The Effects of Taxeson Entrepreneurial Activity

A Presentation to thePresident’s Advisory Panel on Federal Tax Reform

Donald Bruce

March 8, 2005

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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

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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

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The Number of Schedule C Filers is Growing(2005 Entries are Estimates)

0

5

10

15

20

25

1980 1985 1990 1995 2000 2005*

Mill

ion

s

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%# of Schedule C Returns % of Returns with Schedule C

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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?

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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

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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

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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.

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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

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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

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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 ReadingBruce, 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