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
Donald Bruce  March 8, 2005
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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)
18%
25
# of Schedule C Returns
% of Returns with Schedule C
16%
20
14%
Millions
12%
15
10%
8%
10
6%
4%
5
2%
0%
0
1980
Donald Bruce  March 8, 2005
1985
1990
1995
2000
2005*
4
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 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).
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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
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–
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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
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