More taxes, less innovation

Entrepreneurs need passion, but they also respond to incentives.

Entrepreneurs, when asked, generally deny that taxation had any influence on their decision to start a business. The passion to create and to run a company, as they see it, was the only factor in their choice. And yet, taxation has an undeniable effect on an entrepreneur’s income.

Does the heart have reasons which overrule economic reasoning? The answer to this question has many implications for public policy.

One of the challenges economists face is to resist the tendency to want to withdraw a whole range of phenomena from economic analysis and entrust these to psychology, or worse, to magical thinking. In the same way, many try to divorce entrepreneurship from any fiscal questions.

According to them, entrepreneurship is basically a passion, and entrepreneurs start businesses out of love. The problem with these arguments is that they are not really arguments; they are rather ways of ending the discussion before it has really begun.

Another way of refusing to debate the influence of taxation on entrepreneurs is to claim that they must do their part to finance the numerous missions of the government. Yet the problem is precisely that when there are fewer entrepreneurs, there is less economic growth and less prosperity with which to finance those missions.

Even those whose main concern is to maximize government resources, come what may, have an interest in not asphyxiating entrepreneurs with disproportionate taxes.

More taxes, less entrepreneurship

While everyone seems to understand that taxes on certain categories of goods reduce their consumption, a certain romanticism that persists with regard to entrepreneurship keeps many people, including political decision-makers, from applying this reasoning to business creation. Yet the evidence is overwhelming, and a recent research paper published by the MEI provides an overview of this evidence.

Whether as a result of direct taxation, which reduces the gain of entrepreneurs and the incentive to start a business, or indirectly, through the reduction of the savings needed for start-up capital, it is clear that there is less entrepreneurship when taxes are higher.

For example, a study looking at 85 countries found that a 10% increase in the corporate tax rate reduces the number of businesses per 100 people by 1.9. Taxes also reduce the resources available to start a business: One study found that a 1% increase in the capital gains tax reduced the supply of funding by 3.8%.

If we add up all of the observations on the effects of the tax burden on entrepreneurs, as well as those regarding financial assistance from government—which does not create more companies, but entails numerous adverse effects—one conclusion stands out: It would be better to replace government assistance to entrepreneurs (direct subsidies, credits, loans, etc.) with reductions in the taxes that all businesses pay.

This means, of course, when they start a business, but also well beforehand, when entrepreneurs are still accumulating capital with a view to starting a business. Indeed, an entrepreneur’s own personal savings constitute the most important source of initial funding for Canadian businesses: Less taxes mean more savings, and therefore more business creation.

Moreover, the adoption of such measures can sometimes leads to higher tax receipts. At any rate, it is not the case that tax receipts will necessarily shrink.

This was confirmed in Canada in recent history: Revenues from the federal corporate income tax remained relatively stable between 2001 and 2012, while the corporate tax rate was nearly cut in half. Economic activity therefore clearly increased during this period.

It’s time, in Canada and elsewhere, to rethink the approach that various governments have adopted over the years when it comes to entrepreneurship. It is possible to be much more effective simply by intervening less, without it costing any more. Such a proposal should, on its face, be easy to implement.

Mathieu Bédard is Economist at the Montreal Economic Institute. The views reflected in this op-ed are his own.

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