By Ergete Ferede
and Charles Lammam
The Fraser Institute
Entrepreneurship remains a vital source of innovation, which helps grow economies and provide employment opportunities for British Columbians. Unfortunately, several recent studies have found fewer businesses are being started in B.C. (and Canada as a whole), pointing a long-term decline in rates of entrepreneurship.
This downward trend in entrepreneurship could have negative and widespread effects on B.C.’s economic well-being.
Given the current state of entrepreneurship, there’s a growing debate over how government policies affect entrepreneurship and what policies could help reverse the decline. A common focus of these debates is tax policy.
Do higher personal taxes hurt entrepreneurs? If so, how much do changing tax rates affect entrepreneurship? Since B.C. recently increased its top personal income tax rate from 14.7 per cent to 16.8 per cent, these are timely questions with real consequences for British Columbians.
A higher income tax rate can affect entrepreneurship in two ways.
On one hand, it can discourage entrepreneurship because entrepreneurial activity is inherently risky, and entrepreneurs pay significant taxes on all incomes (labour income, capital gains or dividends) when they’re successful.
However, the tax savings for entrepreneurs are quite limited when they incur losses. Higher taxes decrease the reward for entrepreneurs but do little to mitigate the risk, leaving them with plenty of risk and far less opportunity for reward.
On the other hand, with a higher income tax rate, entrepreneurs have more opportunities to reduce their tax burden through legal tax-planning techniques, and the potential tax-saving benefits increase with higher income tax rates. This suggests that higher income tax rates can actually encourage entrepreneurship, even if it’s not productive entrepreneurship.
So how do rising personal income tax rates impact entrepreneurship in practise?
A recent Fraser Institute study sought to answer this question. The study analyzed Canadian provincial data from 1984 to 2015, focusing on how the top personal income tax rate affects entrepreneurship while accounting for other factors that also influence entrepreneurship such as demographics, business taxes and the state of the economy. To measure entrepreneurship, the study uses the business entry rate, defined as the number of new businesses as a percentage of total businesses.
The findings are telling and clearly relevant for British Columbians. Increasing the top personal income tax rate is associated with lower rates of entrepreneurship. In B.C., for every one percentage point increase in the top personal income tax rate (holding all else constant), 315 fewer new businesses would enter the economy over the long term (in this context, approximately a four-year span).
However, the B.C. government in 2018 increased its top personal income tax rate by 2.1 percentage points. Based on the study’s findings, we estimate that 662 new businesses will not start up in the province due to the higher tax rate.
Over the past 30 years, an average of 25,305 new businesses started in B.C. each year. Because the federal government also increased its top income tax rate by four percentage points in 2016, British Columbians can expect the decline in entrepreneurship to be steeper. So relative to the average number of businesses created each year, increasing the top income tax rate by 2.1 percentage points will reduce the number of new businesses by 2.6 per cent.
The Canadian economy has experienced a decline in entrepreneurship for years. If B.C. wants to halt this decline and encourage entrepreneurship, reducing the top income tax rate would be a good place to start.
At the very least, if B.C. policy-makers don’t want to exacerbate the decline in entrepreneurship, they should refrain from further increases in the province’s top income tax rate.
Ergete Ferede is associate professor of economics at MacEwan University and Charles Lammam is director of fiscal studies at the Fraser Institute. The study, The Effects on Entrepreneurship of Increasing Provincial Top Personal Income Tax Rates in Canada, is available at www.fraserinstitute.org
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