PERSONAL
INCOME TAXES
AND THE GROWTH
OF
SMALL
Robert
United
FIRMS
Carroll
States Department
Douglas
Holtz-Eakin
Syracuse University
Mark
of Treasury
and NBER
Rider
Kennesaw
Harvey
State University
S. Rosen
Princeton University
and NBER
EXECUTIVE SUMMARY
This paper investigates
the effect of entrepreneurs'
income tax
personal
on the growth
situations
rates of their enterprises.
We analyze
the per
sonal income tax returns of a large number of sole proprietors
before and
after the Tax Reform Act of 1986 and determine
the substantial
how
in marginal
tax rates associated
reductions
with
that law affected
the
as
of
their
firms
measured
that
We
find
individ
growth
by gross receipts.
ual income taxes exert a statistically
and quantitatively
influ
significant
ence on firm growth
rates. Raising
tax price (one
the sole proprietor's
We
at Syracuse
the Center
for Policy Research
the Center
for Economic
University,
at Princeton,
and the National
Science
Foundation
for their support. We are
comments
for useful
from Gerald
Dan Black, David
Don
Auten,
Blanchflower,
grateful
in the Tax Policy
and participants
and the Economy
Bruce,
James Poterba,
Jeffrey Kling,
We also thank Esther Gray
Conference.
in preparing
for her help
the manuscript.
Policy
thank
Studies
122
Carroll, Holtz-Eakin,
Rider & Rosen
tax rate) by 10 percent
the marginal
increases receipts by about
is consistent with
This
the view that raising income
percent.
finding
rates discourages
the growth of small businesses.
minus
8.4
tax
1. INTRODUCTION
The health and vitality of entrepreneurial
is a matter
of sub
enterprises
stantial policy concern. In this context, a good deal of attention has been fo
of whether
cused on the question
the tax system impedes
the creation and
growth
of small
firms. Certainly,
many
an entrepreneur, I experience first
has grown into a monstrous predator
chokes the hopes and dreams of many
As
and Skinner,
entrepreneurs
believe
that it does:
the horrors of our tax system. It
that kills incentives, swallows time, and
as quoted in Engen
(Kemp Commission,
hand
1996).
not much
is known
tax
about how an entrepreneur's
the growth
The purpose
of the
of his or her business.1
tax
is to investigate
this issue. We analyze
the income
paper
present
returns of a large group of sole proprietors
and after the Tax
before
how their firms' growth rates
Reform Act of 1986 (TRA86) and determine
were affected by that law's substantial
tax rates.
in marginal
reductions
In effect, we
the firms with
seek to find out whether
the largest de
creases in tax rates grew the fastest.
a framework
the ques
Section 2 provides
for the analysis. We address
one might
a
on a priori grounds,
sole
tion of why,
expect
proprietor's
tax situation
to affect the growth of his or her enterprise.
Sec
personal
our
in our analysis.
4 presents
the data used
Section
tion 3 describes
In fact, however,
situation
affects
we find that
and results. To anticipate
the conclusions,
statistical model
on firm
taxes exert a substantial
income
individual
influence
growth
rates. For example,
"tax price" (one minus
the
raising the entrepreneur's
as
tax
10
increases
firm
size
measured
rate) by
percent
by gross
marginal
a
elasticity of 0.84. Section 5 concludes with
receipts by 8.4 percent?an
summary
and suggestions
for future
research.
2. CONCEPTUAL FRAMEWORK
In this section we review what economic
theory has
on
taxes
the
influence
of entrepreneurial
of
growth
1A
to tell us about the
As it
enterprises.
some careful
taxes affect
that has received
attention
is whether
the
related
question
we present
not central
to be self-employed.
to the present
study,
Although
propensity
on this matter
some evidence
below.
Personal
Income Taxes and the Growth
turns out, the bottom
line is that
tions. Nevertheless,
the analysis
a useful
and provides
framework
in
Technical
details are included
on
To begin,
the
focus
decisions
in business
remain
indefinitely
taxes on business
survival). Next
of Small Firms
123
theory yields no unambiguous
predic
the sources of the ambiguity
identifies
for interpreting
the empirical
results.
the Appendix.
an entrepreneur
who will
confronting
(i.e., momentarily
ignore the effect of
the entrepreneur
faces a reduc
suppose
tax rate.2 This generates
tion in his marginal
two conflicting
effects. First,
with a lower tax bite there is an increased
to
reward for effort devoted
one would
assume that this raises the entrepre
the enterprise.
Typically,
neur's
exertions.
At the same time, however,
the old level of effort
into greater after-tax profits. Thus,
the entrepreneur
may be
to enjoy these fruits by living a little
more
better?consuming
and
and, also, leisure. This is the familiar conflict of substitution
and from introspection
the net effect is unclear.
effects,
alone,
does not carry a strong prediction
about even the direction
of the
of taxes on entrepreneurial
efforts.
fundamental
ambiguity
spills over into the effect of taxes on the
translates
tempted
goods
income
Theory
impact
This
activities
of the entrepreneurial
venture.
The entrepreneur
myriad
pro
duces output by combining
his effort with purchased
inputs such as
hired
and so forth. If taxes alter the level of
labor, capital, materials,
he
the mix of other
effort,
may respond by re-balancing
entrepreneurial
nature
of
the
not
The
is
Some
obvious.
however,
inputs.
re-balancing,
are
a
for
owner's
effort
substitutes
to
hire
could
(one
inputs
manager
are
owner
the
while
others
the
(if
supervise
operation),
complements
to close on weekends,
chooses
there is no need
to
for an employee
handle
the cash register). Hence,
effort, the sign of
just like the owner's
the effect of taxes on the demands
for the other components
of the
on
If
is
the
effect
the
of
all
process
production
usage
ambiguous.
inputs
so is the effect on out
effort) is ambiguous,
entrepreneurial
(including
so is the effect on
the price of output
is unaffected,
put, and, assuming
on
It
that
the
overall
follows
effect
the
of
size
the business
is
receipts.
theoretically
Of course,
ambiguous.
as is well known,
small businesses
both start up and fail at
we
rates.
must
also
consider
the
of a tax
Hence,
significant
implications
on the relative attractiveness
reduction
vs.
of being an entrepreneur
a
or
in
an
One
tax
that
income
wage
suppose
working
salary job.
might
is neutral
in this respect, because
income from all activities
is taxed at the
same rate. As shown
the net effect
however,
formally in the Appendix,
on the choice between
a
and
entrepreneurship
wage-salary
job is un
2 Since
this
is an election
year,
it is unseemly
to discuss
an increase
in tax rates.
124
Carroll, Holtz-Eakin,
Rider & Rosen
arises because
clear. The ambiguity
is not exclusively
deter
the decision
mined
but
rather
overall
financial
levels
of
considerations,
by
by
utility
in taxes would
in each activity.
In each case, a small reduction
raise after
tax earnings.
in turn, translate
This would,
into higher
consumption.
on its
in
in
the
associated
mode
each
However,
change
utility
depends
no
reason
and
there
is
the
of
for
consumption,
marginal
utility
marginal
to be the same.
utilities
the tradition
follows
of viewing
effects on relative
taxes
out
mechanism
which
economic
affect
prices
through
comes. However,
not
incentives
channel
be
the
which
may
price
only
by
taxes affect entrepreneurs.
to the extent that the entrepre
Specifically,
neur is liquidity-constrained,3
the increase in cash flow associated with a
in taxes will increase the demand
in turn will
decrease
for capital, which
Our
discussion
as the main
and receipts.
Since the price-incentive
output
are
we will not
not
and liquidity-constraint
stories
exclusive,
mutually
our
to
in
them
attempt
analysis.
disentangle
in the simple model
that is finessed
Another
is
question
important
tax rate is relevant. We have assumed
tax rate is
which
that the relevant
In contrast, much
that on ordinary
income.
of the popular
discussion
of
on the capital-gains
rate. A writer
in the Wall
this matter
has focused
Street Journal, for example,
stated that he was "of a class of entrepreneurs
increase
the enterprise's
capital gains tax in our country" and that
a lower
better
and faster" with
grown
"companies
tax (Rigby, 1996, p. A18).
capital-gains
In the first,
To think about this matter,
consider a variety of scenarios.
a
an entrepreneur?we'll
busi
call her Smith?runs
simple consulting
ness and reports her income on Schedule
C. Her only input is her time,
In this setting,
and her receipts consist of payments
for her advice.
there
or "plowing
for "retained
funds back into the
is no vehicle
earnings"
who
his
feel shackled
by the high
would
have
tax rate is the relevant one.
and the ordinary
own time, she also pur
now
not
that
Smith
Suppose
only uses her
chases paper and hires an assistant.
These purchased
inputs are fully
not
and
thus
the basic story.
deductible
her
do
receipts,
against
change
to the enterprise's
net income.
The ordinary
income rate applies
further that Smith purchases
such as comput
capital assets,
Suppose
or even a structure
to house her burgeoning
busi
ers, office equipment,
ness. If so, to the extent that her annual investment
it is
is under $25,000,
business,"
3
and Peterson
that corporate
investment
Fazzari,
Hubbard,
(1988) argue
to capital; Holtz-Eakin,
limited by lack of access
and Rosen
Joulfaian,
(1994b)
same
for sole proprietorships.
phenomenon
decisions
document
are
the
Personal
Income Taxes and the Growth
of Small Firms
125
in the year of purchase.4
the ordi
Thus,
fully deductible
("expensed")
the net cost of
nary income tax rate is the relevant rate for determining
To the extent that investment
itmust
the investment.
exceeds
$25,000,
if so, the value of the depreciation
in any
be depreciated;
allowances
on
that
tax
rates.
will
income
year
year's ordinary
given
depend
The assets generate
income for the firm, which
is taxed at ordinary
rates on Schedule
C. The assets can also generate
income for the firm if
in value and Smith sells them. If so, the appreciated
they appreciate
value component
of such assets may be taxed at either the capital-gains
an asset
rate or the ordinary
income tax rate. The key issue is whether
as
a
are
asset
the
assets
assets
for
all
business.
capital
qualifies
Capital
in
accounts
the
stock
trade
receiv
except
company's
(inventory property),
and musical/literary
materials,
able, copyrights
commodities,
hedges,
if an art dealer sells a painting
and supplies.
for example,
from
Thus,
as
in
then
is
It
value
taxed
income.5
any appreciation
inventory,
ordinary
is certainly possible,
the capital
then, that for certain sole proprietors
in this context. We have no way of de
gains tax rate may be relevant
the importance
of this possibility.
that in any given year, considerably
at
make
any capital investments
proprietors
and
Rosen,
2000b, p. 431).
Rider,
In the next scenario, Smith sells the company
in cash. The
for $100,000
sells the company
but also
of
only appreciation
capital assets,
termining
however,
It is interesting
to note,
fewer than one-half of sole
all (Carroll, Holtz-Eakin,
she
altogether.
Suppose
sales price will reflect not
assets
such as
intangible
etc.
tax
For
she
value, know-how,
purposes,
good will, going-concern
subtracts her basis in the company
and the difference
from the $100,000,
rate. We have no direct evidence
is taxed at the capital-gains
relating to
a
in
the importance
of such transactions.
recent
careful
However,
on
as
of
data
1985
of
sales
business
realizations,
analysis
capital-gains
were not
even
sets by sole proprietors
to
atten
merit
sufficiently
large
tion as a separate
item (Auten and Wilson,
1999).
Finally,
to realize
4 See
that Smith goes
suppose
here is that going public
Section
ing limit
thereafter
179 of the Internal
In tax years
is $20,000.
itwill be $25,000.
5 In
contrast,
sale
is positive,
but
Revenue
Code.
2001 and 2002,
For tax year 2000, the Section
179 expens
it will
rise to $24,000.
In tax year 2003 and
the art gallery
itself, the income will be treated as a capital
assets
1231 assets")
receive particularly
favorable
("section
the aggregate
of the gains from their
capital gains treatment when
treatment
of aggregate
do not
i.e., the loss limitations
losses;
ordinary
if the dealer
gain. Certain
depreciable
treatment.
They receive
apply.
public with her firm. The key thing
is not a taxable event per se. At the
sells
capital
126
Carroll, Holtz-Eakin,
Rider & Rosen
time of an initial public
receives
(IPO), the sole proprietor
offering
tax
not
in the new
and
the
is
shares
corporation,
capital-gains
paid
until such time as those shares are sold. At that time, the capital-gains
to the difference
tax rate is applied
the sales of stock and
between
in which
Smith's basis in the stock. An IPO is just one of several ways
or in part via some type of tax-free
a business
can be sold in whole
Smith might
For example,
receive
stock in the acquiring
exchange.
our
is
the
the same. The capital
For
company.
purposes,
story
basically
as the
not
rate
until
such
time
is
relevant
stock is
newly-acquired
gains
If the stock is not sold before
the owner's
the capital
sold.
death,
may never be taxed at all.
appreciation
can we conclude
all
these scenarios
about the
together, what
Taking
relevant tax rate? The theoretically
ideal tax rate is a weighted
average of
tax
rate
and
the
the contemporaneous
income
expected present
ordinary
tax rate for that component
value of the relevant capital-gains
discounted
treatment.
which
is accorded
the
However,
capital-gains
eventually
or
ever
one
not
rate
if
be
and
does
so,
may
may
applicable,
capital-gains
not know how many years in the future. The expected present discounted
rate for a sole proprietor would
inmost
value of the relevant capital-gains
cases probably
that
be quite small, especially
the
is
given
expectation
that include failure of the enterprise.
taken over states of the world
as a practical matter,
the ordinary
of all these considerations,
one to use in the analysis of the behavior
seems the appropriate
proprietors.
In light
tax rate
or sole
3. DATA
tax files for
data are drawn from the Statistics of Income individual
tax
returns
of
for
1985 and 1988, a panel
62,159
taxpayers
consisting
on taxpay
in both years. These files contain detailed
information
present
taken from their Form 1040. We excluded
ers' income and deductions
married
from our sample
taxpayers filing as heads of household,
filing
with
(and likely erro
spouses,
taxpayers
surviving
duplicate
separately,
returns in either year, and those who reported
income on a fiscal
neous)
us
with 56,701 returns.
year basis. This left
Our
aged 25 to 55 in 1985 in order to
only individuals
sole propri
that
arise
would
because
of younger
complications
and older sole proprietors'
etors' labor-market
entry decisions
impend
to
the
This
further
reduced
size
retirements.
20,141
by
sample
ing
were
to
who
the
alternative
36,360. We also eliminate
taxpayers
subject
We
next
selected
avoid
minimum
tax (AMT),
as our
tax calculator
did not permit
accurate
com
Income Taxes and the Growth
Personal
of Small Firms
127
tax rates under the AMT.6 The result
of all taxpayers' marginal
putations
was a sample of 32,662 tax returns. Finally, we eliminated
dependent
returns and those who changed filing status between
1985 and 1988. The
is a sample of 31,034 returns.
end result of this process
Our basic sample consists
of individuals
who filed a Schedule
C in
In principle,
1985 and 1988, of whom
there are 6,8177
both
results
drawn
from such a sample might
be subject to selectivity
bias?sole
survive until 1988 may not be a random sample of the
who
proprietors
to
1985 group. Our econometric
described
below,
attempts
procedure,
take this selectivity
into account.
problem
Table 1 summarizes
how the income-generating
activities
of the sam
a Schedule
in
individuals
who
filed
C
1985
of
from
8,675
ple
changed
1985 to 1988. The first row shows the proportion
of sole proprietors who
form between
1985 and 1988. It indicates
exited that organizational
that
8.59 percent of the individuals who had Schedule C income but no wage
exited by 1988. For individuals who reported both Sched
and wage
income in 1985, 21.2 percent were no longer sole
on
1988.
The
four rows provide
information
proprietors
remaining
by
to particular
transitions
from sole proprietorships
income
of
types
earn
to wage
generating
activity. The second row focuses on transitions
as
a
income
without
income
from
business
(defined
any
ing
partnership
or Subchapter
2.9 percent
S corporation).
of the individuals
who had
in
were
C
income
1985
and
12.6
Schedule
of
those
who
percent
only
a
earners
and
sole
such
transition.
made
wage
initially
proprietors
in 1985 income
ule C income
in parentheses
in the
The figures
show the proportion
of individuals
in the row. For
the type of transaction
column who made
indicated
with Schedule
C income only in 1985 who
of the individuals
example,
earners only.
33.8 percent
then exited self-employment,
became wage
The third, fourth, and fifth rows provide
information
for exits
analogous
to business
from sole proprietorships
income only, wage
income and
income nor business
business
income (retire
income, and neither wage
ment),
respectively.
Taken as a whole,
Table 1 indicates
that the overall exit rate is much
lower for those returns that have only Schedule
C income. Also,
exits
are
to
from sole proprietorship
exits
another
split roughly evenly among
6More
we
AMT preferences
observe
to
for taxpayers
specifically,
generally
only
subject
From an operational
it is very difficult
to calculate
the AMT.
tentative AMT
point of view,
when
constant.
income
We
also excluded
filers and individuals
who
holding
dependent
changed
7We
receipts.
marital
required
status.
those
This
who
led to the deletion
filed
a Schedule
C
of 1,628
observations.
in 1985
to have
positive
values
for gross
128
Carroll, Holtz-Eakin,
Rider & Rosen
TABLE 1
Transitions
in Income-Generating
Activity
for
1985 vs. 1988a
Sole Proprietors
Schedule C and
No
Wage-Salary
Income in 1985
Transition
Exit sole proprietorship
0.0859
To wage-salary
0.0290
only
(33.8%)
To business
and
To wage-salary
To
neither
0.0238
incomeb only
business
wage-salary
nor
incomeb
Schedule C and
Wage-Salary
Income in 1985
0.212
0.126
(59.3%)
0.00520
(27.7%)
(2.4%)
0.0226
(26.4%)
(37.4%)
0.0791
0.0105
0.0017
(12.2%)
(0.8%)
business
incomeb
in 1985:
in 1985 who ceased filing a Schedule C in 1988,
(a) Each entry shows the fraction of sole proprietors
row. The figures in parentheses
in the activity in the corresponding
and in 1988 were engaged
show
row.
in each column who are in the corresponding
of individuals
the percentage
(b) Business
Income
is income
from a partnership
or Subchapter
S Corporation.
A
and both business
and wage-earning.
business
form, wage-earning,
across columns,
for those who begin
smaller fraction retires. Comparing
to Schedule C income (recall, for joint filers
in addition
with some wages
there is amuch greater propen
these may be the earnings of the spouse),
move
to
to
and a lower
and
wages
sity
plus business,
strictly wages
move
to
to
business.
propensity
strictly
as a
incomes
Our sole proprietors
have much
than taxpayers
higher
a
In
with
that
is
consistent
the
earlier
research.
1985,
whole,
finding
was
our
mean
in
income
of
sole
(AGI)
sample
proprietors
adjusted gross
with
for all tax returns was $22,683. Also consistent
the mean
$177,267;
is
the
tremendous
for
research
(see,
2000)
example, Hamilton,
previous
of
standard deviation
among sole proprietors?the
incomes
is
also
of
The
distribution
sole
$1,845,269.
proprietors'
AGI was only $54,797. Not surprisingly,
the key
very skewed; median
Mean
AGI
similar
of
exhibited
wages
patterns.
components
qualitatively
=
and salaries on the returns were
$116,572
$461,994), with a me
(s.d.
variation
AGI was
in income
sum of interest and dividends)
dian of $25,413. Mean
capital income (the
=
a
was $50,140
it
with
median
of $2,197. In our context,
$353,160),
(s.d.
in
to
note
net
C
the
schedule
is particularly
interesting
dispersion
Personal
Income Taxes and the Growth
of Small Firms
129
mean
in our sample was $95,726 (s.d. = $618,850),
but the
income?the
median
only $6,593.
our sample
As is well known,
period coincides with a general widen
in the tax-filing population
the
income
distribution.
For
of
ing
example,
ad
of modified
for the bottom 25 percent of the distribution
was
in
1985.
income8
$7,962
By 1988, this grew only 1.7
justed gross
In
to
the
cutoffs
for the 90th, 95th, and 99th
contrast,
$8,100.
percent
and
28.4
grew 12.6, 14.5,
percent,
percentiles
respectively.
this widening
is less pronounced
sole proprietors,
and fo
Among
For example,
cused among
those at the lower end of the distribution.
in both
survivors
sole proprietors
1985 and
(those who were
among
in 1985, mean modified
started in the bottom 25 percent
AGI
1988) who
In contrast,
the mean
rates in the other
fell by 14.9 percent.
growth
as well as the top 5 percent were positive
and tightly bunched
quartiles
the cutoff
In short, with
9.4 and 11.2 percent.
between
the exception
was
est quartile,
sole proprietors
income growth
among
it
is
the
income
that
distribution.
Thus,
throughout
unlikely
in
will be driven by autonomous
the
tail
of
upper
growth
of the low
fairly even
our results
the
income
distribution.9
are enterprises
How
The size of an
owned by sole proprietors?
large
can
in
be
measured
several
number
of em
ways,
enterprise
including
revenues.
measures
of
and
units
Various
output
produced,
ployees,
and Hubbard
(1998) focus on gross re
appear in the literature. Gentry
ceipts. On the other hand,
he reports that analyses
of
similar
results
659).
yield
(p.
so they are the
revenues,
Evans
(1987) studies employment,
although
rates
firms' sales and employment
growth
Tax-return
data include information
only on
we
use
focus of our analysis.10
Specifically,
gross receipts from line 1(a) of Schedule C. Of course, two firms with the
same gross receipts could be in very different
financial health, depend
on
we
on gross rather than
costs.
to
their
choose
focus
Nevertheless,
ing
tax data do not include
net receipts because
costs and hence do not allow an economically
net receipts.
information
meaningful
on economic
measure
of
8Modified
AGI
is the sum of AGI,
excluded
excluded
and ex
dividends,
capital gains,
cluded
compensation.
unemployment
9 The basic
in our computations
is unchanged
if we
include
those who
exited
sole
picture
1985 and 1988. The corresponding
between
rate in this sample
for
proprietorship
growth
25 percent
is -9.3
rates at the upper
the bottom
The mean
end range
percent.
growth
between
9.7 and 11.1 percent.
10While
on
there is no information
there are data on the firm's wage
bill,
employment,
or not
which
allow one to study whether
taxes affect the dichotomous
decision
of whether
to hire labor. See Carroll, Holtz-Eakin,
and Rosen
Rider,
(2000a).
130
Carroll, Holtz-Eakin,
Rider & Rosen
of the particulars
of our measure,
the sole proprietors
in
Regardless
our
an
eco
of entrepreneurial
sample constitute
important
component
nomic activity. According
to the Bureau of Economic Analysis,
national
income in 1985 was $3,380.4 billion, of which
$2,769.9 billion (82 percent)
was
to domestic
attributable
business
income.
The Internal Revenue
Service's
Statistics
of Income (SOI) estimates
that non-farm
sole propri
etors reported gross receipts of $540 billion, or
20 percent
approximately
of domestic
business
income in 1985.
Based on SOI sample weights,
our original
sample of 62,159 returns
reported gross receipts of $473.8 billion?88
percent of the SOI total. The
of sample exclusions
lowers the economic
process
activity represented
our basic
For example,
by the sample, but it remains significant.
sample
of 8,675 returns accounts
for 59 percent
($320.8 billion) of the SOI total
in both 1985 and 1988 account
for 49 per
(those with positive
receipts
cent, or $266 billion).
another measure
of their importance,
the wage bill?payments
Using
a
sole
to
hired
by
proprietors
very similar pattern. Our
labor?yields
basic sample of 8,675 returns comprises
62 percent
($266 billion) of the
SOI estimate
of total wage payments
sole
by
proprietors.
By either mea
for a significant
of
sure, our sample accounts
proportion
entrepreneurial
activity.
An important
in this discussion
is that we can
implicit assumption
as
sole
Is
In the non
this
sensible?
identify
proprietors
"entrepreneurs."
are
statistical
literature on this topic, entrepreneurs
identified
typically
by
their daring, risktaking,
animal spirits, and so forth. However,
statistical
work forces us to settle for more prosaic, observable
criteria for classifying
someone
as an entrepreneur.
With
tax-return
sensible
data, the most
a
for
is
the
of
C
in
Schedule
the
return.11
proxy
presence
entrepreneurship
It has been suggested
that the presence
of Schedule
C is more
indica
tive of tax-sheltering
activity than entrepreneurial
activity. For example,
some economists
on
their
income
and honoraria
may report
consulting
Schedule
C solely in order to be eligible
for certain deductions.
How
that such personal
ever, data from the 1985 Statistics of Income suggest
are undertaken
a small
service activities
of Schedule
by only
proportion
C filers, about 16 percent.12 And surely at least some of these activities
reflect classical entrepreneurial
behavior.
11 For data sets
focused
individual
classifies
him-
on labor-market
the key criterion
issues,
or herself
as
being primarily
self-employed.
Owners
data set created by the U.S. Census
of Business
teristics
based
definition
of entrepreneurship.
12 This
includes
"business
figure
relations,
services,
etc.)
computer
(See Holmes
and Schmitz,
services'7
(advertising,
and "accounting
and
has
been whether
the
the Charac
However,
a tax
Bureau
also uses
1991.)
management
bookkeeping
consulting,
services."
public
Personal
One
which
could
many
bility
some
Income Taxes and the Growth
of Small Firms
131
an
to implement
for identifying
be tempted
algorithm
might
one
are
"serious"
For example,
C filers
Schedule
entrepreneurs.
some
income be above
threshold
level. But
require that business
have low or even zero receipts. Another
possi
startup enterprises
C income to earned income be above
is that the ratio of Schedule
can
serious
But as already
threshold.
entrepreneurs
suggested,
Further complications
result
from their enterprises.
low incomes
starts his or her
who
from using annual data. A serious entrepreneur
business
late in the year is likely to resemble a full-year, but non-serious,
have
entrepreneur.
out spurious entrepreneurs
that trying to weed
not
filers
is
C
of
Schedule
likely to be terribly fruitful.
population
a bit with alternative
thresholds
theless, below we experiment
as criteria for being classified as an entrepreneur,
ness revenues
results.
that they have no serious effect on our substantive
We
conclude
from the
Never
for busi
and find
4. STATISTICAL MODEL AND RESULTS
4.1
Econometric
Setup
to
of the rate of growth
estimate
the determinants
is
of sole
goal
we
in
and
1985
1988.
As
discussed
section
between
receipts
proprietors'
rate depends
the tax rate facing the entrepreneur
2, the growth
upon
and the parameters
functions. Given
these
of his utility and production
an appropriate
that
the
considerations,
posits
empirical
specification
a
in
between
1985
and
is
1988
function
of
the
receipts
change
logarithm
to be 1minus
the
of the reform-induced
change in the tax price?defined
are related to the entrepreneur's
tax
that
variables
rate?and
marginal
we assume
rate
that the growth
and technology.
Specifically,
preference
Our
of gross
receipts,
A\n(GRECEIPTS),
is
=
A\n{GRECEIPTS) a0 + ^AkiCTAXPRICE) + X85? + e,
(4.1)
=
ln(l
A\n(TAXPRICE)
r88) ln(l %) and rs is the entrepreneur's
tax rate in year s; X85 is a vector of characteristics
of the entrepre
marginal
neur as of 1985 (which reflect differences
in utility-function
parameters)
in produc
and of the entrepreneur's
(which reflect differences
industry
is
vector.
and
the
associated
tion-function
?
parameter
parameters);
where
to in
issue related to equation
(4.1) is what variables
important
as rich a set of
in the vector X85. Tax returns do not contain
as some other data sets, but several useful
variables
controls
personal
are available.
their means
and standard
These variables,
along with
are included
in Table 2. Age is listed because
it is related to
deviations,
An
clude
132
Rider & Rosen
Carroll, Holtz-Eakin,
TABLE 2
Statistics^
Sample
Statistic
(l)b
Aln(TAXPRICE)
in gross receipts)
(log difference
A\n(GRECEIPTS)
in tax price)d
(log difference
AGE (age X 10~2 in years)
MARRIED
DEPENDENTS
MFG
(=1 ifmanufacturing
WHOLESALE
0.914
(number of dependents
X 10"1)
0.0238
0.111
SERVICE (=1 if service sector)
(a) Table entries are means
(c) Column
(2) contains
positive receipts in both
(d) The tax price
0.0501
0.0524
(0.353)
(0.373)
(0.280)
(0.278)
0.161
0.162
(0.134)
0.0233
(0.152)
(0.151)
(0.152)
0.0229
(0.150)
0.104
(0.313)
(0.306)
(0.314)
(0.315)
(0.498)
(0.497)
N
8,675
6,817
0.555
standard
deviations.
in our sample who were all proprietors
for all individuals
of whether
in 1988.
they were also sole proprietors
statistics for the subset
1985 and 1988.
is defined
(0.0648)
0.111
0.543
and, in parentheses,
(b) Column
(1) contains statistics
positive receipts in 1985, regardless
(0.0650)
0.0238
0.110
(=1 if finance sector)
(0.0781)
(0.133)
trade sector)
RETAIL (=1 if retail trade sector)
FINANCE
(0.786)
0.916
sector)
(=1 ifwholesale
(0.214)
0.179
income X 10"6)
(=1 ifmarried)
(0.209)
0.416
0.177
(interest and dividend
(0.186)
0.124
0.127
0.414
AGE2 (age X 10~2 squared)
CAPINC
(2)c
0.332?
?
as one minus
of those
the marginal
individuals
tax rate.
who
were
sole proprietors
with
with
Personal
Income Taxes and the Growth
of Small Firms
133
in the job market
and human-capital
one's experience
accumulation;
it affects the entrepreneur's
function.
hence,
production
Age also may
risk aversion and hence the utility function. Previ
affect the individual's
ous research on entrepreneurial
that a qua
suggests
decisionmaking
status and the
dratic term in age is also appropriate.13 We include marital
in view of the possibility
number of dependents
that they may affect the
and risk aversion.
entrepreneur's
leisure-consumption
preferences
We
income as a measure
of the individual's
include capital
assets,
in the presence
of
entrepreneurial
decisionmaking
one
note
tax-return
that
constraints.14
should
However,
capital-market
data on capital income are quite poor. Our variable
is the sum of re
it
and
dividends
omits
and
bond
interest;
ported
capital gains
municipal
one must
in interpreting
inter alia.15 Hence,
be cautious
the
interest,
on this variable as a test of the liquidity-constraint
coefficient
hypothesis.
business
codes reported on Schedule
C, we
Finally, using the principal
a
are
set
variables.
to
of
dichotomous
These
intended
develop
industry
as
take into account
the
that
such
fact
demand
effects,
industry-specific
which
should
affect
the parameters
of the production
and profitable
technology,
across
industries.
differ
opportunities
A second major
with
issue associated
(4.1) is the potential
equation
tax
of
the
variable.
rates, of course, vary
tax-price
endogeneity
Marginal
with taxable income. As receipts go up, taxable income increases,
and so
tax rate, ceteris paribus. This may
induce a spurious
does the marginal
and the growth
between
of re
Aln(TAXPRICE)
negative
relationship
a
another
in
manifestation
of
ceipts,
problem
ubiquitous
investigations
of the behavioral
effects of taxation
(see Feenberg,
1987). As in other
a remedy
is to estimate
vari
the equation
instrumental
settings,
using
a
we
corre
find
which
that
variable
that
is
ables,
(or variables)
requires
to be correlated with the error
lated with Aln(TAXPRICE)
but is unlikely
patterns,
term.
an instrumental
variable that takes advantage
of the most
our
in
data:
the
tax rates
feature
of
exogenous
prominent
change
marginal
tax
due to TRA86 itself. To begin, we compute each individual's marginal
We
13We
results
forms.
Social
construct
a
in age, and found that it left the substantive
quartic
are not
on individual
tax
income
ages
essentially
unchanged.
Taxpayers'
reported
are added
to the Individual
Tax File through
the use of data provided
Ages
by the
Security Administration.
also
estimated
the model
with
14 See Evans
and Jovanovic
and Rosen
Joulfaian,
(1989), Holtz-Eakin,
(1994a, 1994b), and
van
van
on the
of liquidity
constraints
to
(1995) for evidence
importance
Praag and
Ophem
entrepreneurial
decisionmaking.
15Of
on
other conventional
data sets also lack information
course,
components
important
of capital
income.
134
Carroll, Holtz-Eakin,
Rider & Rosen
rate using the data and tax law for 1985.16 Next we compute
each individ
to
tax
rate
1988
ual's marginal
levels), but
using the data for 1985 (inflated
tax
law for 1988. Clearly,
the change between
the 1985 and
the
employing
to
in this fashion is due entirely
modifications
the 1988 tax rates computed
removes
com
this procedure
the endogenous
of the tax code. Essentially,
from Aln(TAXPRICE),
ponent of tax-rate movements
leaving only the part
in
tax
with TRA86.17
the
law
associated
due to the exogenous
change
concern with
is based on the notion
that all of
A possible
this strategy
to high-income
indi
associated with TRA86 accrued
the tax reductions
are somehow
in unobservable
If such individuals
viduals.
different
ways
in the tax price might
rest of the sample,
then the change
To think about
for
differences.
be
these
unobservable
proxying
simply
to begin by noting
it is useful
this issue,
that, in fact, the 1986 law
tax rates for virtually
and actually
increased marginal
everyone
changed
it altered many
that influ
rates at the low end. Also,
of the provisions
ence marginal
tax rates, such as those relating
to medical
expenses,
In
and the two-earner
deduction.
unreimbursed
business
expenses,
tax
the
of
of TRA86 as affecting
short, the characterization
only
prices
from
the
individuals
is inaccurate.
high-income
how much of the variation
That said, it is of some interest to document
in the tax price comes from various
in the change
of the in
segments
come distribution.
the sample into
To investigate
this issue, we divided
on 1985 income,
the percentage
and then examined
based
quintiles
we found that the typical
in
tax
As
price by quintile.
expected,
change
or median)
in the tax price went
income.
up with
(i.e., mean
change
was
remark
of the percentage
the standard deviation
However,
change
across quintiles.18 Hence,
of the tax price coeffi
identification
ably similar
from the high-income
cient is not coming exclusively
part of the sample.
16We
our
tax calculators
tax rates using
detailed
developed
by the
compute
marginal
include
and tailored
for our panel.
These
calculators
U.S. Treasury,
of Tax Analysis,
tax rates
the post-TRA86
rate schedule
and the many
both
the statutory
(e.g.,
implicit
tax
and the personal
tax benefits
with
the
bracket
associated
of
exemp
15-percent
phaseout
tax rates include
the Self
features of the tax code. Our marginal
tion) that arise from special
tax for wage
earners.
Contributions
Act
tax, and the social security
(SECA)
Employment
17An
in tax rates of particular
interest
is that stemming
of changes
component
endogenous
raises reported
is that a cut in tax rates reduces
from tax evasion.
One possibility
evasion,
tax rates,
ceteris paribus.
and as a consequence
raises observed
taxable
income,
marginal
in mar
to eliminate
all behavior-based
variable
is constructed
Our
instrumental
changes
The possibility
with
evasion.
those associated
remains,
however,
ginal tax rates, including
in reporting
to changes
in gross
is due
that some of our estimated
(as
receipts
change
to real) behavior.
opposed
Office
18 The
standard
highest
income
deviations
quintile
of the percentage
are as follows:
10.6,
in tax price
change
9.7.
10.2, 10.4,14.7,
from
the
lowest
to the
Personal
Income Taxes and the Growth
of Small Firms
135
The fact that our sample consists of individuals who were sole propri
etors in both 1985 and 1988 raises a third issue. Survival as a sole propri
etor is not a random process; hence,
estimates
of equation
(4.1) may be
We
bias.19
take
of the
inconsistent
rendered
advantage
by selectivity
to
with
deal
this
Heckman
(1979)
Spe
problem.
technique
by
suggested
in
who were
sole proprietors
the sample of individuals
cifically, using
a
we
of
the
that
the
individual
estimate
1985,
probability
probit equation
was still a sole proprietor
in 1988, and then augment
(4.1) with
equation
arises
the inverse Mills ratio associated with the probit.20 A complication
in the probit
the change in the log of the tax price is endogenous
because
as well as the receipts growth
equation. We therefore employ
equation
in both equations.
This ensures
esti
consistent
variables
instrumental
mates
but complicates
the computation
of consistent
of the parameters,
a
to deal with
standard error. We implemented
procedure
bootstrapping
this problem,
cal
estimating
4.2
Basic
100 times and computing
the system
matrix
variance-covariance
of
the
parameter
the empiri
estimates.21
Results
in column
of the
To begin, we present
(1) of Table 3 the estimates
variables
instrumental
of
(4.1),
parameters
using
equation
computed
bias as outlined
and correcting
above. From our stand
for selectivity
on Aln(TAXPRICE),
that
which
is positive,
is
the
coefficient
point,
key
error by a factor greater
than 5.5. Thus,
the
and exceeds
its standard
a
in
tax
increase
sole
the
between
greater
percentage
price
proprietor's
1985 and 1988, the greater the increase in the size of his or her business.
This resolves
the theoretical
respect to the effect of the
ambiguity with
tax price that we discussed
in Section 2. Given
that the equation
is in
on the tax-price variable
is
the
the
coefficient
form,
essentially
log-log
tax
to
with
the
of
Our
estimate
respect
price.
receipts
implies
elasticity
an
in the
that a decrease
for example,
of 0.84. This suggests,
elasticity
on a sole proprietor
tax
to
rate
from
50
33
levied
percent
marginal
would
lead to an increase in his receipts by about 28 percent. Whether
is a matter
but it appears
that
of judgment,
this is a "large" effect
19
TRA86
Indeed,
main
thrust was
to alter the organizational
incentives
form of a business.
The
embodied
tax (sole
to make
taxation
under
the individual
income
proprietorship,
more
to the corporation
S corporation)
attractive
relative
tax; see
partnership,
Subchapter
and Joulfaian
TRA86 was more
Carroll
(1995) or Plesko
(1994). Hence,
likely to induce
entry than exit.
20 Survival
addition
to initial size,
is related
probability
to the variables
in equation
(4.1), we
1985.
21 See Efron
(1979)
for a discussion.
as documented
include
the
by Caves
logarithm
(1998). Hence,
of gross
receipts
in
of
136
Carroll, Holtz-Eakin,
Rider & Rosen
TABLE 3
Analysis
Variable
(1)
INTERCEPT
-0.948
(0.574)
Aln?TAXPRICE)
AGE
Growtha
of Receipts
(2)
-0.712
(0.0661)
(3)
-0.977
(0.583)
(4)
-0.989
(0.572)
0.836
0.915
0.928
0.746
(0.149)
(0.138)
(0.156)
(0.143)
0.268
0.370
0.489
(2.80)
(2.83)
AGE2
-0.788
CAPINC
-0.128
-0.837
(3.38)
(3.39)
-0.0827
(2.78)
-0.988
(3.33)
-0.114
MARRIED
(0.137)
0.0107
(0.134)
0.00672
(0.131)
0.0135
DEPENDENTS
(0.0737)
0.150
(0.0747)
0.156
(0.0735)
0.152
MFG
(0.174)
0.464
(0.176)
0.454
(0.173)
0.456
(0.129)
WHOLESALE
(0.132)
-0.0127
RETAIL
FINANCE
SERVICE
-0.0306
(0.138)
0.132
(0.0867)
0.115
(0.139)
0.123
(0.0873)
0.105
(0.0832)
(0.0834)
0.338
0.347
(0.0581)
(0.0592)
EARNINGS
(0.129)
-0.0246
(0.136)
0.121
(0.0855)
0.118
(0.0828)
0.338
(0.0576)
-0.186
(0.0831)
0.0525
(0.0171)
Aln(INCOME)
Inverse Mills
ratio
N
2.18
2.13
2.22
2.16
(0.160)
6,817
(0.162)
6,817
(0.165)
6,817
(0.158)
6,817
in gross receipts between
aThe left-hand-side
variable in each equation is the log difference
1985 and
1988. Estimation
as endogenous.
is by instrumental
Standard er
variables,
treating Aln(TAXPRICE)
are in parentheses,
are computed by bootstrapping
are defined
in
methods.
Variables
rors, which
Table 1, except for EARNINGS
in net
(household
earnings in 1985) and A\n(INCOME)
(log difference
income between
1985 and 1988). The latter variable is treated as endogenous.
tax rates have a substantial
of entrepre
effect on the growth
marginal
neurial enterprises.
now
one finds that
to the other right-hand-side
variables,
Turning
terms in age are insignificant.
both the linear and quadratic
the
Similarly,
other
indicators
of the individual's
economic
and demographic
situation
Personal
Income Taxes and the Growth
of Small Firms
137
a
do not exert statistically
influences,
significant
finding consistent with
earlier studies that look at the evolution of various aspects of entrepreneu
and Rosen,
rial enterprises
1994a; van Praag,
Joulfaian,
(Holtz-Eakin,
van
is a statistically
and
1995).22 However,
industry
Ophem,
Mirjam,
in the manufac
In particular,
entrepreneurs
engaged
significant variable.
revenue
than their
greater
growth
turing and service sectors experienced
on the inverse
in other sectors.23 Finally,
the coefficient
counterparts
and statistically
ratio is positive
Mills
(reason
suggesting
significant,
that affect the growth of entrepre
characteristics
ably) that unobserved
and their survival are positively
correlated.
neurial enterprises
An interesting question
iswhether
the positive
effect of the tax price on
on the presence
firm growth depends
of the other covariates. This question
is particularly
variables,
cogent given that some of the right-hand-side
success. To inves
such as marital status, might be correlated with business
we re-estimated
(4.1) with only a constant
equation
tigate this possibility,
and Ah\(TAXPRICE).
The results are reported in column (2) of Table 3. The
and statistically
remains positive,
coefficient
of similar magnitude,
signifi
cant. Hence,
the size and character of the tax effects in column
(1) are not
tax rates and other variables.
artifacts of a correlation between
4.3 Alternative
Specifications
our equation
to a variety of checks to determine
We subjected
whether
or
to
is
the
data
the estimated
sensitive
To
relationship
specification.
we
value
of
and
the
1985
included
family wage
salary earnings.
begin,
More
of this variable
is possible.
To the extent
than one interpretation
are attributable
to the entrepreneur's
that earnings
spouse,
they may
create an income effect for the entrepreneur.
To the extent that they are
an indicator of the cost of
to the entrepreneur,
attributable
they may be
time that is spent in sole-proprietorship
activity. If so, they are also likely
reason for not including
to be endogenous,
in the
the primary
earnings
in
baseline
column
3.
The
of
results
Table
(1)
specification
reported
are included
in column
when
(3) of Table 3. The esti
appear
earnings
a
error of 0.0831).
mated
with
is negative
standard
coefficient
(-0.186
no
the
inclusion
of
the
variable
had
earnings
Importantly,
essentially
effect on the character
of the tax-price
results?the
is 0.93
coefficient
with
22While
various
that a
23 The
an estimated
standard
error of 0.16.
variables
do not seem to be strongly
correlated
demographic
are correlated
these variables
with
characteristics
of small
firms,
is an entrepreneur.
individual
See, e.g., Meyer
(1990).
given
most
with
changes in
the probability
omitted
includes
construction,
category
transportation,
industry
mining,
agricul
are
on an indi
other
industries.
ture, and miscellaneous
because,
They
grouped
together
vidual basis,
each accounts
for a very small proportion
of the observations.
138
Carroll, Holtz-Eakin,
Rider & Rosen
in the tax
feature of TRA86 is that it embodied
important
changes
as well as in marginal
tax rates. For example,
the itemized deduc
tion for state sales taxes was eliminated.
Thus, the tax reform generated
in
in Section 2 sug
income.
after-tax
The
theoretical
framework
changes
ceteris
affect
such
tax-base
effects
that,
gests
paribus,
receipts by
might
own labor supply and his demand
the entrepreneur's
for other
altering
An
base
factors.
we augmented
in Table 3
the specification
To investigate
this possibility,
in the log after-tax
with
the change
income between
1985 and 1988. Of
for the same reasons as our tax
course, this variable may be endogenous
an instrument
can
construct
to that used
variable.
We
for it analogous
price
1988
income
for our tax-price variable
after-tax
(i.e., compute
using 1985
is
income data and 1988 tax structure). The estimates when
the basic model
are
in
in
the
after-tax
with
of
income
the
difference
log
reported
augmented
column
(4). The inclusion of this variable does not affect the nature of our
on the tax price remains positive
and significant?
results. The coefficient
the estimated
is 0.746 with a standard error of 0.143. The coeffi
coefficient
with a standard
cient on after-tax income is statistically
significant?0.0525
error of 0.0171. The fact that increasing cash flow enhances business perfor
mance
is consistent with earlier research which
shows that liquidity con
straints affect the decisions
of small firms (see, e.g., Evans and Jovanovic,
and
1989,
Holtz-Eakin,
Joulfaian, and Rosen,
1994a).
in rate of
allows for cross-industry
Our basic specification
differences
taxes
is
to
be
but
the
of
assumed
of
effect
industry.
independent
growth,
are more
in some
tax
industries
firms operating
Perhaps,
though,
in section 2 indicated
the model
sensitive
than others. More
specifically,
and
that tax responses
upon production-function
parameters,
depend
to differ by industry. To address this issue, we aug
these may be expected
a series of terms interacting
with
the
mented
the basic specification
tax
in
the
various
We
the
with
indicators.
found
price
industry
change
that, in general,
tax-price effects do not vary across industries. Only one
of the coefficients was statistically
(In the service sector, the
significant.
interaction had a point estimate of 1.37 with a t statistic of 3.78.)24 Inmagni
in
the interaction
tude, itwas
(reported
larger than the estimate without
was
the
same.25
result
column (1) of Table 3), but the quantitative
basically
24 An
be to see if the tax-price
exercise would
interesting
sector altogether.
observations
from the service
However,
out more
than one-half
Table 2, this would
involve
leaving
25 Our
ments.
are robust
to dropping
results
as
the bottom
of
toward
implied
the observations.
cross-state
in business
differences
environ
also
canonical
ignores
specification
states differ
To control
in their regulatory
and tax systems.
for such
For example,
a set of dichotomous
we added
to our basic specification.
state variables
The
differences,
had little effect on the tax-price
of these controls
coefficient.
inclusion
Personal
Income Taxes and the Growth
of Small Firms
139
in
of Table 3 is that changes
from our discussion
emerging
a significant
on
tax
rates
have
the
their
impact
growth of
entrepreneurs'
one may wish
to tighten the
As discussed
earlier, however,
enterprises.
criteria for classifying
C filers as entrepreneurs.
To do so, we
Schedule
that sole proprietors
the requirement
$500 of gross
imposed
reported
our
and
business
statistical analysis using this smaller
receipts
repeated
The
theme
more select sample. The basic tenor of our results is
(8,324 observations),
to be positive
continues
Ah\(TAXPRICE)
(0.747) and statisti
unchanged;
=
(s.e.
0.156) As further checks, we raised the minimum
cally significant
to $1,000 of business
threshold
receipts, and then to $5,000. In each case,
remain positive
and significant,
the estimated
the
coefficients
although
to 0.725 and 0.641, respectively.26
diminish
magnitudes
4.4
Tax Rates
As
noted
and
Survivor
the results
above,
whose
first
stage is
procedure
an individual
survives as a sole
cation does not constrain
the
survival and the receipts-growth
cates that there is no reason
Probabilities
a two-step
3 are generated
by
that
for
the
equation
probability
to
from
1985
1988.
This
proprietor
specifi
tax price to have
the same sign in the
in Table
a probit
Our theoretical model
indi
equations.
an
to impose
such a constraint. While
on
in the tax price may
increase
increase
conditional
receipts growth
in business,
at the same time it may also make
the salaried
remaining
sector more
attractive.
This renders
the ultimate
effect ambiguous.
we have viewed
this equation primarily as ameans
for generat
Although
it is of indepen
estimates
of the receipts-growth
model,
ing consistent
dent interest. Specifically,
the probit equation
reveals how the survival
on tax rates.27 The probit coefficients
rate in self-employment
depends
are
4.
in
of
Table
column
(1)
reported
on the change
in the log of the tax price is negative
The coefficient
its standard error by only a factor of 1.3. Hence,
in
and exceeds
(-0.137)
26 An alternative
concern
are "too serious";
is that some of our entrepreneurs
that is, our
of some very large sole proprietorships
results may be unduly
influenced
by the presence
that are not representative
of the small firms that are our focus. To investigate
this possibil
in 1985
of our sample
the largest gross
the 10 percent
reporting
ity, we deleted
receipts
than $803,600).
little effect. The esti
this has very
greater
Qualitatively,
(gross receipts
mated
for the tax price
remains
coefficient
(0.597) and statistically
positive
significant
to further hone our focus on serious,
error equal to 0.126). Finally,
small entrepre
(standard
as measured
both the top 10 percent
and the bottom
10
neurs, we deleted
by gross receipts
there is little qualitative
effect on our conclu
$1,400). Again,
percent
(gross receipts below
error are 0.693 and 0.143,
and its standard
the estimated
coefficient
sions;
respectively.
27 The
on
to corporations,
also
inter
choice
the tax rates applied
organizational
depends
as a consequence
alia. These
also changed
of the Tax Reform Act of 1986. (See Gordon
and
to all individuals,
the change
and hence does not
MacKie-Mason,
1997.) However,
applied
in our analysis.
control
require any special
140
Rider & Rosen
Carroll, Holtz-Eakin,
TABLE 4
Probit
Analysis
Variable
INTERCEPT
of Self-Employment
(l)b
-1.18
-0.137
(3)d
(2)c
-1.26
(0.447)
Ahi?TAXPRICE)
Decisions'1
-0.0994
(0.425)
-5.32
(0.141)
(0.402)
-0.401
(0.109)
(0.0836)
]n(TAXPRICE)
0.657
-0.103
(0.0335)
AGE
-0.268
-0.0453
(2.15)
AGE2
CAPINC
MARRIED
0.803
0.612
(2.59)
MFG
WHOLESALE
-0.0834
-0.0994
-0.0875
7.01
(87.2)
7.03
(0.108)
(86.9)
-0.118
3.88
(0.0590)
(0.144)
-0.0938
R*'85
(0.0597)
0.0830
(0.0423)
0.197
N
(0.00731)
8,675
(0.0069)
8,675
aProbit estimates. Figures in parentheses
variables are as defined in Table 1.
(0.103)
-0.265
(0.0507)
0.0798
(0.0389)
0.192
SERVICE
(0.0425)
-0.253
(0.134)
0.0393
(0.109)
(0.0490)
FINANCE
(0.0296)
0.492
(0.0603)
(0.106)
RETAIL
(1.84)
0.240
-0.0720
(0.149)
0.0440
(0.112)
-0.259
-1.63
(0.0454)
0.0220
(0.0604)
DEPENDENTS
(1.50)
-0.0464
(0.0519)
0.0148
are standard
errors. R85 denotes
(0.0574)
2.40
(2.13)
(2.58)
-0.0565
(4)d
7.05
(38.8)
4.44
(0.108)
31,034
gross
31,034
receipts,
and the other
in 1985. The left
bColumn (1) is estimated over the sample of individuals who were sole proprietors
in 1988 and zero otherwise.
The
variable is one if the individual was also a sole proprietor
hand-side
is by instrumental variables, with the change in the log of tax price treated as endogenous.
estimation
the probability
of surviving as a sole proprietor
from 1985 to
cColumn (2), like column (1), estimates
1988. However,
the change in the log of the tax price is not instrumented.
and wage earners in 1985. The
'klolumns (3) and (4) are estimated over the sample of sole proprietors
in 1985 and zero otherwise.
left-hand-side variable is one if the individual was a sole proprietor
Personal
Income Taxes and the Growth
of Small Firms
141
our data,
taxes exert their major
rates of
effect on the growth
higher
to their survival probabilities.
firms as opposed
existing
is estimated
Recall
that the probit model
variables
by instrumental
of the endogeneity
of the tax price. Column
because
the
(2) reports
in
results when
is
Like
its
instru
the
counterpart
endogeneity
ignored.
on the tax price is
mental-variables
model
of column
(1), the coefficient
is
in
it
value
and
it is statistically
absolute
However,
negative.
larger
a factor of almost
error
exceeds
its
standard
coefficient
(the
significant
by
leads to the incorrect
5). Hence,
failing to correct for endogeneity
ence that increases
in tax rates increase the probability
of surviving
infer
as an
entrepreneur.
issue. In the probit
This finding
leads to a concern about a technical
the instrumental-variables
consistent
esti
context,
generates
procedure
error
mates
terms
in
if
the
both
the
firstand
equa
only
second-stage
are correctly
and both equations
tions are jointly normally
distributed
are
In a linear model
the conditions
less strin
specified.
considerably
in
to be
The
variables
the
have
gent.
first-stage equation
right-hand-side
con
with
but
uncorrelated
the error term in the second-stage
equation,
even if some variables
in
sistent estimates may be obtained
that belong
are
the first-stage
omitted.
the
well-known
Therefore,
equation
despite
it seemed worthwhile
to use
limitations
of the linear probability model,
on the tax price is more pre
it to check our estimates.
The coefficient
in the linear probability model
than in the probit model.
cisely estimated
error
The coefficient,
its
standard
exceeds
-0.0797,
by almost a factor of
the implied elasticity of the probability
three. However,
of survival with
at
to
tax
the
is
evaluated
the
zero,
means,
respect
price,
essentially
are
-0.012.
to
while
needed
with
deal
Hence,
strong
assumptions
in the probit model,
the basic qualitative
result holds when
endogeneity
the analysis
is done using the more robust linear probability model?tax
rates do not greatly affect survivorship
probabilities.
There are not many
results in the literature with which we can com
pare this finding. The most
directly
comparable
study is Bruce (1999),
whose
tax rates reduce
that higher
analysis of U.S. panel data indicated
the probability
and
of exiting self-employment.
Hubbard
(2000)
Gentry
a different
examined
and
type of transition,
entry into self-employment,
that the probability
tax rates are less
found
of entry increases when
The remaining
related studies we have found in effect ana
progressive.
the contemporaneous
to be
between
the propensity
relationship
or
at
and taxes,
either the aggregate
the individual
level.
self-employed
Parker
the
(1996), Blau (1987), and Fairlie and Meyer
(1999) examined
time-series
between
rates and
aggregate
relationship
self-employment
tax rates. Parker (with U.K. data) and Blau (with U.S. data) found that
lyze
142
Carroll, Holtz-Eakin,
Rider & Rosen
On the other hand, Fairlie
self-employment.28
higher tax rates encourage
and Meyer's
examination
of U.S. data over the course of the twentieth
no
indicated
Robson
and Wren
(1999) found a
century
relationship.
rates and marginal
tax
between
negative
relationship
self-employment
rates in a panel study of OECD countries
1980s.
the
(1982)
Long's
during
data indicated
that higher taxes are associ
analysis of U.S. cross-sectional
of being self-employed.
ated with a greater probability
None
of the above studies use tax-return data; hence,
it is of interest
our
to re-estimate
these earlier models
data.
Our
using
sample allows
a model
us to estimate
that is in the spirit of the studies
that focus on
to be self
the contemporaneous
between
the
propensity
relationship
we
tax
rates.
and
the links
employed
Specifically,
marginal
analyze
that an individual
the probability
is a sole proprietor
and his
between
or her tax price
a
in the 1985 cross section.
To begin, we
estimate
in which
the only right-hand-side
is the loga
variable
simple probit
tax price. The results are in column
rithm of the individual's
(3) of
with
set of
Table 4. In column
this model
the usual
(4) we augment
that the tax-price variable
covari?tes.
Note
from being negative
goes
in
to
in
and statistically
column
and significant
(3)
positive
significant
column
that
cross-sectional
between
relationships
are
tax
rates
to
sensitive
the
self-employment
probabilities
particu
in the equation.
lar co vari?tes
This problem
included
be com
may
if no correction
ismade
for the endogeneity
of the tax price, a
pounded
in a single cross section.
task that is likely to be quite difficult
(4). This
suggests
and
5. CONCLUSIONS
have
about the possible
Policymakers
inhibiting
long been concerned
is known
but not much
about the
effects of taxes on small businesses,
tax rates and business
In this paper, we
between
growth.
relationship
a sole
have focused on the empirical
between
proprietor's
relationship
income tax rate and the growth
of the receipts from his enter
personal
tax-return data for sole proprietors
from before and
prise. We examine
a sole
after the Tax Reform Act of 1986. We find that when
proprietor's
tax rate goes up, the rate of growth
of his enterprise
goes
marginal
down. The elasticity
of receipts with
respect to the tax price (one minus
tax rate) is about 0.84. This implies,
for example,
that a
the marginal
28 This
not
in our simple
included
is generally
rationalized
finding
by considerations
or
tax rates are associated
to tax evasion
returns
with
theoretical
model.
higher
Higher
a
our model
can generate
risk. As already noted,
offer "insurance"
against
entrepreneurial
tax rates and self-employment
without
between
correlation
probabilities
appealing
positive
to such factors.
Personal
Income Taxes and the Growth
of Small Firms
143
in the marginal
tax rate levied on a sole proprietor
from 50
to 33 percent would
lead to an increase in his receipts by about
percent
28 percent.
in organizational
Of course,
also operate
entrepreneurs
decrease
forms other
be worthwhile
enterprises
than sole proprietorships.
Our results
to explore whether
taxes discourage
as well.
that itwould
suggest
the growth of such
APPENDIX
our framework
formalizes
the effects of
for analyzing
appendix
on
the
and
taxation
survival
of entrepre
probabilities
personal
growth
we
on
in
main
neurial
taxes
As
the
focus
first
how
text,
enterprises.
affect the entrepreneur's
decisions
and
then
deduce
the
input
implica
tions for firm size.
to revisit the derivation
To fix ideas, it is useful
of the influence
of
as wage
earners because
taxation on individuals'
decisions
the underly
in this setting. Specifically,
assume
that
ing forces are easily elucidated
individuals
choose their labor supply e ("effort") to maximize
utility
This
U(c,e),
where
c is
consumption.
where
w
Choosing
determining
t is the
is the wage,
e to maximize
-
is
7)e + A,
(A.2)
tax rate, and A is non-labor
income.
the familiar necessary
condition
for
(A.l) yields
labor supply,
Uc + w(l
the net wage
due
changes
as
effort
well:
optimal
changes
When
de
-{Uc
dw{l
where
constraint
The budget
c = w{\
(A.l)
denote
subscripts
in which
of labor supply,
yields no firm prediction
to show
straightforward
t)
r)Ue
= 0.
(A.3)
to, say, a reduction
+ welIcc+Uee)
w2Ucc + 2wUce +
-=
?-^ 0,
in taxes,
then
the
(A.4)
14
This is the textbook model
partial derivatives.
the conflict of income and substitution
effects
effort will rise or fall. It is
regarding whether
that
244
Rider & Rosen
Carroll, Holtz-Eakin,
de
?--->0
dw(l
where
a =
**
-
w(l
+ ae)>0
l-a(ac
(A.5)
r)
ac
r)e/c,
=
and
-Uccc/Uc,
turn next to entrepreneurs.
on the entrepreneur
conditional
We
At
ae
=
Uecc/Ue.
the outset,
we
decisions
analyze
in business;
the possi
assume
later. We
that
always remaining
to wage
is introduced
bility of exiting
earning
is determined
output of the entrepreneurial
enterprise
by the production
function F{e,t), where we assume
that labor, (,, is the only
for simplicity
the output price to unity and defining
purchased
input.29 Normalizing
the tax price ?jl as one minus
the tax rate, the entrepreneur's
budget
constraint
is
c=
The
entrepreneur
pair of first-order
fi[F(e,?)
e and
chooses
conditions
I so as to maximize
Lic(/x)(F
Uc(^)Fe
] + A. (A.6)
w
w)
=
utility,
yielding
the
0,
(A.7)
+ Ue = 0.
(A.8)
To determine
in taxes, note that (A.7) implies
the impact of a reduction
=
so that the impact on
is tied to
dt/dfji
?(Fte/Fu)de/dii,
hiring decisions
own effort.
the impact on the entrepreneur's
to the latter, the
Turning
first-order
conditions
imply that
de _
dfi
-{Ufe
+
-ilUc(F2M
+
[FM)
?JiUJee +
wt](pLFeUcc +
ix2F2Ucc+
iy}
fjLFelIce+
ilF Uk + Ue'e
Not
if (A.5) is
However,
(A.9) is ambiguous.
expression
surprisingly,
the substitution
effect will dominate
the income effect and a
satisfied,
in taxes will raise e. When
is this likely to be the case? Intu
reduction
the
the
share
of
financed by business
greater
consumption
itively,
profit
will
the
be
the
of
the
(a),
greater
importance
marginal
utility of consump
to supply
tion to the decision
effort to the business.
the more
Also,
29We
readily
inputs.
focus
on
generalized
a
input for expositional
single purchased
to situations
in which
entrepreneurial
clarity
ventures
alone. Our
use
multiple
approach
purchased
is
Personal
Income Taxes and the Growth
145
of Small Firms
ceteris paribus, the
declines,
utility of consumption
rapidly the marginal
will
effort.
induce
less likely it is that additional
profits
the implications
To determine
for the effect of taxation on the receipts
of the enterprise,
recall that (because
the output price is unity) gross
=
are
R
It
that
follows
F(e,t).
receipts
given by
dR
/ -FeeFe
\ de
dpi
\
J dpi
Fu
that the effect of taxes on receipts depends
of (A.10) indicates
Inspection
on
of the produc
effort, but also upon the parameters
upon their effect
so is the effect
In any case, because
tion function.
de/d\x is ambiguous,
on receipts.
that entrepreneurs
We
arrived at equation
will
(A.10) by assuming
In fact, however,
there is always
the option
always remain in business.
we consider
to the wage-salary
sector. Hence,
the impact of
of exiting
as
taxes on survival as well. Let Ve denote
the maximal
utility achieved
an entrepreneur,
and Vo the corresponding
maximal
value as an em
in utility, and hence
Then the impact of taxes on the difference
ployee.
to remain an entrepreneur,
is
the incentive
d(Ve
V") -=
*)
Uc[F(e*,
-
wC*}
(A.ll)
U?(we+),
dpi
+
*
as an entre
and
indicate the optimal decisions
the superscripts
a
as
a
and
information
Without
earner,
wage
preneur
priori
respectively.
in each sector of the econ
the marginal
regarding
utility of consumption
as observed
in the main
text.
omy, the effect of taxes is ambiguous,
where
REFERENCES
Auten, Gerald, and lanette Wilson
(1999). "Sales of Capital Assets Reported on
Individual Income Tax Returns, 1985." SOI Bulletin, Spring: 113-136.
in the
of Self-Employment
Blau, David M. (1987). "A Time-Series Analysis
United States." Journal of Political Economy 95:445-467.
Bruce, Donald (1999). "Taxes and Small Business Failure: Evidence from the Self
Center
Employed."
of Tennessee.
versity
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