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July 01, 2004
Changing Tax Policy Could Spell Economic Disaster
William M. Gentry of Williams College and R. Glenn Hubbard of Columbia University have released a ground breaking study (this is a site that asks you to purchase the study--hopefully, you get the point from my summary) on the power of tax policy to effect entrepreneurial behavior.
Their study is based on over 50,000 observations. They found that progressive marginal tax rates (rates that increase at higher levels of income) reduce the likelihood that people will engage in entrepreneurial activity. While this makes common sense to many of us, this study provides compelling evidence on how changing our tax policy as proposed by Sen. Kerry could damage or even reverse our current expansion.
"We found robust results that progressive marginal tax rates discourage entry into self-employment and business ownership. Those effects are large: The Omnibus Budget Reconciliation Act of 1993, which raised the top marginal individual income tax rate, was estimated to have reduced the probability of entry into self-employment for upper middle income households by as much as 20 percent. Moreover, those estimated effects were robust to controlling for differences in family structure, spousal income, and measures of transitory income."
The implications of this study cannot be overstated. We face the possibility of a shift of policy at the national level that could result in higher marginal progressive tax rates. Sen. Kerry has made it clear he plans to raise the tax rates of what he calls "the rich". Many of them are entrepreneurs who pay personal taxes on their businesses due to their S-corp, LLC, or partnership status.
Why does tax policy have such an impact? Entrepreneurs who are considering expanding an existing business or starting another may think twice. Each expansion or new business carries risk. And if the rewards are reduced with each new initiative the entrepreneur undertakes, there comes a point when it just isn't worth the risk. So progressive marginal taxes create the most significant disincentives for the very entrepreneurs we want to encourage--those who have already succeeded with other ventures. When I was an entrepreneur in health care we started multiple ventures. We built off our previous success to go into new lines of business and new markets. But each success brought higher taxes and lower after tax returns for those of us taking the risk. We found ourselves thinking twice about deals that we normally would have eagerly pursued as the risk return ratio turned more and more against us.
This site and many others have shown how dependent this economy has become on entrepreneurial growth. Entrepreneurs are not just leading this recovery, they are transforming this economy. The changes being planned by the democrats could act like a cold, wet blanket on our economic future.
Thanks to Ben Cunningham who e-mailed this study to me.
Posted July 1, 2004 06:31 AM
Comments
Wow! That is a pretty eye-opening point of view on the tax brackets. I am confused about the increase in tax rates for the highest income bracket. I know the rate decreased by almost 3% this past year (03) from the prior year (02). I did one tax return this past spring where the couple made approximately $1,000,000 and there income tax was $300,000 less (3%) than their '02 return. At first glance, I was sure I had made a mistake; that is a huge difference.
On the other hand, I completely agree with the indirect relationsip between tax rates and entrepreneurs. Although a myth, I think most Americans associate entrepreneurship with an increase in income. If the governement is going to take more money from individuals, the risk to reward ratio diminishes.
However, I do not understand why you believe the increase in the progressive tax rate will have the biggest impact on successful entrepreneurs. It seems to me that the increase would "scare away" up and coming businesses more than it would effect established, successful owners who know the ins and outs of a individually owned company.
Either way, it is going to effect the direction of our economy. An economy that is beginning to head in the right direction definitely doesn't need to take a u-turn b/c of a tax so seemingly simple.
Posted by: Raven Teeples at July 7, 2004 01:22 PM
It has been no surprise to me that the study from Columbia University supports the current tax cut and warns against changes proposed by Senator SKerry. There are several examples in history that prove the point you made in your comments. We could even take a look at the present state of the economies of several very successful Western European states. Their citizens have a significantly higher tax burden than U.S. citizens. Their economies are strong but cannot match the U.S. Their recovery from economic crises is always much slower, and unemployment and inflation much higher. The key to America’s success is low taxes and little government regulations. It would be interesting to know why the media is so quiet about Columbia University’s study. In my opinion the general public is unaware of the string of negative impacts a withdrawal of the tax cut would create.
Posted by Ewa Wilk-Durakiewicz
Posted by: Ewa Durakiewicz at July 7, 2004 10:31 PM
at Belmont University in Nashville, Tennessee. He consults with a variety of businesses on start-up and growth related issues, and with larger corporations on re-establishing entrepreneurial cultures within their organizations. Dr. Cornwall's current research interests include entrepreneurial finance and entrepreneurial ethics. He has authored or co-authored four books.
