No. 252

March 2005

SMALL BUSINESS

RESEARCH

SUMMARY

Taxes and Entrepreneurial Activity:

An Empirical Investigation Using Longitudinal Tax Return Data

By Donald Bruce, Ph.D., and Tami Gurley, Knoxville, TN

under contract no. SBAHQ-04-M-0521 (2005, 51 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

The decision to start a business or engage in entrepreneurship depends in part on tax incentives. The

U.S. income tax is a graduated tax, designed so that

people pay an increasing percentage rate as their

income rises through various tax brackets. The rate

of tax paid on the highest dollars of income is the

marginal tax rate. 

Currently, the tax code is largely blind to the

source of income when one files a personal income

tax statement. Historically, however, income from

wages and salaries and income from entrepreneurial

activities—running a business—were taxed differentially. This study explores the historical differences

and subsequent standardization, largely stemming from

the Tax Reform Act of 1986, to determine how marginal income tax rates affect an individual's decision

to enter, remain in, and exit entrepreneurial activities.

The report uses longitudinal tax return data to

measure the responsiveness of individual tax filers to

changes in marginal income tax rates with respect to

their choices to engage in entrepreneurial activity.

Individual choices to engage in wage-and-salary

employment, entrepreneurial activity, or a mixture of

both, are taken as given by the existence of each type

of income as reported in individual income tax filings.

Overall Findings

Marginal tax rates have significant effects on entrepreneurial entry and exit, suggesting that the formation and closure of small enterprises are in part determined by the handling of income from these activities

in the tax code. The findings show that the level of

entrepreneurial entry, exit, and duration react differently to changes in marginal rates on wage-and-salary

and entrepreneurial income. Specifically, lower marginal rates on entrepreneurial income encourage more

entrepreneurial entry and lower rates of exit, and

lengthen the duration of spells of activity. Similarly,

higher marginal rates on wage-and-salary income also

increase entrepreneurial activity as more workers

switch from wage-and-salary work to starting their

own business. Importantly, however, the magnitude of

the entry, exit, and duration effect is larger for marginal tax rates on entrepreneurial income than on wageand-salary income. 

Highlights

• Marginal tax rate reductions have effects on

entrepreneurial entry. A reduction in the marginal

tax rate on entrepreneurial income of one percentage

point would increase the probability of entry into

entrepreneurial activity by 1.42 percentage points for

single filers and 2.0 percentage points for married

filers. Conversely, reducing the marginal tax rate on

wage-and-salary income by one percentage point

would decrease the probability of entrepreneurial

entry by 0.58 percentage point for single filers and

0.51 percentage point for married filers.

• Marginal tax rate reductions have effects on

entrepreneurial exit. Individuals' decisions to exit

entrepreneurial activity are similarly related to tax

rates. A marginal tax rate reduction of one percentage

point on entrepreneurial income reduces the probability
of exiting entrepreneurial activity by 17.32 percentage points for single filers and by 7.81 percentage

points for married filers. Likewise, a reduction of

one percentage point in the marginal tax rate on

wage-and-salary income would increase the probability of exit from entrepreneurial activity for single

and married filers by 9.17 and 3.98 percentage

points, respectively.

• The net effect of across-the-board marginal

tax rate reductions is an increase in entrepreneurial entry and a decrease in entrepreneurial exit.

Entry and exit choices are affected by marginal tax

rates on both entrepreneurial income and wage-andsalary income, but the magnitude of the effect is

larger for entrepreneurial income. The result is that

an across-the-board marginal income tax rate reduction of one percentage point would increase the rate

of entrepreneurial entry by 0.84 percentage point

among single filers and 1.49 percentage points

among married filers. The same marginal rate reduction would reduce the likelihood of exit by 8.15 percentage points for single filers and 3.83 percentage

points for married filers.

• Marginal tax rate changes have effects on the

duration of entrepreneurship. In addition to affecting entrepreneurial entry and exit, changes in marginal tax rates affect the duration of entrepreneurship. A one percentage point reduction in the marginal tax rate on entrepreneurial income would increase

the duration of entrepreneurial activity by 32.5 percent for single filers and 44.8 percent for married filers, while a one percentage point increase in the

wage-and-salary marginal income tax rate would

prolong the duration of entrepreneurship by 16.1 percent for single filers and 12.7 percent for married filers. The median entrepreneurial period in the sample

was between three and four years; thus a marginal

tax rate difference that increases duration by onethird corresponds to an increase of one year or more

in the duration of entrepreneurship.

• Effects of marginal tax rate increases are the

opposite of reductions. Effects of marginal tax rates

are symmetric, and therefore increases by one percentage point will have the opposite effects from

those described above for tax rate decreases.

Scope and Methodology

The researchers used a panel data file drawn from

the University of Michigan Tax Research Database.

This file was compiled by the Office of Tax Policy

Research at the University of Michigan from publicuse tax return data from the Internal Revenue Service

(IRS) Statistics of Income (SOI) Division. The panel

spans the years 1979-1990 to encompass exogenous

tax policy changes that took place during the 1980s.

These changes had the effect of largely standardizing

the marginal tax rates on income from various

sources, allowing the researchers to identify the

effects of rate changes on entrepreneurship. In order

to normalize the data, tax rates were estimated using

the TAXSIM model developed by the National

Bureau of Economic Research. The estimates of

marginal tax rate effects use an instrumental variable

(IV) regression model to control for detected tax rate

endogeneity. Appendix Table 1 provides a complete

detailed list of variables included in the modeling.

This report was peer-reviewed consistent with

Advocacy's data quality guidelines. More information on this process can be obtained by contacting

the Director of Economic Research by email at 

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

Ordering Information

The full text of this report and summaries of other

studies performed under contract to the U.S. Small

Business Administration’s Office of Advocacy are

available at www.sba.gov/advo/research. Copies are

also available from:

National Technical Information Service

U.S. Department of Commerce

5285 Port Royal Road

Springfield, VA 22161

(800) 553-6847 or (703) 605-6000

(703) 487-4639 (TDD)

www.ntis.gov

NTIS order number: PB2005-102161

Pricing information:

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CD-ROM, A00 ($18.95)

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