Entrepreneurship and a Pro-Growth Tax Code

September 23, 2014

Research in the field of economic development has widely recognized that entrepreneurship and new firm formation play an important role in promoting job creation and economic growth. According to a report released by Kauffman Foundation in 2011, nearly all net job creation in the United States occurred in firms less than five years old during the period of 1980-2005.

Using more recently available data from the Census Bureau Business Dynamics Statistics and Longitudinal Business Database which providing information on firm births, deaths, and employment size, it is confirmed that startups contribute significantly to both gross and net job creation.

While firms that are over 10 years old and have more than 500 hundred workers account for around 45 percent of all jobs in the private sector, they account for just under 40 percent of job creation and destruction. In huge contrast, business startups account for only 3 percent of total employment but almost 20 percent of gross job creation.

What Role Do Taxes Play in Entrepreneurial Activity?

Entrepreneurship involves risk taking. Before they decide which risk to take, entrepreneurs consider the tax cost between marginal tax rates for wage earnings, capital gains, and corporate income. The potential after tax return on their investment in time or money guides their decision. Is an entrepreneur going to keep his or her current wage job? Or invest in financial markets? Or start a business?

The current tax code influences this decision due to its non-neutral treatment of saving and investment. A pro-growth tax code eliminates any distortion of business decisions.

Complexity Deters Business Creation

The complexity of the tax code and the administrative burden of tax compliance deters entrepreneurs from engaging in innovative activities. Empirical research by Swedish scholars found that tax complexity has a negative effect on new firm formation across 118 countries.

In today’s world, international entrepreneurs have the opportunity to compare tax codes and rules across different countries and select the country with the more beneficial and friendly tax system to maximize their after-tax profits. If the United States—with a tax code ranked 32nd out of 34 OECD countries—hopes to compete for entrepreneurship, it will need to takes steps to simplify and reform its tax code.

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