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Audio Transcript
Introduction.
Welcome to The Ripple Effect, where we explore how policies impact our economy beyond the surface level. Today, we’re diving into the proposal to raise the tax credit for starting a business from its current $5,000 to $50,000. At first glance, this policy might seem like an enormous win for aspiring entrepreneurs. But what does it really mean for many small business owners? We’ll explore the first, second, and third-order effects of this policy to get a clearer picture.
Understanding the Tax Credit Concept.
First, let’s talk about how tax credits work. Under the proposal, small businesses would be allowed to deduct up to $50,000 of their first-year startup expenses. The deduction applies specifically to expenditures during the startup phase, not beyond the first year. These expenses typically include costs like market research, advertising, employee training, and legal fees incurred before the business even opens its doors. Essentially, these are the investments made to get the business up and running.
A tax credit directly reduces the amount of taxes a business pays on its profits. In this case, the $50,000 credit would offset taxes owed on the business’s earnings. Sounds great, right? But here’s the catch: the tax credit is only valuable if the business is profitable. And the reality is many small businesses aren’t profitable in their first year—or sometimes, ever. Even in the best-case scenario, the tax credit would only apply after the first year of operations, meaning there’s a significant lag between when the expenses are incurred and when the business can actually use the credit to reduce taxes on profits. In fact, according to the Small Business Administration, only about 40% of businesses turn a profit. The rest break even or incur losses, which delays or eliminates the benefit of the tax credit altogether.
For those businesses that do succeed, it might take several years to generate significant profits. Here’s where the concept of “carry forward” comes in: if the business’s profits in the first year don’t exceed $50,000, they won’t be able to use the full tax credit right away. Any unused portion of the credit can be carried forward and applied to future profitable years. However, there’s a potential pitfall here—business owners might feel tempted to spend more than is prudent during the startup phase in order to maximize the credit.
For example, a startup might purchase expensive office equipment like high-end desks for employees they hope to hire in the future or invest in an elaborate security system to push their pre-start expenses higher. The goal might be to claim the full tax credit, but this could lead to overspending before the business model is fully defined. If the business pivots or never needs some of these expenses, those early investments could become wasted money.
Additionally, if a business takes on debt to fund these startup costs, it often requires a personal guarantee from the owner. So, even if the business fails, the owner is still responsible for any unpaid debt—much like paying off student loans for a degree that goes unused. This can leave owners on the hook for substantial debt even if their business never turns a profit.
That’s why I always recommend a different approach: starting slow, testing your business model, and scaling only after you’ve gained traction. The lean startup model helps avoid cashflow problems, which is the number one cause of business failure. However, with a $50,000 tax credit dangling in front of them, some business owners might be tempted to scale too early, leading to unnecessary risk and overspending.
Now that we have covered the basics let’s explore the first, second, and third-order effects of this policy to get a clearer picture.
First-Order Effects: Immediate Financial Incentive.
Raising the tax credit to $50,000 will likely encourage more people to start businesses. Entrepreneurs like John’s Tech Services, for example, see that big tax credit as a reason to jump in headfirst. For some, this boost will be crucial to covering startup costs like equipment, software, and initial marketing. But remember, the credit is a tax benefit, not a direct cash infusion. John won’t see the benefit until he’s profitable—and that might take years.
In the meantime, John could be taking on more debt to make sure he qualifies for the full $50,000 credit. If he spends $50,000 in the first year on fancy equipment but doesn’t turn a profit for three years, he still has to pay the monthly principal and interest payment on the debt, eating into his cash flow.
Second-Order Effects: Risk of Cashflow Problems.
The second-order effects dig deeper into this issue of cash flow. John’s pre-launch spending to take full advantage of the credit might push him into a situation where he’s struggling to pay the bills. Early-stage businesses are notorious for running out of cash, and that’s the leading cause of failure. John’s loan payments started to pile up, and his business hadn’t yet hit break-even. So, while the tax credit looks like a great deal on paper, it doesn’t solve his most immediate problem: cash flow. Without positive cash flow, even the most promising businesses fail. John now faces tough decisions—does he cut back on marketing or staff to make ends meet? And all this pressure comes before he’s even seen the real benefit of the tax credit.
Third-Order Effects: Long-Term Consequences.
Finally, let’s look at the third-order effects, which reveal some deeper consequences. If John’s Tech Services doesn’t survive those critical early years, he’ll never get to fully realize the $50,000 credit. A business filing losses can carry forward the unused credit, but if John’s business folds before he turns a profit, the benefit is lost entirely. This is where the tax credit has limitations. It’s meant to incentivize entrepreneurship, but if a business fails, all that potential benefit vanishes.
Moreover, if more businesses like John’s go under due to cashflow issues, we could see higher rates of business closures in industries where startups took on too much debt early on. This could lead to a ripple effect in the broader economy as vendors, employees, and local economies suffer from the loss of small businesses.
Conclusion:
So, while raising the tax credit to $50,000 might seem like a strong incentive to start a business, its long-term benefits are limited to businesses that survive and thrive beyond the early, challenging years. And if business owners overspend in an attempt to maximize the tax credit, they may find themselves facing cashflow problems, debt obligations, and business failure. It’s a future benefit, not an immediate solution, and can actually push some businesses to take on more risk than they should.
Thanks for tuning in to The Ripple Effect. Join us next time as we explore the far-reaching consequences of another key policy.