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Taxes and Entrepreneurship: A Literature Review and Research Agenda
Taxes and Entrepreneurship: A Literature Review and Research Agenda
Donald Bruce
Douglas and Brenda Horne Professor of Business
Boyd Center for Business and Economic Research
and Department of Economics
University of Tennessee, Knoxville
722 Stokely Management Center, 916 Volunteer Blvd.
Knoxville, TN 37996, USA
Tami J. Gurley-Calvez
Associate Professor
Department of Health Policy and Management
University of Kansas Medical Center
Mail Stop 3044, 3901 Rainbow Blvd.
Kansas City, KS 66160, USA
Alex Norwood
Research Associate
Boyd Center for Business and Economic Research
University of Tennessee, Knoxville
712 Stokely Management Center, 916 Volunteer Blvd.
Knoxville, TN 37996, USA
This article may be used only for the purpose of research, teaching,
and/or private study. Commercial use or systematic downloading
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Boston — Delft
Contents
1 Introduction 395
Acknowledgements 434
References 435
Taxes and Entrepreneurship:
A Literature Review and Research
Agenda
Donald Bruce1 , Tami J. Gurley-Calvez2 and Alex Norwood3
1 Boyd Center for Business and Economic Research and Department of
Economics, University of Tennessee, Knoxville, TN 37996, USA;
dbruce@utk.edu
2 Department of Health Policy and Management, University of Kansas
ABSTRACT
The potential impacts of tax policies on entrepreneurial ac-
tivity have attracted the attention of researchers and policy
makers for several decades. Entrepreneurship and innova-
tion are critical elements of the macroeconomy and small
businesses contribute significantly to employment and eco-
nomic growth. Recognizing this, policy makers have a long
history of attempting to encourage small business activity
through a variety of attractive tax policies. The effectiveness
of these policies hinges critically on the extent to which
entrepreneurs actually respond to taxes. The theoretical
literature has recognized that taxing the returns to risky
activity can actually increase risk-taking, especially in the
presence of progressive marginal tax rates and loss offset
provisions (Domar and Musgrave, 1944). The empirical lit-
erature has been inconclusive, with some studies finding a
Donald Bruce, Tami J. Gurley-Calvez and Alex Norwood (2020), “Taxes and En-
trepreneurship: A Literature Review and Research Agenda”, Foundations and Trends®
in Entrepreneurship: Vol. 16, No. 5, pp 393–443. DOI: 10.1561/0300000079.
394
1
Holtz-Eakin (1995) provides a useful discussion of the possible arguments in
favor of targeted subsidies for small or innovative businesses.
395
396 Introduction
models of relative risk begin with the assumption that wage employ-
ment brings a certain income while small business or entrepreneurial
activity yields unknown income. An increase in the relative tax rate
on entrepreneurial income has two potentially offsetting effects. On
one hand, it reduces the relative return to (and thus discourages)
riskier entrepreneurial activity. On the other hand, the ability to use
entrepreneurial losses to offset other sources of income compresses the
post-tax distribution of entrepreneurial income and provides implicit
insurance against the risk. The extent to which one of these effects
outweighs the other depends on the worker’s preferences over risk and
return. Gordon and Sarada (2018) take the concept of loss offsets further
by showing that refundable loss offsets are the best way to support
entrepreneurial efforts with substantial risk.
Some theoretical studies have focused on the lack of third-party
reporting for income and/or expenses in entrepreneurial activities, which
provides greater opportunity for legal tax avoidance and/or illegal tax
evasion activity. Watson (1985) and Kesselman (1989) are two early
examples of this work, and both find ambiguous effects of tax rates on
small business activity.
Gurley (2005) combined these two broad areas of the theoretical
literature and produced unambiguous conclusions. In her model of
relative risk with opportunities for evasion, she showed that increasing
the relative marginal tax rate on wage income (by increasing the wage
tax rate and/or decreasing the entrepreneurial tax rate) increased one’s
likelihood of reporting entrepreneurial income on a tax return. The
interesting conclusion from her model is that the U.S. tax reforms of
the 1980s should have reduced entrepreneurial income as reported on
tax returns.
The empirical literature has been inconclusive, with some studies
finding a positive relationship between tax rates and small business
activity, others finding a negative relationship, and still others finding
no significant relationship at all. In this monograph, we review those
studies with the goal of identifying themes from their results and laying
out an agenda for future research.
We first discuss the many ways in which researchers have measured
entrepreneurship and small business activity. We explore the various
399
400
401
The basic fact remains that any possible tangible measure of en-
trepreneurship or entrepreneurial activity is necessarily imperfect. Re-
searchers can only hope to provide a proxy for the underlying concept.
Indeed, policies intended to encourage entrepreneurial or small business
activity are just as diverse as the set of available proxies, and those
policies are not necessarily focused on a singular goal of encouraging
innovation or informational spillovers. It is, therefore, counterproductive
to criticize any single measure as less than perfect, unless they are being
sold as something better or different than they are. The best strategy
is to move forward with the data at our disposal, and to ensure that
the chosen proxy is closely linked to the research and/or policy goals
at hand. Rather than hang our hats on a single “best” measure, we
can only hope to surround the empirical question with a multitude of
possible candidates.
Fortunately, researchers who are interested in understanding the
impacts of policy on entrepreneurship or small business activity have
many options from which to choose. In this section, we list several of
the more common options and briefly evaluate each one. Before we get
into the specifics of each measure, we first consider several front-end
questions that must be addressed when selecting one or more indicators
of entrepreneurial or small business activity.
One issue is whether the researcher is interested in the extensive or
intensive margin. The vast majority of the empirical studies reviewed
herein have considered extensive-margin indicators of the mere existence
of entrepreneurial or small business activity. Several more recent studies
have explored intensive-margin indicators of the scale or success of the
activity. One’s choice here is obviously dependent on the task at hand,
but our sense is that most of this literature is policy-driven and policy
makers are probably more concerned with the intensive margin. It is
probably better to have a smaller number of more successful enterprises
than a larger number of failures, especially when it comes to evaluating
the effects of pro-entrepreneurship policies.
Another issue is whether one is interested in stock or flow indicators.
While some studies intentionally focus on the counts of entrepreneurs or
small firms, others explore measures of net firm creation or destruction
402 Measuring Entrepreneurship
years, respectively. One major advantage is that the data are available
for sub-national geographies and for a long period of time, at least for
the U.S.
It is important to recognize that small firm establishment births
and deaths do not necessarily represent new firm formation or existing
firm failure. Business entities can move between size categories and
legal forms (e.g., from non-corporate proprietorships to corporations).
The IRS Statistics of Income Integrated Business Data is perhaps the
only large-scale data source that enables the examination of businesses
across all legal forms (sole proprietors, partnerships, and corporations
of varying forms).2 Examples of measures from this source include the
number of sole proprietorships or partnerships, either in levels or as a
percentage of all businesses. Bruce and Glenn (2016) also explore the
percentages of gross and net income across each of the major legal form
categories. It is important to recognize that small firms, those most
often associated with entrepreneurship in the literature, distribute rather
broadly across all legal forms, including corporations. Additionally, as
with most measures, many forms that attract larger numbers of smaller
firms include some that might not be widely viewed as entrepreneurial.
The empirical literature has recently turned towards the considera-
tion of several widely-available intensive-margin indicators. These in-
clude more continuous measures of the scale or success of entrepreneurial
activity. Examples include self-employment (or small business) income
and employment, and variants on both. These can be expressed simply
in dollar terms at the individual or aggregate levels, or as shares of
totals within a particular geography and/or point in time. For most of
the available extensive-margin indicators discussed above, there is at
least one intensive-margin indicator. As noted, the presence or level of
income or employment does not necessarily indicate success.
Several recent studies have explored intensive-margin indicators
from the Bureau of Economic Analysis’ National Income and Product
Accounts. One example is nonfarm proprietors’ income (pre-tax income
earned by sole proprietorships, partnerships, and other nonfarm and
2
For more details, see http://www.irs.gov/uac/SOI-Tax-Stats-Integrated-
Business-Data.
405
25% 100
90
20% 80
70
15% 60
50
10% 40
30
5% 20
10
0% 0
Figure 2.1: Self-employment rates, the share of individual tax returns with small
business income, and maximum marginal individual income tax rates, 1950–2018.
3
For more details, see the Bureau of Economic Analysis NIPA Handbook
(especially Chapter 11: Nonfarm Proprietors’ Income) at http://www.bea.gov/
methodologies/index.htm#national_meth.
406 Measuring Entrepreneurship
6000 65000
60000
5500
55000
5000
50000
4500
45000
4000
40000
3500
35000
3000 30000
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Number of Small Firm Number of Small Firms Small Firm Total
Establishments (1,000s) Employment (1,000s,
(1,000s) Right Axis)
U.S. federal individual income tax returns with income from a business
or profession, partnership, or small business corporation. The maximum
U.S. federal statutory marginal individual income tax rate is also pro-
vided. The divergence between the two entrepreneurship indicators is
apparent and interesting. While the self-employment rate has trended
downward along with the top marginal tax rate, the percentage of tax
returns with small business income has grown substantially.
It is clear from this figure that studies of the impacts of tax rates
on entrepreneurship or self-employment could easily yield contradictory
results depending on the selected outcome measure. We note that the
figure implies that lower tax rates reduce self-employment, consistent
with theoretical predictions that lower rates reduce the attractiveness
407
750
700
650
600
550
500
450
400
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Small Firm E stablishment E ntry Small Firm E stablishment E xit
(1,000s) (1,000s)
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
2010
2011
2012
2013
2014
2015
2016
Nonfarm Proprietors' E mployment Nonfarm Proprietors' Income as a
as a % of T otal Nonfarm % of Personal I ncome
E mployment
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
-10%
business income is large and rising over time. This figure illustrates
that non-corporate filers report a disproportionate share of taxable net
business income, which is likely a product of factors that might include
profitability, but might also reflect sophistication in applying long-term
financial planning and tax avoidance activities.
3
Measuring Tax Policy
412
413
can provide important benefits to new and existing small firms, yet only
a few studies have considered them.
At the subnational level, state and local governments are notorious
for providing a menu of tax relief in the forms of outright subsidies, tax
abatements, and a seemingly endless string of other tax and non-tax
incentive programs. These are often deliberately designed to have an
impact on the number and scale of small business enterprises, and should
be considered by researchers in this area. That being said, gathering
systematic data on the existence and use of these provisions has proven
to be very difficult.
While the vast majority of studies documented in this review have
focused on individual income taxes at the national level, a number
of them have explored a variety of other taxes and other levels of
government. We discuss each of the major tax areas here, focusing on
their potential impact on entrepreneurial activity. We return to a review
of the empirical findings on each tax below.
Long, 1982a,b; Robson and Wren, 1999). Marginal tax rate increases
can create additional behavioral responses on the intensive margin
among existing small businesses. Saez (2010) provided interesting recent
evidence that certain taxpayers were increasing reported small business
income in order to maximize Earned Income Tax Credits.
income tax or even the highest marginal tax rate, most probably hope
they will at some point in the future.
Other studies have explored the importance of other important
features of state-level corporate income tax systems, such as sales factor
weights in the formulas used to apportion multi-state firms’ taxable
income to the various states (Bruce and Deskins, 2012; Bruce et al.,
2019; Bruce et al., 2015). While most state-level corporate income taxes
initially used a traditional three-factor weight with equal weight on sales,
payroll, and property, recent years have seen a gradual shift toward
higher weights on sales and lower weights on the other two factors. This
is deliberately intended to shift the corporate tax burden away from
larger in-state firms onto out-of-state firms (Luna and Murray, 2010).
and Regan, 2015; Gurley-Calvez, 2011; Heim and Lurie, 2010, 2014),
estate, inheritance, and gift taxes (Burman et al., 2018; Cagetti and De
Nardi, 2009; Kreft and Sobel, 2005; Yakovlev and Davies, 2014), research
and development tax credits (Fazio et al., 2019), and business-related
regulations (Crum and Gohmann, 2016; Klapper et al., 2006).
4
Common Problems with Empirical Analysis of
Taxes and Small Business Activity
418
419
420
5.1. Studies Focusing on National Taxes 421
Schuetze and Bruce (2004) and Bruce and Gurley-Calvez (2008). For
convenience, we begin with studies that have focused primarily on
national-level tax policy before turning to a separate discussion of
sub-national tax policy and concluding with international studies.
430
431
these impacts are expected for reporting activity, real economic activity,
or both.
Another key area of consideration is whether changes in tax rates are
expected to impact extensive margin outcomes, such as the number of
entrepreneurs, share of entrepreneurs in total employment, or business
survival and/or intensive margins such as business growth, employment,
or capital investment. It is certainly possible that targeted tax cuts could
have larger impacts on the start-up or existence of a new small business
than on the success of that business (e.g., income or employment). The
latest research suggests that extensive-margin impacts are larger than
the more policy-relevant intensive-margin impacts.
Future research should also continue to make efforts to better identify
causal effects of tax policy on entrepreneurial activity. Ongoing changes
in national, state, and local tax policies can be used to construct
natural experiments, perhaps making use of regression discontinuity
and/or difference-in-differences approaches to identification. Analyses
of tax competition and other regional effects should also take advantage
of the tools of spatial econometrics. Empirical analysis should also
continue to build upon recent efforts to explore the importance of
tax code complexity and administrative burden on small businesses.
Indeed, a greater understanding of these important impacts could
be instrumental in understanding the diversity and evolution of the
empirical results from the literature described herein.
All of these suggestions hinge on continuing improvements in the
quality and availability of data for research purposes. We look forward
to continuing to follow this literature as new and better administrative
and survey data sources become available.
Acknowledgements
434
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