2016

Owner-Level Taxes and Business Activity

Reprint No. 2016:13

Author(s): Magnus Henrekson and Tino SanandajiYear: 2016 Title: Foundations and Trends in Entrepreneurship Volume (No.): 12 (1) Pages: 1–94
Online article (restrictions may apply)

Owner-Level Taxes and Business Activity Magnus Henrekson and Tino Sanandaji


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.


Reference:
Henrekson, Magnus and Tino Sanandaji (2016), "Owner-Level Taxes and Business Activity". Foundations and Trends in Entrepreneurship 12(1), 1–94.

Magnus Henrekson

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Interdisciplinary European Studies

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This book explores the complex and ever-changing relationship between the European Union and its member states. The recent surge in tension in this relationship has been prompted by the actions of some member state governments as they question fundamental EU values and principles and refuse to implement common decisions seemingly on the basis of narrowly defined national interests.

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