The benefits of targeted tax incentives for startups and innovative companies may be weakened and sometimes eliminated in part because they may be limited in their ability to use tax deductions and credits, according to a new report.

Researchers at the Tax Policy Center said targeted tax incentives can lower the cost of capital for small businesses, startups, and those that invest in intellectual property. Those incentives include the research and experimentation tax credit, expensing of R&D, lower capital gains taxes, and more favorable depreciation rules.

The study concludes, however, that under current U.S. tax law, startups and innovative firms are unable to realize the full benefits of the tax breaks.

For one thing, they rely on higher-taxed equity financing more than firms that focus on tangible investment. And “potentially more important, limits on the ability [of startups] to use tax losses can significantly increase the cost of capital and marginal effective tax rates, relative to what they would be if new firms could take full advantage of preferences such as accelerated depreciation, expensing of research, and the research credit.”

The TPC noted that if a company is incurring losses during its initial years of operation, “it may not receive any immediate benefit from write-offs or credits resulting from new investment; instead, those benefits are in many circumstances delayed until the company becomes profitable. That delay, along with rules that reduce the value of accrued tax losses if a company is acquired, increases the effective tax rate on start-up investment.”

“In some cases, the reduction in benefits from these loss limitations more than offsets the benefit provided by tax incentives aimed at small and new businesses,” the report adds.

On the policy side, the researchers suggest that efforts to reform the tax code, especially those aimed at lowering the corporate tax rate and “leveling” the playing field among different types of investment, “should pay particular attention to [the possible] effects on startups and entrepreneurship.”

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