Policy and Entrepreneurship

Dean Glenn Hubbard talks about why progressive tax rates tend to deter new entrepreneurs and how far governments should go to create a favorable environment for entrepreneurship.
June 15, 2005 | Case Study
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In your paper with Bill Gentry, you found that a progressive tax rate has a negative effect on entrepreneurial entry. Could you briefly summarize your findings?

A lot of times, when people think about the way tax policy affects behavior, they focus on whether taxes discourage work. So, if you have a high tax rate, you’re less likely to work hard. The problem is, it’s not always easy to find that in the data. Most people who are very talented work very hard whether the tax rate is high or low. Bill and I wanted to look at entrepreneurship because it struck us that entrepreneurship is about taking a lot of risk. And so if you have a tax code that says, “If you take a risk and you’re successful, we tax you at a high rate; if you take a risk and you fail, we don’t share that loss with you,” you’ve changed the bet, and that might discourage entrepreneurship.

We found, using data on a number of tax reforms in the 1970s, 1980s and 1990s, that indeed that was the case. When you had a more progressive tax code, you wound up discouraging people from entering entrepreneurship, holding constant other characteristics of the person — how much money they have, what industry they’re in, and so on.

How did you become interested in the impact of tax policy on entrepreneurship?

There had been a paper about 10 years ago by Marty Feldstein that was showing that tax reforms to lower marginal rates led to very large changes in taxable incomes. He looked at data on households. And I thought, “That’s odd, because most of what labor economists say is that the literal response in work effort is not so large with changes in tax, particularly for men. So why are there these big responses in the data?” After looking at the data with Bill, we found that a lot of this was people switching into higher-risk and higher-return investments — entrepreneurship.

Investment isn’t just buying machines; it’s human capital. So that led us to think about, Does the tax code affect whether you go into business? The answer is yes. Does it affect the rate of job turnover? If I’m thinking about changing jobs, suppose there’s an offer in the next building that pays more but is a little riskier, with less job security. My willingness to make those changes may again depend on the tax code because the tax code taxes the whole upside but doesn’t share the downside. And indeed we found that job turnover got reduced in periods when taxes were more progressive.

How did you go about testing your hypothesis?

We used data that are from the government’s Panel Study on Income Dynamics (PSID), which follows several thousand families over time, so that you have two kinds of variation in the data. One is the tax code changes. But because families have different situations, even within a single year, you have variations in tax rates. So you can literally do an experiment. If you change somebody’s situation, you change behavior, controlling for other things that might have an effect.

What are the directions for future research in that area?

A lot of the models that guide tax policy — that we teach economics students who then go on to policy staff jobs at the Fed or with the government — are based on worlds where people save up at some predetermined rate of interest, and that’s how capital gets accumulated, and so on. When you look at data, you see that people who are rich almost entirely are rich because of entrepreneurial risk taking, which says that these people are pursuing margins that are very different from what our standard models suggest. That’s important not just academically but from a policy perspective. Maybe changes in the tax code need to be looked at through the lens of what they would do to the behavior of these people, because they’re doing so much of the saving in the current period.

In your opinion, would a flat tax rate create the most conducive environment for entrepreneurship?

Well, it’s hard to say because when you make a big change in the tax code, you’re changing a whole lot of things at once. Looking at entrepreneurial entry, I could say that more people would enter if we had a flatter tax code. What we don’t know as economists is whether they’re the right people. Whether they become the most successful entrepreneurs, I think we don’t know. I’d like to see more work merging what people are working on in sociology with what people have done in economics to make sure we’re getting the most talented entrepreneurs. But in talking about this research with business groups, I’ve found a lot of support for that idea that a flatter tax schedule — which might have detriments for other reasons — would be good for entrepreneurship.

What about health care? Would universal health coverage encourage more entrepreneurial entry?

Well, it is certainly true that health care costs are a burden on job creation. I’d like to see the tax code tilt away from being biased only toward employer coverage and give the same breaks to individual coverage. So suppose you got the same tax break whether your employer paid for your health insurance or you did, you got the same subsidy; we’d see a lot more competition in insurance and health care, and we’d see lower health care costs. And yes, I think that would be good for the expansion of small businesses.

In a down economy, financing is scarce, but so are jobs. Can you talk about what happens to entrepreneurship in a recession?

It definitely goes down, because people do tend to husband their resources and stick to what they know. Up economies tend to encourage people to enter. The current expansion has been associated with quite a bit of entrepreneurial activity, probably for two reasons. First, the economy’s doing very well, and second, we have had changes in the tax code that have reduced the top marginal rates, which might encourage people to go out and start a business if they have good ideas.

The United States has a more entrepreneurial culture than a lot of other countries. But is there such a thing as too much entrepreneurship?

Well, there can be. I certainly wouldn’t want to see the government explicitly encouraging entrepreneurship, as opposed to not discouraging it. Those aren’t the same thing. I think a hallmark of the U.S. system is, first, culturally, that it’s OK to fail here. If you started with a reasonable idea, you can move on. People do that all the time. But another hallmark is the financial markets here. It’s easier to get risk capital, not just in early-stage ventures or true venture capital, but also going from midsize to larger companies, raising that kind of private equity. It’s so much easier here, for a number of reasons, than it is in other countries. And I think that has helped entrepreneurship really take off in the United States, and to the good of the country.

Entrepreneurship obviously plays a crucial role in economic development. Should policymakers be doing more to encourage entrepreneurship among lower-income segments of the population?

Well, here we need a classic economist’s yes and no. There are really important roles for policy. But generally if you look across countries, those roles have to do more with making sure there’s a rule of law, protection of investors — so the people who are supplying risk capital get rewarded — and later, markets that are flexible enough that people can go in and out of entrepreneurship or self-employment. When you’ve done that, I think that’s about the most the government can do.

Certainly, if you look at countries that have changed their regimes toward better investor protection, you’ve seen more entrepreneurship and you’ve higher incomes. And we know, looking at cross-country data, that high incomes are generally associated with higher incomes for previously low-income people, which is just an economist’s way of saying, “A rising tide lifts all boats,” as President Kennedy said many years ago. For the United States, I’m not sure that we’d want to have active encouragement, so much as that we’re not discouraging it. The government should be making opportunity available, but without pushing people to do it, because not everybody should do it.

Glenn Hubbard is dean of Columbia Business School and the Russell L. Carson Professor of Finance and Economics.

R. Glenn Hubbard

Professor Hubbard is a specialist in public finance, managerial information and incentive problems in corporate finance, and financial markets and institutions. He has written more than 90 articles and books on corporate finance, investment decisions, banking, energy economics and public policy, including two textbooks, and has co-authored Healthy, Wealthy, & Wise: Five Steps to a Better Health Care System. In a recent book...

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Read the Research

William Gentry, R. Glenn Hubbard

"'Success Taxes,' Entrepreneurial Entry, and Innovation"


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William Gentry, R. Glenn Hubbard

"The Effects of Progressive Taxation on Job Turnover"


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