52 Quick Reads to Help You Think Like an Economist, The Weekly Economist II:52 More Quick Reads to Help You Think Like an Economist and The Weekly Economist III: Another 52 Quick Reads to Help You Think Like an Economist.

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