State Tax Policy and Entrepreneurial Activity

Donald Bruce, University of Tennessee, Knoxville, TN 37996; and 

John Deskins, Creighton University, Omaha, NE 68178

2006. [42] pages. Under contract SBAHQ-04-Q-0023

This report was developed under a contract with the Small Business Administration, Office of Advocacy, and contains information

and analysis that was reviewed and edited by officials of the Office of Advocacy. However, the final conclusions of the report do not 

necessarily reflect the views of the Office of Advocacy.

Engaging in entrepreneurship and starting a small 

business can be made more or less difficult by the 

structure of income taxes. While federal income 

taxes are the single largest tax on small business, 

state and local taxes can also impact small firms. 

Recent studies have shown how federal income tax 

rates can affect decisions to engage in entrepreneurial activities; this study tests whether the same pattern holds for state tax policy. The paper examines 

the impact of both state tax rates and tax composition (i.e., which taxes are imposed and in what proportion) on entrepreneurship rates.

There is substantial variation in both the structure 

of taxes and tax rates across the 50 states. The paper 

identifies the effects of tax rates and tax composition on entrepreneurship. Using state-level data from 

1989 through 2001 on taxes and entrepreneurship, 

the authors attempt to isolate the impact of tax policy 

by examining aggregate rates of entrepreneurship. 

Two entrepreneurship measures are employed: one 

is the number of filers of Schedule C on their federal 

income tax returns, and the second is the share of all 

non-farm employees who are sole proprietors. The 

paper examines not only the impact of tax policy on 

the number of entrepreneurs in the state using the 

two measures, but also on the state’s share of all U.S. 

entrepreneurs. The effects of tax rates are estimated 

with top marginal tax rates for a number of different 

state taxes, including personal income tax, sales tax, 

corporate income tax, estate tax, inheritance tax, and 

gift tax. Other tax policy variables, such as combined 

reporting and throwback rules which affect where 

corporations must file taxes, and homestead rules 

which affect bankruptcy filings, are also examined.

Overall Findings

State tax policy, including both tax rates and the 

type of taxes in a state’s portfolio, has only a modest 

effect on aggregate state entrepreneurship rates. 

Highlights

• Higher top tax rates on individual income, 

higher sales tax rates, and the existence of state-level 

inheritance or gift taxes all tend to slightly reduce a 

state’s share of the national entrepreneurial stock;

• Top marginal tax rates on individual and corporate income do not have statistically significant 

effects on state entrepreneurship rates, but states with 

higher sales tax rates tend to have higher entrepreneurship rates;

• States with combined reporting and throwback 

rules for corporate income taxes tend to have higher 

entrepreneurship rates;

• The composition of state tax portfolios (which 

taxes are imposed and what share of total taxes each 

imposes) is not a significant determinant of state 

entrepreneurship rates.

Scope and Methodology

The researchers use a panel of aggregated state-level 

tax data to estimate the effects of tax policy on entrepreneurship. These data include as explanatory variables state tax rates for personal income, sales, and 

corporate taxes; control variables for demographics 

and state fiscal policy; and state economic variables, 

such as employment and output measures. The primary dependent variables of interest are the number 

of entrepreneurs in the state, measured by either a 

November 2006 No. 284
tax or employment proxy, and the state’s share of 

national entrepreneurial stock, measured again by 

either the tax or employment proxy share of the relevant national stock.

This report was peer reviewed consistent with 

the Office of Advocacy’s data quality guidelines. 

More information on this process can be obtained 

by contacting the director of economic research at 

advocacy@sba.gov or (202) 205-6533.

Ordering Information

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studies performed under contract with the U.S. Small 

Business Administration’s Office of Advocacy are 

available on the Internet at www.sba.gov/advo/research. 

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