IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
The current crisis includes two components: high indebtedness and low growth. No easy solution is in sight, since policy-makers are currently facing a double bind, since they need extra cash from the taxpayers and also lighter taxation in order to encourage entrepreneurship, the key ingredient in economic growth.
This paper focuses on the second part of the problem by analyzing the mechanisms through which taxation has affected entrepreneurship during the past decade in the European context. In particular, the authors have examined the relation between taxation and nascent entrepreneurship, by distinguishing between the tax burden (the average tax rate faced by new firms) and the tax structure (progressivity).
Most of the literature confirms the common-sense intuition: that corporate tax rates have a negative effect on growth and that progressive taxation discourages entrepreneurship. Yet, there are ambiguities. For instance, it has been argued that a progressive tax structure might allow a reduction in the tax rate on the median company. If the latter effect prevails on the former, then progressive taxation can indeed have a positive effect on entrepreneurship (and growth). Put differently, the prospective entrepreneur might perceive a progressive taxation system as a mechanism that involve higher tax pressure when things go well (high profits), but a relatively mild tax treatment when profits are normal or low. In this case, progressive taxation works as an implicit insurance scheme, especially when the entrepreneur shows some degree of risk aversion.
This study aims at shedding light on these ambiguities by examining nascent entrepreneurship in a sample of 15 European countries. Prospective entrepreneurs are divided in two three categories, depending on their income before they become entrepreneurs. The empirical work presented by the authors shows that higher average and marginal tax rates do discourage entrepreneurship. Yet, the effect of tax progressivity depends on the income level of the prospective entrepreneur: Progressivity acts as an insurance scheme for low and average income earners and has a negative effect on high income earners. In other words, progressivity encourages entrepreneurship among low income earners and operates in the opposite direction for high income earners. These results do not change when tax rates are replaced by tax wedges, i.e. when the tax burden includes both income taxation and social security charges. In particular, for above-average income levels, a 1% decrease in progressivity would lead to a 0.4% increase in new firms.
One may conclude that the tax structure (progressivity) turns out to be a powerful way of selecting entrepreneurs. While low progressivity encourages those who aim at significant profits, high progressivity will be more likely to attract less ambitious individuals, or prospective entrepreneurs who believe that they can hide their profits more easily (tax avoidance or tax evasion). From a broader standpoint, it seems clear that if the response to the current crisis includes higher tax pressure and higher progressivity, growth and prospective successful entrepreneurs will be paying a significant price.