EVENTS

Date:	Tuesday, September 17, 2002
Time:	10:15 AM -- 12:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

September 2002
Do Taxes Affect Entrepreneurial Activity?

At a tax policy seminar on September 17, Roger Gordon, professor of economics at the University of California, San Diego, demonstrated how features of the personal and corporate income tax codes affect the incentives to assume the risks of initiating a business venture. Gordon provided significant evidence that income taxes and business cycle factors have had a large impact on entrepreneurial behavior in the United States. Kevin Hassett of AEI, moderated and Eric M. Engen of AEI, and Len Burman of the Urban Institute and Georgetown University, commented on Gordon's findings.

Roger Gordon
University of California, San Diego

For the purpose of this paper, my fellow economist Julie Berry Cullen and I are examining the entrepreneurial activity that consists of risky projects in new business ventures and start-up firms. Since entrepreneurial activity is important to economic growth, tax subsidies are appropriate. But how do taxes affect the amount of entrepreneurial activity? Is entrepreneurial behavior responsive to taxes? These are questions that have been explored by many economists and are further addressed in this paper.

We used approximately two million individual tax returns filed between 1964 and 1993 to determine the impact of tax incentives. This period is notable for the number of major tax reforms enacted, which gives the data diversity and strength. Three empirical models detailed in the paper show that taxes, in particular, personal income taxes, payroll taxes, and corporate taxes can negatively affect entrepreneurship.

Contrary to conventional wisdom, cutting the personal tax rate actually decreases entrepreneurial activity. Such a tax cut reduces the taxes saved from deducting business losses, while profits remain largely at the corporate tax rate. While on the one hand economists have proven that a progressive rate schedule discourages risk-taking, on the other hand, taxes share the risk associated with entrepreneurial activity. Since a lower personal tax rate implies less risk sharing with government, a cut in personal tax rate decreases entrepreneurial activity.

The models also show that entrepreneurial activity is encouraged when business income is taxed at a lower rate than wages and is discouraged when profits push entrepreneurs into higher tax brackets. Another finding is that, a shift to a 20 percent flat tax would increase entrepreneurial activity threefold.

This evidence shows that tax policy and macroeconomic policy are key factors for generating entrepreneurial activity. To increase entrepreneurial activity, the government must share losses to a greater extent. The fact that entrepreneurship is an important source of innovative ideas and economic growth makes this is an important issue for tax policy discussions.

Len Burman
Urban Institute

This paper is very ambitious and presents a sophisticated model. Gordon and Cullen answer the question of how taxes affect one's decision to be an entrepreneur. Clearly, potential investors or founders of start-ups are good illustrations of their theory. Yet, there are limitations to their data set. In the future, the authors should explore the impact of age of the individual and more closely analyze investment opportunities of single versus married people. Single people are less risk averse, which may affect their entrepreneurial decision-making. Overall, the paper and model make a great contribution to economics.

Eric M. Engen
AEI

For many decades members of Congress have believed that taxes do not affect entrepreneurial behavior and that people begin new business ventures for the "love" of the trade or with "animal spirits." As cited in the proceedings of National Tax Association's 1969 annual conference, Daniel Holland predicted that people do not consider taxes when deciding on the amount and type of investment. This paper puts that theory to rest. His basic results are very robust. Gordon and Cullen do a great job in showing how tax rates affect how much to work, changes in entrepreneurial activity, and departures from more "traditional" jobs. While there are many possible additions, an examination of the change in the personal income tax rate would be the best way to extend their conclusions.

AEI staff assistant Sean Gupta prepared this summary.