Demographics and Entrepreneurship blog series: Tax policy and entrepreneurship
As part of the blog series summarizing the Fraser Institute’s Demographics and Entrepreneurship essays, this post examines the effect of taxation on entrepreneurship.
One avenue through which taxation affects entrepreneurship is through its effects on capital accumulation. At least since John Stuart Mill’s 1848 Principles of Political Economy, economists have recognized that a tax on all income results in the double taxation of returns to savings.
By contrast, a tax on consumption is neutral with respect to savings versus consumption decisions.
While the capitalist and the entrepreneur may be distinct individuals, access to capital is essential for entrepreneurship to flourish. Thus, to the extent countries tax savings more heavily than consumption, they reduce the supply of capital available to entrepreneurs. When taxes on investment returns are very high, the negative consequences, compounded over time, can be dramatic. This is exemplified in a stylized counterfactual focusing on the growth of the Ford Motor Company during the first half of the 20th century.
In that example, an 80 per cent effective tax on the returns to savings, compounded over 40 years, reduces Ford’s capital stock by 99.997 per cent compared to a no-tax scenario.
Through a second avenue, taxes also foster harmful entrepreneurial activity. That is, taxes alter the allocation of entrepreneurial activity between productive and unproductive channels. This notion of entrepreneurship was developed by Baumol (1990).
Baumol’s “central hypothesis… is that it is the set of rules and not the supply of entrepreneurs or the nature of their objectives that undergoes significant changes from one period to another.” High taxes discourage productive entrepreneurship by reducing after-tax returns. At the same time, high tax rates make it profitable for tax accountants, lawyers and financial planners to devise elaborate and ingenious methods for avoiding taxes.
With respect to corporate taxation, some of the world’s richest U.S. firms have paid effective tax rates that are just tiny fraction of U.S. statutory rates. One innovation employed by Apple and many other companies is the “Double Irish with a Dutch sandwich.” The technique involves a U.S. headquartered firm setting up an Irish subsidiary, which is headquartered in a tax haven, plus subsidiaries in Ireland and the Netherlands. The U.S. firm’s intellectual property licences are then distributed, and royalty rates set, across the subsidiaries to minimize tax liability.
A third avenue through which taxes affect entrepreneurship involves their treatment of risk. The tax treatment of risk affects incentives for entrepreneurship, since entrepreneurship tends to entail high risk. When risk is substantial, the manner in which tax rates change with income affects incentives for entrepreneurship. A progressive tax schedule is where tax rates increase with income. For a given expected income, greater progressivity results in higher expected (ex ante) tax burdens the higher the standard deviation of earnings.
However, risk aversion implies that, for a given expected tax burden, greater progressivity encourages risk-taking. Holding the expected return constant, a risk-averse individual prefers a certain outcome to an uncertain one. Risk aversion is consistent with diminishing marginal utility of income, where a dollar gained is valued less than a dollar lost. Thus, progressivity acts as insurance against bad outcomes.
Greater progressivity implies lower tax burdens when income is low and thus the marginal utility of income high; and, tax burdens are heavier when income is high and the marginal utility of income low.
Note: greater progressivity encourages risk-taking when holding expected tax burdens constant. This is likely not the case when progressivity entails increasing expected tax burdens. In practice, progressivity does sometimes discourage entrepreneurship because tax systems generally do not afford full offsets for losses, making progressivity effectively a tax increase. Furthermore, entrepreneurs may overestimate their likelihood of success, which implies they will pay more attention to the high tax rates associated with successful endeavours.
My chapter in the essay series cautions against high tax rates on investment. High taxes, and high top tax rates, discourage entrepreneurial activity that, if successful, could have huge returns for both the entrepreneur and society at large.
High taxes produce disincentive effects by lowering after-tax returns, and over time, such taxes retard the accumulation of capital necessary for entrepreneurship to flourish. High tax rates are further problematic in that they encourage unproductive entrepreneurship. That is, high tax rates make it profitable to shift away from socially-productive investments and towards devising schemes to circumvent taxes.
Aside from tax rates, unproductive entrepreneurship is abated in tax systems resistant to both finagling by taxpayers and tinkering by legislators in response to lobbying or political donations.
Finally, the tax system can encourage risk-taking with symmetrical treatment of gains and losses. Here, progressive tax rate schedules can actually increase risk-taking, as long as the increased progressivity is not increasing expected tax burdens.