# Presentation: 401629

## The Effects of Taxeson Entrepreneurial Activity

**A Presentation to the**
**President’s Advisory Panel on **
**Federal Tax Reform**
**Donald Bruce**
**March 8, 2005**

## 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

## 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

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

## 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?

## 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

## 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*

## 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.

## 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*

## 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 *

## 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*

## 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).

## 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