Tax Policy and Entrepreneurial Entry

Many models of tax-policy evaluation abstract from decisions about entrepreneurship, such as entry, saving, and investment. Given recent emphasis on the significance of business ownership in explaining aggregate wealth accumulation and its distribution (see e.g., Gentry and Hubbard, 1999; Vincenzo Quadrini, 1999), such omissions are likely to be significant. In addition, entrepreneurs’ decisions may account for much of the responsiveness of taxable income to changes in marginal tax rates. We focus on impacts of tax rates and, in particular, tax progressivity on the decision to become an “entrepreneur.” While recent research has examined effects of marginal tax rates on investment decisions of entrepreneurial households (Robert Carroll et al., 1997), analysis of effects of taxation on entry is less often pursued. While a proportional tax with a full loss offset will not affect the entry decision for a risk-neutral individual, a progressive schedule with imperfect loss offsets can discourage entry. We find substantial evidence for this effect on entrepreneurship using variation in tax schedules faced by households in the Panel Study on Income Dynamics (PSID) over the period from 1979 to 1992. While progressive taxation could in principle encourage entry via insurance for risk-averse entrepreneurs through the tax system or through offering greater incentive to avoid taxes on self-employment income, we find no evidence to support such channels. Our empirical results imply a significant increase in entrepreneurial entry when tax rates are less progressive; whether such encouragement is efficient (that is, stimulating the most talented entrepreneurs) is a topic for future research. I. Tax Policy and Entrepreneurial Selection