Foundations and Trends® in Entrepreneurship > Vol 12 > Issue 1

Owner-Level Taxes and Business Activity

Magnus Henrekson, Research Institute of Industrial Economics, Stockholm, Sweden, magnus.henrekson@ifn.se Tino Sanandaji, Stockholm School of Economics, Sweden, tino.sanandaji@gmail.com
 
Suggested Citation
Magnus Henrekson and Tino Sanandaji (2016), "Owner-Level Taxes and Business Activity", Foundations and Trends® in Entrepreneurship: Vol. 12: No. 1, pp 1-94. http://dx.doi.org/10.1561/0300000060

Published: 17 Mar 2016
© 2016 M. Henrekson and T. Sanandaji
 
Subjects
Corporate governance,  Taxation,  New business financing,  Firm ownership,  Industrial organization
 
Keywords
L26 EntrepreneurshipH25 Business Taxes and Subsidies including sales and value-added (VAT)H32 Fiscal Policies and Behavior of Economic Agents: FirmH26 Tax Evasion
Business taxationCapital income taxationCorporate governanceEntrepreneurshipInstitutionsTax policy
 

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In this article:
Executive Summary
Introduction
I. Tax Effects on Incumbent Firms
1. Taxation of Mature Firms
2. Corporate Governance and Taxation
3. The Relevance of the Small Open Economy Model for Owner-Level Taxation
4. Tax Effects on Existing Firms — A Summary of the Different Views
II. The Effect of Taxes on Startups and Entrepreneurial Firms
5. Owner-Level Taxes and Entrepreneurship
6. Taxation of Stock Options and Innovative Entrepreneurship
7. The Effects of Different Taxes on Debt and Owners' Equity
8. Conclusions
Acknowledgements
References

Abstract

In some classes of models, taxes at the owner level are "neutral" and have no effect on firm activity. However, this tax neutrality is sensitive to assumptions and no longer holds in more complex models. We review recent research that incorporates greater complexity in studying the link between taxes and business activity — particularly entrepreneurship.

Dividend taxes on owners of large firms affect firm activity in models that include agency conflicts between owners and managers. Similarly, after incorporating entrepreneurs' occupational choice into the model, taxes are no longer neutral. By forsaking lucrative alternative careers, skilled entrepreneurs tend to have high opportunity costs, which make the choice of attempting to start a business of first order importance. Moreover, in models where it is assumed that capital flows across borders without cost, taxes on domestic business owners do not alter business activity because foreign capital seamlessly compensates for tax-induced declines in investments. This theoretical notion is contradicted by the strong "home bias" observed in business ownership, in particular for small firms and startups without easy access to international capital markets.

Recent empirical work has emphasized that taxes have heterogeneous effects on mature firms, entrepreneurial startups, and ownermanaged small firms. Lowering dividend taxes on firms with dispersed ownership has been shown to shift capital from mature firms into rapidly growing firms. Moreover, capital gains taxation tends to reduce the number of innovative startups and diminish venture capital activity, while high owner-level taxes encourage small business activity and nonentrepreneurial self-employment because such firms have more opportunities to avoid or evade taxes.

To obtain efficient incentives in entrepreneurial startups, contractual terms are required that ex ante guarantee that all providers of critical inputs, especially equity-constrained entrepreneurs, are entitled to a share of the resulting capital value of the firm. Unless properly designed, owner-level taxes prevent such ex ante contracting and thus lower the likelihood of eventual success.

DOI:10.1561/0300000060
ISBN: 978-1-68083-104-7
111 pp. $75.00
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ISBN: 978-1-68083-105-4
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Table of contents:
Executive Summary
Introduction
I. Tax Effects on Incumbent Firms
1. Taxation of Mature Firms
2. Corporate Governance and Taxation
3. The Relevance of the Small Open Economy Model for Owner-Level Taxation
4. Tax Effects on Existing Firms — A Summary of the Different Views
II. The Effect of Taxes on Startups and Entrepreneurial Firms
5. Owner-Level Taxes and Entrepreneurship
6. Taxation of Stock Options and Innovative Entrepreneurship
7. The Effects of Different Taxes on Debt and Owners' Equity
8. Conclusions
Acknowledgements
References

Owner-Level Taxes and Business Activity

Owner-Level Taxes and Business Activity examines advances in both theoretical and empirical research that paint a clearer picture of the effects of owner-level taxation on business activity. Commonly used macroeconomic models tend to find that taxes at the owner level are "neutral" and have little or no effect on firm activity. However, the conclusion that ownership taxation has no effect on firm behavior – and on entrepreneurship – is derived from models based on unrealistic simplifications. When complex and more realistic dimensions such as entrepreneurship and corporate governance are incorporated into these models, taxes can affect business activity through these channels. A key lesson from this monograph is that the models used in economics are necessarily simplified. Moreover, it is important for political decision makers to be conscious of these simplifications when the conclusions derived from economic models motivate or are used to justify tax policy decisions. Conclusions from overly simplified models – such as the model that concludes that dividend taxes do not influence firm behavior – may thus change when additional factors are considered.

 
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