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.