Entrepreneurship and Taxes

Would allowing the Bush tax cuts to expire discourage entrepreneurial activity and, by extension, lower economic growth? Of all the policy questions being considered in Washington these days, this one may be the most important.

High taxes disproportionately affect small business owners. The Tax Policy Center reports that 8.4 percent of tax filers with business income – twice the proportion of filers without business income – are in the 28 percent tax bracket or higher.

Economic theory suggests that progressive income taxes discourage entrepreneurship. Glenn Hubbard of Columbia University argues that our tax code, which takes much of your money if you take risks and succeed, but does not share your losses if you take risks and fail, discourages people from taking chances. And, as many of you probably already know, working for yourself is risky.

In a paper written with William Gentry, Hubbard found that higher marginal personal income tax rates do, in fact, discourage people from working for themselves.

Other studies find similar results for a variety of different types of taxes. For instance, Christian Keuschnigg of the University of St. Gallen and Soren Bo Nielsen of Copenhagen Business School write that “even a small capital gains tax … diminishes incentives to provide entrepreneurial effort.”

Researchers from the World Bank showed that higher corporate taxes are associated with lower rates of new business entry across countries. (This finding is particularly bad news for the United States, which the Organization for Economic Development and Cooperation found had the second highest corporate tax rate of the 30 countries its researchers examined.) And several studies show that countries with higher marginal personal income tax rates have lower rates of self-employment.

Higher tax rates discourage economic growth and job creation by reducing business owners’ incentives to expand their businesses. Research papers by Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen indicate that higher taxes lead small business owners to reduce hiring and investment. Because small business accounts for half of private sector GDP and employment, the dampening effect of higher taxes on small business can be seen in the form of lower GDP growth and job creation.

In addition, businesses that have the potential to generate wealth and jobs through rapid growth often need external capital. Much of this money comes from informal investors – friends, family, and business angels. When taxes rise, these sources are less inclined to finance growth-oriented entrepreneurs and more likely to put their money in tax free bonds (because higher taxes reduce the gap in after-tax returns between the two investments).

Increasing taxes on the wealthiest entrepreneurs has the most adverse effect because small business performance is skewed. Few entrepreneurs are successful, but those that are tend to be very successful. For instance, tax filers with an adjusted gross income of less than $250,000 in 2008 accounted for only 21.2 percent of the filers of partnership and subchapter S tax returns, but 78.5 percent of the income from those filers. The skewed performance of business owners means that the job and wealth creating entrepreneurs, whose incentives we need to worry about most, are the in the highest tax brackets. Raise their taxes and they will be less willing to hire and invest, reducing economic growth.

The United States has an enormous budget deficit, which may require tax increases to close the gap. But we need to carefully consider the law of unintended consequences when raising taxes. Much evidence shows that higher taxes discourage entrepreneurial activity, including investment and hiring by small business owners. If we let the Bush tax cuts expire, we risk shutting off already weak small business hiring and investment. Is that possibility really worth the relatively small reduction to the deficit that we might derive from a tax increase?


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

17 Reactions
  1. I don’t agree with this argument at all. Wasn’t the election about trying to reduce our deficits? Isn’t it time that we stopped lying to ourselves claiming that we can tax-cut our way out of this situation? We’ve tried that for 10 years now and it isn’t working.

    There is a report issued by a bipartisan budget deficit committee that lists a number of strategies for trying to reduce the structural deficit. Extending the Bush tax cuts isn’t on the list because it isn’t part of the solution.

    We can have either more tax cuts or a lower deficit burden that we leave for our children. We cannot have both.

  2. Despite being right-of-center on economic issues, I am not sure that higher taxes discourages entpreneurial initiatives. If someone wants to start a business, he or she will do it regardless of tax rates. However I am sure that higher taxes makes it very hard for entrepreneurs to re-invest in their businesses. As pointed out above, it is simply a matter of nature of pass-through entities (S-corps, LLCs, sole proprietors, etc.).

    I also have recently wrote about Congress’ definition of rich (see http://nyreport.com/articles/77791/what_the_election_means_for_business_owners_entrepreneurs_2010). While in the article I refer to a NYC entrepreneur (where the cost of living and taxes are very high), the point is valid throughout the country. Fortunately based on what I read in the paper today, the tax rates for all are unlikely to go up for a year or two.

  3. If you reduce the incentives through higher taxes, of course you’re going to affect the rate which people start businesses or work for themselves. It goes back to the basic risk/reward balance associated with any decision. Higher taxes reduce the reward so if the risk isn’t also reduced the balance shifts and fewer people take the risk (in this case, starting a new business).

  4. Good article. There are a lot of reasons to not raise our taxes and small business development is certainly one of them. Many countries have now seen that lower taxes stifle growth and capital formation. In small business, taxes are simply a cost of doing business and someone has to pay for them.

    Some anti-business people would argue, like one of the comments from your post, that we need higher taxes to reduce the deficit. Sorry, the higher the tax rates, the less will be paid to our beloved governments. Most of us know this to be true. Only a good economy will bring down the deficit.

  5. With respect to taxes and the deficit, it is quite simple. The government needs to hunker down and spend less. We all cut back when the bubble burst and now government must do the same. It is highly inefficient and there is way too much pork. As Norm Brodsky has said, “when was the last time government did something right?”

  6. My gosh, where has the business knowledge in this country gone? It seems to have been wiped out with one swing of Hannity’s arm.

    It just doesn’t work the way this article says it will. Taxes provide incentives. When rates on successful business owners are high, they look to shelter money. The best way they can shelter money is to invest pre-tax dollars back into the business, thus lowering taxable profits. That’s how we not only survived the much higher rates we had in earlier decades, but actually thrived during those periods – at times as high as 91 percent.

    Lower tax rates are an incentive to do all sorts of things that aren’t great for the economy. They are an incentive to take money out of the business, and to chase get rich quick fads without all that hard work of actually starting a business. Look at what’s happened since the 1980s and the start of our 30 year experiment with low income tax rates. Cowboy capitalism, an expectation of wealth without the slow, conservative work of building a business, etc.

    Now, can someone walk me through exactly how higher taxes would be a disincentive to starting a business, which provides the owner with the ability to shelter greater amounts and determine his own takehome? Anyone? Didn’t think so.

    • Paul, let me offer this perspective as a small business owner adding to the economy: we have a finite amount of money to spend in our business. The more we spend on taxes, the less we have to spend on other things such as staff, services, technology purchases, and so on.

      My business is in a constant growth stage, so most of the revenues we generate get plowed back into the business or paid in taxes.

      If you want business owners like Robert and me to invest in the economy, leave us more money to invest and don’t take so much of it in taxes. And I guarantee you we’ll spread it around the economy.

      People can argue theory and philosophies all day long, but to me as a business owner it’s incredibly simple. It’s accounting. Money in, money out. There’s only so much of it. Let it be to pay other businesses that provide services/products (and which in turn hire employees), or let it be to pay for the human resources we need. But don’t take it in taxes, or we’ll have less of it to spend in the economy.

  7. Anita, I don’t want you to spend a lot on taxes. I do want you to spend on on staff, services… all those things you mentioned. Here’s where this argument goes beyond the stupid simplicity you’ll find on Fox News. The money you spend on those things are pre-tax dollars, right? Starting to see my point now?

    • Paul, I appreciate that, but they’re still dollars that have to be paid out. And at some point I’d like a little more left over for myself. No business owner is going to work 70-hour workweeks just to keep plowing money into a business forever and never taking out more than a small amount for groceries and an SEP for their old age — they need more than that to look forward to. They’d like to not have all the money go to the government to eventually get spread out to other people. There’s no incentive to work for everyone else forever.

      I’m not against social programs and contributing toward the general good (in moderation). I don’t begrudge paying taxes as a general matter, as long as it’s in moderation. But I do have a HUGE problem with the government wanting to dig too deeply into my pocket, because I surely don’t have the faith that our government officials deploy the money anywhere NEAR as wisely as I do.

    • Paul you are missing the point. I know, I am a tax CPA of over 40 years and fully aware of your argument. Where it falls short is this.

      If a business is growing, it has CASH FLOW problems because in many cases, they are taxed on income, not on CASH. So, growth increases Accounts Receivable, increases Accounts Payable, and payables want to be paid quicker then Receivables. In addition, purchase of inventory, fixed assets, buildings, etc require AFTER TAX outlays, not pre tax outlays and for many, inventory is their largest asset. So, taking taxes based on income, not cash, TAKES CASH away from companies to grow. I know, I see it thousands of times. I am on the Board of a few companies and every year, they have to forego additional growth and hiring because they have to distribute funds to the partners to pay the taxes, as much as 50%. And that is 50% NOT OF CASH, but what is deemed income. So, any company that is growing, and hiring, is experiencing severe cash flow and has to grow super slow and miss opportunities. Hence the reason for banks. And their loan abilities have been hampered by Barney Frank and the mortgage debacle whereby even rich people have to go thru the ringer on every single piece of credit, etc So, your argument does not hold water

  8. Anita, it’s a progressive tax rate so I’m not sure I understand your comment. If your company is struggling, then taxes are lower. The higher rates only apply when the company is more profitable.

    When the top tax rate was 91 percent, there was no shortage of people trying to start their own businesses. In fact, I’d argue proportionately more so than today. With taxes set as low as they are, why do the hard work as well as take on the risk of starting and running a business? There are so many other bubbles to chase, and actually catching one won’t have any huge tax consequences. So why not do that?

    Fortunately there are a few still who are looking for something more than bubbles to chase, like you and your husband. But make no mistake about it – this current 30-year experiment in low taxes is taking its toll on the entrepreneurial spirit of this country.

  9. Oh, and for the record, I think to survive as a nation we’ll have to cut back on the entitlement programs, too, as well as defense.

    But seeing as I’m not confident we’ll have the social will to 1) re-set taxes to what’s proven to be a more effective method at building the economy, 2) cutting entitlement benefits and 3) cutting defense, I’m also making preparations for the collapse of the dollar. I don’t expect to see it in my lifetime, but you never know. And the preparations I’m making will pass down to my kids.

  10. Why did they need to do ANY studies to determine that increasing tax rates would serve as a deterent for business growth? I can’t believe there was a time when income taxes on the rich were at 70% and even at 91% at one time. Where is the incentive to work for yourself when you pay that much? Good lord, when it becomes cost prohibitive to do business, why would ANYONE participate in it?

    Who is going to work for themselves and even attempt to star their own business when you can make more at a call center working for someone else.

    They should cut their spending. There’s a toilet for a park being built. The idiots opened a park and didn’t have a public bathroom available for people visiting the park, so they are building a bathroom that costs 2.3 million dollars. Why?! That’s an insane way to waste money. And this is just ONE instance, there are probably thousands of cases just like this that are a complete waste of money.