Growth rates of small firms substantially improved by lower taxes

Many entrepreneurs and policymakers believe that the tax system is an obstacle to the establishment and growth of small businesses. To date, however, there has been little hard evidence to support this notion.

However, a recent study provides evidence that income taxes do exert a significant influence on firm growth rates.

Researchers analysed thousands of income tax returns filed by sole proprietors in 1985 and in 1988 – before and after the Tax Reform Act of 1986, which cut the top marginal tax rate from 50 percent to 33 percent – to determine how reductions in marginal tax rates affect the growth of sole proprietors' firms.

Among their findings:

  • Cutting a sole proprietor's marginal tax rate from 50 percent to 33 percent on average increased the size of his or her business (measured by receipts) by about 28 percent.

  • The greater the decrease in the sole proprietor's marginal tax rate between 1985 and 1988, the greater the increase in the size of his or her business.

  • In 1985, non-farm sole proprietors had gross receipts equal to approximately 20 percent of the $2.8 trillion in domestic business income.

    Furthermore, they found that the size and character of the tax effects are not markedly correlated with the entrepreneur's personal profile or the industry in which the entrepreneur operates. In short, the growth-inhibiting effect of taxes on sole proprietorships is general and pervasive.

    Source: Matt Nesvisky, High Income Taxes Inhibit the Growth of Small Firms, NBER Digest, April 2001; based on Robert Carroll, Douglas Hotlz-Eakin, Mark Rider and Harvey Rosen, Personal Income Taxes and the Growth of Small Firms, NBER Working Paper No. 7980, October 2000, National Bureau of Economic Research.

    For Digest text
    For Working Paper
    For more on Income Tax Rates

    FMF Policy Bulletin\4 December 2001
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