NCPA - National Center for Policy Analysis

TAXES AND ENTREPRENEURSHIP

March 21, 2008

A tax system with low rates and little or no progressivity provides the greatest incentives to encourage entrepreneurship, says the Fraser Institute.

Entrepreneurship is increasingly being recognized as a critical determinant of job creation, innovation, and productivity gains.  Taxes have an impact on the rewards of such activity, says Fraser.

One of the most frequently used measures of entrepreneurship is self-employment.  According to economists William Gentry and Glenn Hubbard, a more progressive tax structure reduced the probability of becoming self employed.  For example:

  • When tax rates are more progressive, entrepreneurs pay substantial taxes on profits but save little in taxes when losses occur
  • A 5 percent reduction in tax progressivity would increase the probability of entrepreneurial entry by .86 percent.
  • Reducing capital gains taxes, corporate income taxes and payroll taxes all have a positive impact on self employment.

Another often-used indicator of entrepreneurship is business creation and growth.  A number of studies have shown the impact of taxes on creation and growth of businesses, says Fraser.

According to economist Robert Carroll:

  • A decrease in the marginal tax rate levied on a sole proprietor from 50 percent to 33 percent would lead to an increase in revenues of about 28 percent.
  • A 5 percent rise in marginal tax rates would reduce the proportion of entrepreneurs who make new capital investments 10.4 percent, as well as lowering mean capital outlays by 9.9 percent.

This shows that taxes not only affect people's decisions to become or entrepreneurs, but also impact their decisions while they are entrepreneurs.  Overall, the evidence suggests that a simple tax system, characterized by little or no progressivity and low rates for numerous types of taxes, would provide the least amount of distortion in the economy and provide the greatest incentives to encourage entrepreneurship, says Fraser.

Source:  Keith Godwin, "Taxes and Entrepreneurship," Fraser Institute, February 2008.

 

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