High Income Taxes Inhibit the Growth of Small Firms

The greater the decrease in the sole proprietor's marginal tax rate between 1985 and 1988, the greater the increase in the size of his or her business.

It is a common belief among entrepreneurs and policymakers that the tax system is an obstacle to the establishment and growth of small businesses. To date, however, there has been little hard evidence to support this notion. In Personal Income Taxes and the Growth of Small Firms (NBER Working Paper No. 7980), authors Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen use tax return data surrounding the Tax Reform Act of 1986 to determine how reductions in marginal tax rates affect the growth of sole proprietors' firms. They find that income taxes exert a significant influence on firm growth rates. For example, cutting a sole proprietor's marginal tax rate from 50 percent to 33 percent would on average increase the size of his or her business (measured by receipts) by about 28 percent.

The authors base their conclusion on the analysis of thousands of income tax returns filed by sole proprietors in 1985 and in 1988. These years bracket the Tax Reform Act of 1986, which cut the top marginal tax rate from 50 percent to 33 percent. The Tax Reform, in effect, serves as a natural experiment that can be used to assess the impact of tax rate changes on entrepreneurial enterprises. The sole proprietors who are the objects of this study constitute an important component of entrepreneurial economic activity. In 1985, non-farm sole proprietors had gross receipts equal to approximately 20 percent of the $2,769.9 billion in domestic business income. The sample used in this study represents almost 90 percent of that total.

An important issue is that not all the businesses in 1985 survived until 1988. Indeed, failure rates of small businesses are notoriously high. The authors study the effect of taxes on exit rates from entrepreneurship, as well the growth rates of the firms that survive. Looking first at the impact of taxes on survivorship rates, they find that tax rates do not greatly affect survivorship probabilities.

However, even after controlling for differences in survivorship rates among different types of entrepreneurs, the authors find that the greater the decrease in the sole proprietor's marginal tax rate between 1985 and 1988, the greater the increase in the size of his or her business. Further, the size and character of the tax effects are not markedly correlated with the entrepreneur's personal profile or the industry in which the entrepreneur operates. In short, the growth-inhibiting effect of taxes on sole proprietorships is a general and pervasive phenomenon.

-- Matt Nesvisky