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 Ontarians. Unfortunately, several recent studies have found fewer businesses are being started in Ontario (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 Ontario’s economic well-being.
Given the current state of entrepreneurship, there’s a growing debate over how government policies affect it 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 Ontario has recently increased its top personal income tax rate from 17.4 percent to 20.5 percent, these are timely questions with real consequences for Ontarians.
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 are 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 influencing factors , 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 Ontarians. Increasing the top personal income tax rate is associated with lower rates of entrepreneurship. In Ontario, for every one percentage point increase in the top personal income tax rate (holding all else constant), 696 fewer new businesses would enter the economy over the long-term (in this context, approximately a four-year span).
However, the Ontario government in 2013 increased its top personal income tax rate by 3.1 percentage points. Based on the study’s findings, we estimate that 2,158 new businesses will not startup in the province due to the higher tax rate.
Over the past 30 years, an average of 50,638 new businesses started in Ontario each year. Relative to the average number of businesses created each year, increasing the top income tax rate by 3.1 percentage points will reduce the number of new businesses by 4.3 percent. Because the federal government also increased its top income tax rate by four percentage points in 2016, Ontarians can expect the decline in entrepreneurship to be steeper.
The Canadian economy has experienced a decline in entrepreneurship for years. If Ontario 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 Ontario 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.