Corporate Taxes, and Their Real Impact On Small Business

Capterra, an online software marketplace that I co-founded in 1999, was like most other software companies structured as a standard C corporation. While other structures such as LLCs and S corporations would have allowed us to avoid income taxes, their inherent complexities, higher associated costs and other limitations were enough to turn us away. Additionally, we expected that it would take years for the company to reach profitability. Now, almost ten years later, our business has grown significantly, we've been profitable for six years, and we've been subject to corporate income taxes all of those six years.

I never seriously considered the sensibility of corporate income taxes until Capterra was required to start paying them. I probably learned from an economics textbook that it isn’t really the corporation that pays the tax, but instead it is the shareholders, employees and customers who pay them through lower returns, lower wages and higher prices, respectively. This is certainly true, but as an entrepreneur I can now speak to the very real and negative impact that the corporate tax imposes on businesses subject to it.

Every dollar we have paid in corporate income taxes has been a dollar we haven’t been able to use to grow our business – whether through new hires or additional investments. Retained earnings are the reward for a company well run. These earnings represent capital for future growth and corporate income taxes quite simply decrease (steal?) these funds that could otherwise be used to benefit the business. How much faster would Capterra have grown had we held on to all of our earnings and invested them into our firm? Furthermore, less money to invest in our future has an impact beyond our own ability to grow.

It means lower employment since we cannot afford to hire as many people.

It means less opportunity for other businesses since we don’t have as much to invest in external services or products.

It means less potential for wage increases for our current employees.

The list could go on indefinitely. All of these factors represent unintended consequences of a tax that ends up being highly regressive since it impacts all of society, regardless of income.

A secondary point worth acknowledging: when you essentially penalize a company for what it is supposed to be striving for, namely profits, it creates additional costs and misdirected behavior for that business. One obvious example is that companies will hire consultants and similar service providers to reduce tax costs. Money spent on these initiatives is not available to provide a better customer experience and can’t be used to grow the business.

Many companies will take it a step further and invest in tax havens and other schemes that only make sense due to the presence of the taxes, but that are an otherwise poor use of resources.

A less obvious example is the complexity that results when tax implications are considered as part of the true cost of a new expenditure. For example, a company is on track to generate $1,000,000 in profit and is considering a $100,000 ad campaign. This campaign will reduce the company’s profit by $100,000 and its corporate income taxes by $33,000, so is the real cost actually $67,000? The answer depends upon, among other things, other initiatives that may also reduce profits. This complexity requires the time and effort of valuable employees - time that would be better spent growing the business.

A common counter-argument is that small, high-growth companies should immediately reinvest all profits back into the business so as to avoid being taxed. I believe there is some validity to this argument, but I disagree with the use of the word “all.”

Capterra reinvests most of its profits, but not “all” for three reasons. First, we are saving for future investments that are too large for just one year’s left-over profits. Second, not all revenue and costs are entirely predictable in time to spend accordingly. And third, it is prudent to save some cash for the possibility of a downturn. It is risky for any business to re-invest “all” of its profits. We did that in the early years of Capterra when we were just getting started. Now that we have hired employees and it’s more than just the founders’ livelihoods on the line, it is prudent to have a cushion to rely on during a downturn.

Since it is the citizens of a country who are ultimately responsible for paying taxes, and since it is those same citizens who effectively pay corporate income taxes, why not abolish them entirely, given the reality of the additional costs that they incur? More pointedly, since “companies paying their fair share” is just a political campaign myth that serves to confuse citizens, what is the benefit to society of taxing its citizens in such a backdoor way that reduces transparency and results in such obvious additional costs?