Title: The Effects of Taxes on Entrepreneurial Activity
1 The Effects of Taxeson Entrepreneurial Activity
A Presentation to the
Presidents Advisory Panel on
Federal Tax Reform
March 8 2005
2 Small Businesses are Vital to the Economy
According to the SBA small businesses are firms with less than 500 employees
99.7 of all employers
Employ half of all private-sector employees
Pay 44.3 of the total payroll
Generate 60-80 of new jobs on average (and almost all new jobs during recessions)
Create more than half of non-farm private GDP
3 How are Small Businesses Taxed
Sole proprietors most partnerships and many S corporations are taxed under the individual income tax
16 of individual tax returns report Schedule C sole proprietorship income and 5 have income from a partnership or S corporation
Up to 80 of businesses pay tax through the individual income tax
Individual Income Tax Reform is
Small Business Tax Reform
4 The Number of Schedule C Filers is Growing(2005 Entries are Estimates) 5 Should Entrepreneurs be Tax-Favored
Do small businesses create positive spillover benefits (job creation and contributions to economic growth)
Do liquidity constraints result in too little entrepreneurial activity
Does risk deter entrepreneurship
Is the tax code relatively more complex for entrepreneurs
Do taxes distort small business activity
6 Do Taxes Matter
In theory the effect of tax rates is ambiguous
On one hand higher tax rates reduce the after-tax return to entrepreneurial activity
On the other hand higher tax rates (with loss offsets) compress the distribution of after-tax returns thereby reducing entrepreneurial risk
Incentives to evade or avoid taxes contribute to the ambiguity
This is inherently an empirical question
7 What Makes an Entrepreneur
Unquantifiable entrepreneurial spirit
No consensus on an appropriate measure
Available proxies for entrepreneurship
Survey responses Are you self-employed
Tax return information
Sole proprietorships (Schedule C)
Partnerships and S corporations
Rent and royalty income
8 Taxes and Entrepreneurial Activity An Empirical Investigation by Donald Bruce and Tami Gurley
Question Do tax rates affect small business formation and survival
We compare the tax rate an individual would face as an entrepreneur with the tax rate he or she would face in a wage job and ask whether that tax difference matters for behavior.
9 Results Relative Tax Rates Matter
Cutting relative tax rates in the entrepreneurial sector (vis-à-vis wage employment) increases the probability of entrepreneurial entry and survival
Suggests that the leveling of the tax playing field during the 1980s might have resulted in lower rates of entrepreneurial entry and survival than might have otherwise occurred
10 Results Absolute Tax Rates Matter
Reducing the tax rate an individual expects to face as an entrepreneur increases entrepreneurial activity
Reducing the tax rate an individual expects to face in a wage job decreases entrepreneurial activity
We find that the first effect is larger than the second
Suggests that across-the-board tax cuts could increase entrepreneurial start-up and survival
11 Results Echo Recent Findings by Economists
Carroll Holtz-Eakin Rider and Rosen (2000a 2000b and 2001)
marginal tax rate increases reduce overall firm growth (as measured by receipts) investment expenditures and the probability of hiring employees
Gentry and Hubbard (2000)
probability of entry into self-employment increases as tax rates become less progressive progressive rates serve as a tax on success in self-employment
12 Appendix A Further Reading
Bruce Donald. 2002. Taxes and Entrepreneurial Endurance Evidence from the Self-Employed. National Tax Journal 55(1) 5-24.
Bruce Donald. 2000. Effects of the United States Tax System on Transitions Into Self-Employment. Labour Economics 7(5) 545-574.
Bruce Donald and Douglas Holtz-Eakin. 2001. Who Are the Entrepreneurs Evidence from Taxpayer Data. Journal of Entrepreneurial Finance and Business Ventures 1(1) 1-10.
Carroll Robert Douglas Holtz-Eakin Mark Rider and Harvey S. Rosen. 2001. Personal Income Taxes and the Growth of Small Firms. In James Poterba (ed.) Tax Policy and the Economy Vol. 15 Cambridge MA MIT Press.
Carroll Robert Douglas Holtz-Eakin Mark Rider and Harvey S. Rosen. 2000a. Entrepreneurs Income Taxes and Investment. In Joel B. Slemrod (ed.) Does Atlas Shrug The Economic Consequences of Taxing the Rich New York Russell Sage Foundation pp. 427-455.
Carroll Robert Douglas Holtz-Eakin Mark Rider and Harvey S. Rosen. 2000b. Income Taxes and Entrepreneurs Use of Labor. Journal of Labor Economics 18(2) 324-351.
Cullen Julie Berry and Roger H. Gordon. 2002. Taxes and Entrepreneurial Activity Theory and Evidence for the U.S. NBER Working Paper No. 9015.
Gentry William M. and R. Glenn Hubbard. 2000. Tax Policy and Entrepreneurial Entry. American Economic Review 90(May) 283-287.
Schuetze Herbert J. and Donald Bruce. Forthcoming. Tax Policy and Entrepreneurship. Swedish Economic Policy Review 11(2).
13 Appendix B Further Information on Bruce/Gurley Study
Approach entrepreneurial transitions are modeled as functions of post-transition expected tax rates in both possible outcomes (entrepreneurship vs. a wage job)
Taxes considered federal and state income and payroll taxes
We control for other factors to isolate the effects of taxes
age household size region access to capital risk attitudes (all at pre-transition values)
Data 12-year panel of federal individual income tax returns
University of Michigan Tax Panel 1979-90
8200 to 46000 returns per year
6000 returns present in all 12 years
We use only the representative sub-sample
Spans several major tax changes during a period in which tax advantages for small businesses were gradually eroded
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