Abstract
This paper employs the dynamic panel estimation method to investigate the effects of the top personal income tax rate on entrepreneurship as proxied by the employer business entry rate using data from Canadian provinces over the period 1984–2015. The empirical findings of this paper show that the top income tax rate has a negative and statistically significant effect on entrepreneurship both in the short and long term. According to the preferred estimate of this study, a one percentage point increase in the top statutory marginal income tax rate is associated with a 0.13 percentage point decrease in the business entry rate in the short term and a 0.41 percentage point decrease in the long term. Based on the long-term results, on average, a province that raises its top personal income tax rate by one percentage point can expect to have about 405 fewer new employer businesses enter its economy. This is a significant loss for an economy that has been experiencing a decline in entrepreneurship for a long time. The key findings of this paper are robust to various sensitivity checks.
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Notes
As discussed in Poterba (1989) and Gentry (2010), sometimes the benefit of business start-ups is captured primarily in capital gains when the start-up goes public or is sold. Entrepreneurs take a lot of risk expecting success and higher capital gains. Thus, capital gains tax can be considered as a tax on successful entrepreneurs and it may discourage business start-ups. In Canada, during the period under investigation, part of an individual’s net capital gains is included as income in the personal income tax system. Thus, there is not much distinction between capital gains tax and personal income taxes.
For example, in Canada, as in many countries around the world, self-employment income is subject to the personal income tax after the self-employed deduct all their business expenses. Some argue that such arrangement provides entrepreneurs a greater opportunity for tax planning and avoidance.
Some business losses can be carried forward to offset future income, and this can partly compensate for some of the risks that entrepreneurs face.
The Statistics Canada dataset covers all businesses (in all sectors) which employ workers. In Canada, all employer businesses are required by law to remit to the Canadian Revenue Agency (the tax authorities) on the payments they made to their employees and income tax deducted from them. Thus, all firms that hire workers (regardless of their size and sector) and issue employment records (also called T4 slips) are included in the database. A firm is considered “new” when the business issues T4 slips in the current year for the first time. That is, a new firm is the one that did not file T4 slips to the government in the previous year.
During the period under investigation, the federal top marginal income tax rate was 34% (between 1984 and 1987) and 29% (between 1988 and 2015). Currently, the federal statutory top marginal income tax rate is 33%, a rate that has been in place since 2016.
In Canada, all provincial governments apply their respective income tax rates on comparable personal income tax base as defined by the federal government.
See Industry Canada (2015).
For the province of Quebec, Parti Quebecois is categorized as an NDP government.
The ten Canadian provinces listed in ascending order based on current population are Prince Edward Island (PEI), Newfoundland & Labrador (NFL), New Brunswick (NB), Nova Scotia (NS), Saskatchewan (SK), Manitoba (MB), Alberta (AB), British Columbia (BC), Quebec (QB), and Ontario (ON).
During the period under investigation, detailed information on the share of employer businesses in total businesses is not readily available for Canada. Statistics Canada began compiling such data only beginning from 2015. In 2015 (the last year of our sample period), employer firms account for about 32.5% of all business establishments in Canada.
This is commonly termed as own-account self-employment, and Ferede (2013) uses own account self-employment rate as the main dependent variable.
There is a lot of variation in the NDP dummy across time and provinces. During the period under investigation, the NDP held power in Nova Scotia (for 5 years), Quebec (for 12 years), Ontario (for 5 years), Manitoba (for 21 years), Saskatchewan (for 16 years), Alberta (for 1 year), and British Columbia (for 10 years). In the other three provinces (Newfoundland & Labrador, New Brunswick, and Prince Edward Island—which are the three smallest Canadian provinces both in terms of population and economic sizes), NDP was not in power during the sample period.
According to the numerical estimate, a one-percentage point increase in the top personal income tax rate is associated with a 0.409 percentage point decline in the employer business entry rate. The mean value of the number of total active businesses during the period under investigation is 99,110. Thus, a 0.409 percentage point reduction in the business entry rate is translated as a reduction in the number of new business by 405 (i.e., 0.00409X99110).
One may wonder whether the tax-induced reduction in the number of businesses is efficiency enhancing and beneficial. However, the issue of the optimal number of businesses in the provincial economies is beyond the scope of this paper. Our analysis focuses on the issue of employment creation and higher economic activities associated with the rise in the number of businesses.
We experiment by using the gap between the top marginal personal income tax rate and the small business corporate income tax rate as an explanatory variable instead of the two variables separately. The results do not change much. The coefficient of this new variable is − 0.137, and it is statistically significant at the 5% level.
One may be puzzled with this result given the uniqueness of Quebec in the federation. However, a closer look at the empirical results reveals that this is not entirely unexpected. The reason is that the inclusion of provincial dummies captures time-invariant provincial characteristics. The year dummies also absorb important events that are common to all provinces.
During the sample period under investigation, province-specific policy changes that may affect business entry could occur over time. For example, changes in the federal grants to the provinces, the ability to write off inputs, and changes in tax pass through resulting from the harmonized sales tax (HST). In the empirical literature, a common approach to deal with such changes is by including province-specific time trends. Our main empirical finding is robust to the inclusion of province-specific time trends. The empirical results with province-specific time trends are available upon request.
Differenced-GMM estimation method also provides similar results.
We also obtain similar results when we use one period-lagged (rather than contemporaneous) values of the explanatory variables as in Da Rin et al. (2011).
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Ferede, E. Entrepreneurship and personal income tax: evidence from Canadian provinces. Small Bus Econ 56, 1765–1781 (2021). https://doi.org/10.1007/s11187-019-00226-w
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DOI: https://doi.org/10.1007/s11187-019-00226-w