How tax policy shapes small business
at the Andrew Young School of Policy Studies

Does tax policy affect the investment decisions of small businesses? Can the tax system impede the creation and growth of small firms? Do some policies promote tax evasion by entrepreneurs and small businesses? Do others encourage self-employed individuals to save more for retirement?

Although entrepreneurial firms have long contributed to the nation’s economic activity, policy-makers have just begun to ask how taxes impact important investment and savings decisions made by small businesses. Interestingly, says Associate Professor of Economics Mark Rider (above), much of the existing body of research on tax policy and business has focused on larger firms.

As economic development officials look harder into the job growth created by entrepreneurial firms, they have begun to generate a great deal of interest in the related tax policy research of Rider and his coauthors. Their articles, recently published in leading economic journals and books, are receiving attention in the general press as well. (See R. Glenn Hubbard, “Let’s Talk Taxes,” The Wall Street Journal, September 8, 2004: A18.)

“Although the health and vitality of small businesses are a matter of substantial policy concern, there has been little systematic investigation of how tax policy may affect entrepreneurial behavior,” says Rider. “It is important to know exactly what these policy impacts are, and how they may support or deter entrepreneurial investment and growth.”

In their chapter, “Entrepreneurs, Income Taxes, and Investment,” (Does Atlas Shrug? The Economic Consequences of Taxing the Rich, Harvard University Press 2000) for example, authors Robert Carroll, Douglas Holtz-Eakin, Rider and Harvey Rosen examine how an entrepreneur’s tax situation may affect his or her investment behavior. They looked at tax return data for sole proprietors before and after the Tax Reform Act of 1986, which lowered marginal tax rates, and found that higher income tax rates discouraged entrepreneurs from making capital outlays. “When a sole proprietor’s marginal tax rate goes up, the probability that he or she buys capital assets goes down,” they write, noting that the magnitude of such responses is quite substantial.

Further analyzing this data, Rider and his co-authors then looked at how the drop in marginal rates after the 1986 act affected small business growth as measured by gross receipts in, “Personal Income Taxes and the Growth of Smaller Firms.” (Tax Policy and the Economy, 15 [2001]) They focused on the empirical relationship between a sole proprietor’s personal income tax rate and growth in receipts, and found that “individual income taxes exert a statistically and quantitatively significant influence on firm growth rates.” Their findings imply, they write, that a sole proprietor whose marginal tax rate decreased from 50 percent to 33 percent would see a 28 percent increase in his or her receipts.

In “Differential Taxation and Tax Evasion by Small Business,” (National Tax Journal, 51[4]) Rider and David Joulfaian examine the compliance patterns of small businesses that are taxed at different rates. The IRS estimates that some entrepreneurs, depending on the business, underreport income by as much as 60 percent. Rider and Joulfaian find that for the selfemployed, income below a certain threshold is subject to the self-employment tax (SECA), which raises their total tax liability. Based on the evidence, they conclude that this different tax treatment helps explain the disparity in voluntary income tax reporting by the self-employed.

Tax policy can influence retirement savings. In “The effect of tax-based savings incentives on the self-employed,” (Journal of Public Economics, 85 [2002]) Rider and co-author Laura Power find that taxes have a substantial effect on both the decision to contribute and the amount contributed to tax-deferred retirement savings plans. “The contributions of self-employed individuals to taxdeferred retirement plans are responsive to changes in their tax price,” they write.

Rider continues to look at the impact that tax policy has on small businesses, most recently in his research for the Jamaica tax reform project through the International Studies Program. “It is widely believed that entrepreneurship is an important source of economic growth and employment in the U.S. economy. Therefore, it is important to examine the effect of taxes on this sector of the economy,” he says.