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
• Donald Bruce
• 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

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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).

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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
• 8,200 to 46,000 returns per year
• 6,000 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