Eliminating state capital gains tax could spark an entrepreneurial surge

An important driver of job growth is investment. Without investment, new businesses may not flourish or even see the light of day. And venture capital investment in technology start-ups is one of the highest-profile sources of new business births.

Tax policy can either obstruct the new capital that businesses need or it can step out of the way and allow thousands of flowers to bloom. A number of studies have shown that taxes on capital gains – the return an entrepreneur or investor receives on their investment – have been shown to be a barrier to entrepreneurship and the job growth it creates.

Capital flows where it can find high returns and low barriers to allocation, and businesses in states with lower capital gains taxes receive more investment than their higher-tax counterparts. A 1998 study by Harvard University professors Paul Gompers and Josh Lerner concluded that entrepreneurial activity is sensitive to the taxation of capital gains. In particular, the authors found that a reduction in capital gains taxes is associated with an increase in venture capital funding in a state.

A 2010 study by William Gentry of Williams College came to the same conclusion. His paper noted that “capital gains taxes 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.”

Arizona, like most states with an income tax, treats capital gains as “normal” income and taxes it at the same rate as all other income. But nine states, including New Mexico, tax investment at a lower rate than their standard income tax.

In the material released after the State of the State speech, Governor Brewer indicated she understands that Arizona needs to lower its tax barriers to capital investment – an important step. But the governor and legislature should go further and eliminate the tax on capital gains altogether.

Arizona can be the first state with an income tax to do that and could, as a consequence, end up being a hub for new venture capital activity.

Learn more:

American Council for Capital Formation: Capital Gains Taxation and Entrepreneurship

Harvard University: What Drives Venture Capital Fundraising? (PDF)

American Action Forum: Employment Effects of Reducing Capital Gains Tax Rates in Ohio