Working Paper Correlates Reductions in Personal Tax Rates And Lower Entrepreneurial Activity

Do personal income tax cuts encourage entrepreneurship? Conventional wisdom and many politicians may suggest that if people have more cash on hand, they may be inclined to launch or start their own businesses. A working paper released earlier this month by the National Bureau of Economic Research (NBER) concludes just the opposite: lowering personal tax rates in most cases appears to discourage entrepreneurial activity.

Because entrepreneurship generates many benefits and spillovers to society, this sort of activity is greatly desired in regional economic development policy. In Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S., Julie Berry Cullen and Roger H. Gordon of the University of Michigan and University of California at San Diego, respectively, explore the effect changes to tax law have on the growth and/or decline of entrepreneurial activity. The economists specifically consider changes to progressive personal income tax schedules and the risks and advantages of incorporating.

Since personal tax rates generally are higher than corporate tax rates in the U.S., Cullen and Gordon state there is more incentive for an entrepreneur to incorporate to have profits be taxed at the lower corporate rates. Therefore, this option effectively subsidizes risk-taking: the larger the difference exists between personal and corporate tax rates, the larger the subsidy for risk taking, thereby increasing entrepreneurial activity.

Through their model and empirical evidence on business starts, the economists conclude cuts to progressive personal tax schedules result in a decline in the taxes saved from deducting business losses while profits remain taxed by corporate tax rates.

The study finds that a reduction of 5 percent in the corporate tax rate correlates with a doubling of entrepreneurial activity. On the other hand, if personal income tax rates were reduced across the board by 5 percent, a 30 percent decrease in entrepreneurial activity follows.

When applied to the tax reforms of 2001, Cullen and Gordon's model predicts a 20 percent decrease in entrepreneurial activity will occur once the reforms are fully enacted. The authors explain this is because the tax reforms cut the personal tax rates while leaving the corporate tax rate unaffected.

The economists also found that a universal or flat personal income tax rate of 20 percent correlates with a 15 percent increase in entrepreneurial activity through the model.

The working paper is available for purchase from NBER at: http://papers.nber.org/papers/W9015