Taxes and Entrepreneurial Activity : Theory and Evidence for the U.S

Current literature suggests that informationspillovers, particularly those resulting from entrepreneurial activity,generate economic growth.In light of these productive spillovers, it isreasonable to subsidize entrepreneurial activity through the taxsystem. There are several hypotheses surrounding the degree to which the tax systemactually affects the amount of entrepreneurial activity.First,individuals may be persuaded to undertake risky projects by the fact that smallbusiness owners can much more easily underreport their taxable income than canwage workers.Second, high tax rates make risky projects relatively moreattractive by providing an alternative means of risk sharing that is free fromadverse selection problems.Finally, if the marginal tax rate under thepersonal income tax is an increasing function of taxable income, thenentrepreneurs may owe substantial taxes on any profits. These hypotheses are examined in light of cross-section samples of personalincome tax returns from the U.S. Statistics of Income (1964-1993).Thedata indicate that, contrary to conventional wisdom, cuts in personal tax ratesactually reduce entrepreneurial activity.Tax cuts also imply lessrisk-sharing with the government, making self-employment less attractive towould-be entrepreneurs.Overall, tax policy and macroeconomic policiesplay key roles in generating entrepreneurial activity.For example, ashift to a 20 percent flat tax would triple the self-employmentrate.(SAA)