Tax Rates and the Growth of Small Businesses

The recent tax cut legislation which passed through Congress will slowly roll-back marginal tax rates over the next decade, provided that some future Congress doesn't reverse the process. One of the arguments often advanced for cutting marginal tax rates is that it would boost both work effort and entrepreneurial activity. In a new study titled "Personal Income Taxes and the Growth of Small Firms," economists Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey Rosen demonstrate that cutting marginal tax rates has a substantial positive impact on the growth rates for small businesses.

The study uses the Tax Reform Act of 1986 as an opportunity to detect behavioral changes triggered by the cutting of marginal tax rates. The authors examined thousands of tax returns filed by sole proprietors in 1985 and 1988 to develop "before" and "after" snapshots of small-business activity. They found that the cut in marginal tax rates did not greatly affect survivorship of new small businesses. However, after controlling for differences in survivorship rates across different types of entrepreneurs, they found 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. Specifically, 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 revenues) by about 28 percent.

The study has been published by the National Bureau of Economic Research and is available at http://papers.nber.org/papers/w7980.