NCPA - National Center for Policy Analysis

Effect of Flat (and Progressive) Taxes on Entrepreneurship

November 11, 2002

A recent study explores how taxes affect the decision to start a new business. Differences in the tax treatment of profits versus losses also can have strong effects on the choice of entrepreneurs.

  • Under a progressive tax schedule, profits will push the entrepreneur into higher tax brackets while losses will have the opposite effect.
  • This implies that profits will be taxed at a higher rate than the rate against which any losses can be deducted, making risk-taking less attractive.
  • Similarly, profits from a partnership or proprietorship are subject to the payroll tax, but losses are not deductible, again implying that entrepreneurs will keep fewer of their profits than of their losses.

Researchers find that allowing noncorporate firms a tax rebate for any losses beyond those sufficient to reduce their taxable income to zero, as under a negative income tax, would generate a 50 percent increase in entrepreneurial activity.

More dramatically, replacing the current personal and corporate income taxes with a 20 percent flat tax should virtually triple the amount of entrepreneurial activity, even with the remaining distortions under the payroll tax and the lack of tax rebates when taxable income becomes negative.

Source: Linda Gorman, "Taxes and Entrepreneurial Activity," NBER Digest, November 2002; based on Julie Berry Cullen and Roger Gordon, "Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S.," Working Paper No. 9015, June 2002, National Bureau of Economic Research.

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