How Taxation Drains Small Businesses

Corporate taxation influences business strategy. But not all firms are affected in the same way — the most vulnerable must make greater efforts to adapt. Tax reforms should therefore avoid a one-size-fits-all approach and instead reflect the diversity of businesses. This is the conclusion of a study by Ioannis Bournakis, professor and researcher at SKEMA Business School, and his co-author Desiderio Romero-Jordán. Their work leads to four key policy recommendations.

Runners of various capabilities are running on treadmills. The treadmill controller, at frequent intervals, switches to a mode called “Tax Burden,” which steeply inclines the treadmill. High-performing runners remain fast and manage to achieve their targets, though at a slightly slower pace. However, the least fit runners struggle to keep up and look like untrained athletes.

Similarly, higher tax liabilities are unpleasant for all firms. While large firms can absorb these costs more easily, smaller firms struggle. They often become trapped in a vicious cycle. Their ability to make productivity-enhancing investments are hindered by a lack of financial resources, which are further constrained by high tax payments.

What Higher Taxes Mean for Businesses

Increased taxes have several implications for firms, including:

higher cost of capital. When firms face higher tax rates on profits generated from capital investment, this effectively increases the cost of capital, which in turn discourages investment in new assets.
reduced after-tax earnings,
limited capacity to fund high-risk ventures like innovation and penetration to new markets.

Firms that seek to invest in research and development (R&D) and international expansion need financial strength to cover “sunk costs”. These refer to non-recoverable expenses incurred regardless of whether the investment is successful or not. These include the installation of commercial networks in foreign markets, the establishment of supply chains, the adjustment of products to international standards, the installation of research laboratories, and more. These costs are especially challenging and nearly prohibitive for smaller and less productive firms.

One size doesn’t fit all

Corporate taxation plays a pivotal role in shaping a firm’s strategic decisions, particularly those related to innovation (R&D) and exports. Bournakis and Romero-Jordán (2024) demonstrate that, among 7,819 European manufacturing firms from France, Germany, Hungary, Italy, Spain, and the UK over the period 2001–2014, taxation is not a significant burden for highly productive firms.

A 10% increase in the tax that a firm pays as a share to its added value (Effective Average Tax Rate) reduces, on average, the likelihood of R&D investment by 2.3% and exporting by 1.4%. The effect, however, remains highly disproportionate across firms with different productivity levels. For firms at the bottom of the productivity ladder, these numbers can reach as high as a 12.9% decrease in R&D investment and a 25.5% decline in exporting. In contrast, firms that are more productive and profitable tend to handle higher taxes better. They are more resilient and can absorb the impact of higher taxes with ease, as they can expand their export activities into special economic zones or export-processing zones where tax rates are lower.

In fact, higher taxes can sometimes motivate productive firms to expand into multiple countries, allowing them to shift profits to jurisdictions with lower taxes legally.

Four Reform Ideas

Policymakers aiming to foster economic growth must recognize that tax changes disproportionately impact R&D and exports particularly in the face of rising global competition and productivity stagnation in Europe. Furthermore, corporate tax reforms should not follow a one-size-fits-all approach; rather, they should account for firm diversity to support both small-scale domestic firms and larger, globally competitive enterprises.

Introduce a progressive tax system

A progressive tax system adjusts tax rates based on a firm’s size, profitability, or stage of development. By linking tax rates to a firm’s ability to bear financial risks, such a system can encourage firms at different stages to invest in R&D and export activities. Smaller or less profitable firms would pay lower taxes, helping them free up resources to innovate or expand internationally, while larger, more established firms would contribute more based on their capacity. This creates a more equitable environment that encourages greater participation in innovation and international trade, ultimately boosting overall productivity and fostering long-term economic growth.

Implement Sector-Specific Tax Policies

Different industries face varying challenges in terms of innovation and international expansion. Governments should consider sector-specific tax policies that target industries with high growth potential but substantial sunk costs (such as technology, pharmaceuticals, and advanced manufacturing). These industries are particularly sensitive to changes in taxation due to the high levels of R&D required for product development and market entry.

Driving Innovation and Export Growth Hand in Hand

Through tax schemes that support the development of new products that are designed for international markets. Firms should pay less taxes for export profits that are reinvested into R&D or benefit from tax breaks if they achieve a certain threshold of export sales. Such policies would create a positive feedback loop, where innovation fuels exports, and export profits are invested back to innovation.

Enhance Access to Finance for Innovation and Exporting:

To complement tax incentives, governments should improve access to finance for firms investing in innovation and exporting. Given that there are already fiscal deductions for R&D expenses, the financial system should provide loans where intellectual property or R&D outcomes can be accepted as collateral. Equally important is the enhancement of Public-Private Partnerships (PPPs), in which governments share the risks associated with financing innovation and exporting with financial institutions, encouraging banks to lend more to these firms on favorable terms.

Time to End Blind Taxation

Corporate taxation is an important determinant of R&D and export decisions. To support firms at all stages of development, tax policies should be progressive, reducing the burden on smaller firms while ensuring larger firms contribute proportionally more.

Sector-specific policies can further encourage investment in high-growth industries like technology and manufacturing. By integrating tax incentives for both innovation and exports, and improving access to finance, governments can create a positive feedback loop, where innovation fuels exports and vice versa.

The future lies in designing a tax ecosystem that supports businesses of all sizes, fostering an environment that benefits not only the frontier firms, but also emerging and smaller players.