NCPA - National Center for Policy Analysis

Self Employment And Tax Rates

August 24, 1999

How does tax policy affect self employment versus wage-and-salary employment? It depends on how tax changes affect after-tax returns between the two types of employment.

A higher marginal tax rate, all else equal, tends to reduce self employment because it cuts the after-tax reward to effort, more so than in paid employment where the link between effort and reward is much looser.

On the other hand, an increase in the average (overall) tax rate makes self employment more attractive because the tax bite can be reduced through illegal evasion with better chances of success than in wage jobs where the employer withholds taxes. Marginal tax refers to the additional tax owed on another dollar of earnings while the average tax rate means taxes paid as a share of income.

  • Using economy-wide data from 15 OECD countries for 1978- 1992, two British economists find that both marginal and average tax rates have big, opposite effects on self employment.
  • They found that a one point increase in the marginal tax rate reduces self employment about 0.8 points from its 8.5 percent average while the same increase in the average tax rate increases self employment by 0.8 points.
  • During the 1980s there were major cuts in marginal tax rates (reduced tax progressivity) in countries like Sweden, Italy and the United Kingdom with little reduction in the average tax burden, and they experienced a strong rise in self employment.

If both marginal and average tax rates rise or fall together, they tend to offset each other in terms of the attraction of self employment versus wage employment.

Source: Martin T. Robson and Colin Wren, "Marginal and Average Tax Rates and the Incentive for Self-Employment," Southern Economic Journal, April 1999.

 

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