The Effects of Taxation on Entreprenuership

This post by James Manzi about Obamanomics being bad news for innovation made the blogosphere rounds this week. While it got some people excited, specifically the "tax cuts solve all problems" crowd that I have previously addressed, the argument has some gaping holes in logic. It begins by citing Edmund Phelps as follows:

For an academic macroeconomist, Nobel laureate Edmund Phelps can sound shockingly in touch with the real world. In a recent interview, he described the possible implications of the large government-spending programs in President Obama’s stimulus package: “There’s . . . a chance that the perceived increase in the role of government of this sort will have some unanticipated effects on the animal spirits of entrepreneurs.”

Now, Phelps' statement clearly isn't definitive, and certainly doesn't mention taxes in any way. In some blogging jujitsu, Manzi uses the credibility of Phelps, who clearly wasn't making the same point, to support a diatribe about the Obama tax plans:

In fact, not only the stimulus package itself, but the higher taxes that it will require—both tax increases explicitly proposed in the president’s budget and the expectation of large future tax increases because we’re paying for all this spending with the national credit card—are likely to reduce the number of entrepreneurs in America.

What evidence does he supply for making such a dramatic leap? Just an abstract thought study, using an engineer who has an idea to start a business. His point being, the deciding factor for an entrepreneur taking the leap to start a business is a calculation based on the success rate of businesses and the expected payoff:

But consider the prospective entrepreneur’s incentives as they exist the moment before she makes the leap. She multiplies her potential payout by the odds of success. Tax increases influence this calculation directly by reducing the size of the payout. The capital-gains tax that hits her when she sells her company is just the first thing for her to consider. Second and more important are increasing tax rates on dividends, interest income, and (again) capital gains—since she will invest the proceeds she gets from selling her company in a portfolio of stocks, bonds, and so forth, and rising taxes will reduce the present value of the after-tax consumption that the portfolio will generate in perpetuity.

As an engineer, who has considered starting a couple different businesses, I will say this just isn't true. While the stakeholders providing the funding for a venture almost assuredly would factor in expected payoff, an entrepreneur is thinking very differently. First, they absolutely will not think 'their idea' has only a 20% chance of success, it's the "it can't happen to me" syndrome, although they will be aware that failure is a possibility. Second, how their life will change immediately after making the leap to being self-employed and what happens to them in the event of failure, is a much much larger consideration.

In other words, the ability of the entrepreneur to provide for the day to day needs of his household, and the ability to recover if the venture fails. Can they meet their household's monthly cash flow requirements? Will they have to forgo health care coverage? Can they afford college for their kids? How quickly can they find a job if the venture fails? These are examples of what an entrepreneur is thinking about immediately before they make the leap. The differences between an upper income bracket tax rate of 35% and 39% (or slightly higher) and how that would effect the entrepreneur in the event of success, probably isn't even in the way back of their mind.

However, don't take my word for it. Let's take a look at what the data tells us. The below graphs are from the US Census Bureau:

Disclaimer: This data does not include non-employers, which can be found here. It also only looks at the net increase in number of businesses, not the number started in any given year.

The census data only goes to 2006, so we can only compare the first 6 years of each presidency. After 6 years, Clinton and Bush had presided over a net increase of roughly the same amount of businesses (375K to 369K respectively). Clinton's final two years, coinciding with the height of the tech boom, included a huge jump to a final net increase in businesses of 557k under his presidency. Keep in mind the top tax rate under Clinton was exactly the same that Obama is proposing it return to.

Clearly, the data doesn't support Manzi's argument that a return to a 39% tax rate will negatively affect entrepreneurship and innovation. In fact, by addressing health care and college affordability as well as energy and infrastructure, the safety net Obama is creating for entrepreneurs could lead to an increase in new business starts. At the least, there isn't going to be some grand implosion of innovation due to a 4% increase in taxes as Manzi suggests.