Entrepreneurial activity is presumed to generate important spillovers, potentially justifying tax subsidies. How does the tax law affect individual incentives? How much of an impact has it had in practice? We first show theoretically that taxes can affect the incentives to be an entrepreneur due simply to differences in tax rates on business vs. wage and salary income, due to differences in the tax treatment of losses vs. profits through a progressive rate structure and through the option to incorporate, and due to risk-sharing with the government. We then provide empirical evidence using U.S. individual tax return data that these aspects of the tax law have had large effects on actual behavior
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.
Taxes and Entrepreneurship reviews the existing empirical literature on the impacts of tax policies on entrepreneurial activity and presents an agenda for future research.
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.
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.
