The Effects of Taxes on Entrepreneurial Activity A Presentation to the President’s Advisory Panel on Federal Tax Reform Donald Bruce March 8, 2005

Donald Bruce  March 8, 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, 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

Donald Bruce  March 8, The Number of Schedule C Filers is Growing (2005 Entries are Estimates)

Donald Bruce  March 8, 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?

Donald Bruce  March 8, 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

Donald Bruce  March 8, 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

Donald Bruce  March 8, 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.

Donald Bruce  March 8, 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

Donald Bruce  March 8, 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

Donald Bruce  March 8, 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

Donald Bruce  March 8, Appendix A: Further Reading Bruce, Donald “Taxes and Entrepreneurial Endurance: Evidence from the Self-Employed.” National Tax Journal 55(1): Bruce, Donald “Effects of the United States Tax System on Transitions Into Self-Employment.” Labour Economics 7(5): Bruce, Donald and Douglas Holtz-Eakin “Who Are the Entrepreneurs? Evidence from Taxpayer Data.” Journal of Entrepreneurial Finance and Business Ventures 1(1): Carroll, Robert, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen “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 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): Cullen, Julie Berry, and Roger H. Gordon “Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S.” NBER Working Paper No Gentry, William M. and R. Glenn Hubbard “Tax Policy and Entrepreneurial Entry.” American Economic Review 90(May): Schuetze, Herbert J. and Donald Bruce. Forthcoming. “Tax Policy and Entrepreneurship.” Swedish Economic Policy Review, 11(2).

Donald Bruce  March 8, 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 –University of Michigan Tax Panel, –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