Economic Policy and the Start-up, Survival, and Growth

of Entrepreneurial Ventures 

by Douglas Holtz-Eakin, Syracuse University and Harvey S. Rosen, Princeton University

under contract SBAHQ-01-M-OI53 (2001, 60 pages)

This Small Business Research Summary (ISSN 1076-8904) summarizes one of a series of research papers prepared under contracts

issued by the U.S. Small Business Administration’s Office of Advocacy. The opinions and recommendations of the authors of this study do

not necessarily reflect official policies of the SBA or other agencies of the U.S. government. For more information, write to the Office of

Advocacy at 409 Third Street S.W., Washington, DC 20416, or visit the office’s Internet site at www.sba.gov/advo.

Purpose

This research focuses on two important questions

regarding entrepreneurial ventures:

• Do the owners of such enterprises face constraints in capital markets?

• How do entrepreneurs react to changes in their

personal income tax situations?

Overall Findings

Using tax return data, this research found that with

lower taxes or when owners receive lump sums such

as inheritances, they invest in their businesses. This

investment leads to increased growth and probability

of survival. A lack of access to sufficient liquidity is

slowing the growth of entrepreneurial ventures. 

From a public policy standpoint, targeted government programs to relieve liquidity constraints could

help, but a cost-benefit analysis of each program would

need to be conducted. The research does indicate that

cutting marginal tax rates for all taxpayers may be

superior to targeted small business tax relief because

the latter does not encourage nascent entrepreneurs.

Comments from Advocacy

The Office of Advocacy is proud to present research

from two highly regarded economists, Dr. Douglas

Holtz-Eakin and Dr. Harvey Rosen, focusing on tax

policy and entrepreneurial issues.

"For Advocacy to be at the fore front on issues

vital to small business we need sound and timely

research. So I am very pleased that our Economic

Policy and the Start-Up, Survival and Growth of

Entrepreneu-ial Ventures report provides valuable

insights into the impacts of tax policy on entrepreneurship," said Susan Walthall, Acting Chief Counsel

for the Office of Advocacy.

Highlights

Inheritances:

• The probability of becoming an entrepreneur

varied positively with inheritance; moreover, the

greater the magnitude of the individual's initial liquid

assets, the smaller the incremental effect of inheritance. The results imply that a $100,000 inheritance

increased the probability of a transition between

1981 and 1985 from 19.3 percent to 22.6 percent.

Thus, an inheritance made it more likely that the heir

would start a sole proprietorship.

• The size of the inheritance had a positive and

statistically significant effect on the amount of capital invested in the new enterprise, a result that is consistent with the presence of liquidity constraints.

• On average, every $100 increase in inheritance

increased purchases of depreciable assets by $7.

Among taxpayers who start sole proprietorships with

some depreciable capital, a 10 percent increase in

inheritance increased spending on depreciable assets

by about 5.2 percent.

• The "survival rate" for remaining an entrepreneur increased with inheritance, from 67.4 percent in

the low inheritance (under $25,000) class to 76.5

percent in the high inheritance (over $150,000) class.
• An inheritance exerts a statistically significant,

positive effect on the probability that an entrepreneur

will stay in business rather than to become a wage

earner. A simulation showed that a $150,000 inheritance increased the probability of remaining an

entrepreneur by 1.3 percentage points and decreased

the likelihood of becoming a wage earner by 1.4 percentage points. Similarly, the level of liquid assets

has a positive and statistically significant impact.

Also, the more successful the enterprise was prior to

receiving an inheritance, the more likely the entrepreneur is to continue in business rather than to

become a wage earner. But receipt of an inheritance

makes it less likely that an entrepreneur will move to

a partnership/S corporation and more likely that he

or she will retire.

• An inheritance of $150,000 in 1985 would have

increased a sole proprietorship's average receipts by

about 20 percent, thereby increasing the success of

ongoing firms.

Tax rate changes:

• A model using the 1985-1988 linked data

implies that a decrease in a sole proprietor's tax rate

from 50 to 33 percent (as happened to the top individual income tax rate in those years) would lead to

an increase in business receipts of 28 percent. Thus,

marginal tax rates have a substantial effect on the

growth of entrepreneurial enterprises. However, the

probability of a firm's surviving at all does not seem

to be affected by tax rates.

• The Tax Reform Act of 1986 lowered rates the

most for high-bracket taxpayers. Sorting entrepreneurs into high- and low-tax in 1985 shows that

those who received the largest rate cuts were most

likely to begin or continue making capital outlays

and to begin or continue paying wages. A simulation

showed that an increase in the user cost of capital

(such as through a rate increase or reduction in

depreciation allowances) would lower the probability

of investing by 25 percent. Raising each 1988 marginal tax rate by 5 percentage points would lower the

probability of investing by 10.4 percent. Both simulations imply a substantial response of investment

decisions to tax rates.

• Changes in user costs and, thus, in tax rates have

a substantial and statistically significant impact on

entrepreneurs' investment expenditures. A 10 percent

increase in the user cost of capital would lower average investment outlays by 17.8 percent, implying

that small businesses of the type in the sample are

more likely to be liquidity constrained than corporations, for which other researchers have found lower

response rates. A 5-percentage-point increase in all

marginal tax rates would lead to a 9.9 percent

decline in average investment expenditures.

• The greater the decline in a sole proprietor's tax

rate, the more likely that he or she would hire some

labor. Reducing the marginal rate from 39.6 percent

(the top marginal income tax rate in 2000) to 33.2

percent would increase the probability of employing

labor by 12.1 percent, a substantial effect. The average magnitude of a change in an existing wage bill

would be 4 to 5 percent.

Scope and Methodology

The research is based on confidential tax return data

that was only analyzed by Treasury Department

employees. (Neither of the co-authors of this report

nor any SBA employees had access to the data.) The

data were used in econometric models the authors

constructed to test the above questions.

Inheritances invested in businesses were used as a

proxy for a capital shortage. Federal individual tax

returns from 1981 and 1985 of individuals receiving

inheritances from 1982 and 1983 captured this information. The presence of a Schedule C was used to

indicate entrepreneurial activity, and to determine

whether receipt of an inheritance affected the likelihood of starting or continuing such a business. In addition, it was noted whether the filer had earned income

and whether the Schedule C included depreciation

expense, indicating investment in fixed assets. Marginal

tax rates changed during the period studied allowing

the researchers to determine the changes entrepreneurial activity while holding other variables constant.

Ordering Information

The complete report is available online at

http://www.sba.gov/advo/research or from:

National Technical Information Service

U.S. Department of Commerce

5285 Port Royal Road

Springfield, VA 22161

(703) 487-4650, (703) 487-4639 (TDD)

www.ntis.gov

Order number: PB2001-105510

Price codes: TBA