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When the top personal tax rates are above the corporate rate, high-income individuals have an incentive to reclassify their earnings as corporate rather than personal income for tax purposes. U.S. tax law at least imposes strict limits on the extent to which employees in publicly traded corporations can engage in such income shifting. However, entrepreneurs setting up new firms can easily reclassify their income for tax purposes. This tax incentive therefore favors entrepreneurial activity. The paper discusses how best to subsidize entrepreneurial activity while avoiding other economic distortions.
I use a twelve-year panel of tax return data to assess whether or not taxes affect entrepreneurship. Beyond assessing possible distortions in entrepreneurial activities created by the tax system, this research provides information to policymakers on the effectiveness of tax policy in influencing entrepreneurial activity. The extent of entrepreneurial activity in the economy is a vital policy concern as entrepreneurs are thought to contribute to economic growth by creating jobs and producing innovations. Past theoretical and empirical studies examining the effects of taxes on entrepreneurship produced ambiguous results creating the need for further study. Toward this end, I investigate the effects of tax rates on entrepreneurial entry and survival as well as the effects of health insurance deductibility on exits from an entrepreneurial activity. My contributions to the current literature include developing a model combining the two past theoretical approaches, using a panel of tax return data, and examining an aspect of the tax system (health insurance deductibility) beyond the tax rates typically studied. I find convincing evidence that marginal tax rates and health insurance deductibility have important effects on entrepreneurial decisions. Results show that increases in marginal tax rates on wage income increase the probability of entry, increase the duration of entrepreneurial activities, and decrease the probability of exit. Increases in marginal tax rates on entrepreneurship income decrease the probability of entry, shorten entrepreneurial spells, and increase the probability of exit. The effects from changes in the entrepreneurial marginal tax rate are larger than those from the marginal tax rate on wages suggesting that an across the board tax cut would increase entrepreneurship by increasing entry, decreasing exit, and enhancing survival. Additionally, the availability of a health insurance deduction from income tax calculations enhances entrepreneurial survival. Taken together, the results indicate that tax policy is a potentially effective tool for influencing levels of entrepreneurship in the economy. More broadly, these results provide evidence that multiple aspects of the tax code, including but not limited to tax rates, are relevant for assessing behavioral responses.
This paper analyzes the impacts of tax changes on entrepreneurial activity. The analysis is focused on the U.S. personal income and capital gains tax reforms of 2001 and 2003 respectively. For this study a panel data set is constructed from several government agencies. The data is assessed using a time-series model with controls for macroeconomic and industry specific conditions as well factors approximating to capital availability. I find that for the 1998-2009 period there is a statistical, negative correlation between both the personal income tax rate and the capital gains tax rate and entrepreneurship as measured by the number of non-farm sole proprietorships (NFSP) tax returns as a percent of the labor force population across major U.S. industry categories. These findings are contrary to Georgellis and Wall (2002) that personal income tax rates above 35% increase entrepreneurship, but support the conclusions of both Wu (2005) and Bruce (2006) that tax increases negatively impact entrepreneurship. This paper finds that lower taxes at either the personal income or capital gains level encourage entrepreneurship.
Taxes and Entrepreneurship reviews the existing empirical literature on the impacts of tax policies on entrepreneurial activity and presents an agenda for future research.
This volume provides a comprehensive review of the theoretical concepts and empirical models of entrepreneurship from a non-conventional perspective. It makes recent advances in the theory and application of the economics of entrepreneurship accessible to a wider audience, including policy makers. It emphasizes data requirements to advance the future research agenda and to allow for a better design and monitoring of entrepreneurial policy.
A common concern about tax policies is their influences on entrepreneurial activity. Basic theory of taxation posits that a tax alters individual behavior, often yielding less output than in the absence of the tax. Income taxes may provide a disincentive to work, and they also limit an individual's total capital in the absence of the income tax. This likely decreases the total amount one has to invest in businesses and entrepreneurial activities. This study examines the relationship between income taxation and entrepreneurship. It utilizes a panel dataset constructed from the Census Bureau's Statistics of United States Businesses as well as Tax Foundation's dataset on state income taxes in addition to other datasets on state and federal taxes, federal loan expenditures and state populations. Using OLS, random and fixed effects regressions, this paper will examine the hypothesis that there is a negative relationship between small retail establishment creation and U.S. State personal income tax rates for the years 1998 to 2007. The findings are inconclusive indicating that, while income tax may influence small retail firm birth, there are likely other significant influential factors as well. A combination of state tax policies may potentially impact retail establishment birth while access to start-up capital is a significant variable for entrepreneurs. Policies crafted to encourage retail entrepreneurship should focus on all facets of tax reform as well as factors that impact access to capital.
This paper studies the effects of income taxation on entrepreneurship, empirically and in a structural macro model with entrepreneurial choice. Combining state-level tax data with household and firm data we document that higher and more progressive taxation has a strong negative impact on entrepreneurial activity across time and space. A one percentage point increase in the tax rate at median income leads to 4.5% fewer entrepreneurs and 1.5% fewer employees at small firms, whereas a 1% increase in the progressivity of the tax schedule leads to 1.0% fewer entrepreneurs and 0.2% fewer employees at small firms. To explain this relationship and to evaluate the impact of taxation on output and welfare, we develop a life-cycle, incomplete markets model of the labor market with entrepreneurial choice. The model generates elasticities of entrepreneurship to taxation that are similar to those found in the empirical analysis. Progressive taxation lowers both the risk and return to becoming an entrepreneur. However, quantitatively the return effect dominates. We find that converting to a flat tax (while keeping the level of taxes constant) would increase the number of entrepreneurs by 25% and output by 4.5%. Under the assumption of a small open economy, the level of tax progressivity that maximizes steady state welfare is, however, only slightly lower than for the current U.S. tax code. Allowing for general equilibrium effects, the socially optimal tax code is about half as progressive as today and would lead to a 0.4% welfare gain if implemented.