A Theory of Small Business Tax Neutrality

Tax minimization by multinational firms creates the potential for an effective tax rate differential in relation to small business where both operate in the domestic economy. A structural differential may arise irrespective of the legal entity form of the small business or the statutory tax rate. Such a differential in domestic taxation is not economically “neutral” and was initially posited by Musgrave as a potential “intra-state” economy “inefficiency” particularly where large firms accumulate capital and are not subject to shareholder level taxation. The tax rate differential to multinational firms is averred here to be the underlying cause of the domestic “crowding out” effect of FDI now well documented in the economic literature. As such, tax systems designed to attract “mobile capital” fail to take into account such “crowding out” externality in the domestic economy and would tend to reduce the relative proportion of innovative small businesses in the overall economy. This article proposes a policy of Small Business Tax Neutrality where targeted tax incentives are made available to small business sufficient to offset the effective tax rate differential available to multinational firms