Marginal and average tax rates and the incentive for self-employment.

Summary

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A study was conducted to determine how the incentives for persons to consider self-employment, rather than paid employment, are affected by the marginal and average income tax rate. A model was devised in which a person optimally selects the supply of labor effort and the amount of tax to evade. Results showed a negative correlation between self-employment and the marginal tax rate but a positive relationship with the average rate, assuming that remuneration is more sensitive to effort but that the possibilities for evasion are greater in self-employment.

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Marginal and average tax rates and the incentive for self-employment.

1. Introduction

How do income taxes influence the incentives for individuals to engage in entrepreneurial activity? For the United Kingdom, the government view has been that high rates of income tax are inimical to enterprise, prompting a series of reductions in tax rates since the late 1970s. The U.K. government position is that "a more beneficial tax regime has been an important factor in stimulating enterprise" (Employment Department 1989, p. 16), and this approach has been mirrored in many other countries.

In fact, the economic literature provides only weak support for this rationale for tax cuts. Models involving linear income tax systems, such as those developed by Kanbur (1981) and Kihlstrom and Laffont (1983), find that changes in the income tax rate have an ambiguous effect on the number of entrepreneurs, whereas empirical evidence, such as that of Blau (1987) and Evans and Leighton (1989) in the United States and Parker (1996) and Robson (1998) in the United Kingdom, typically find a positive relationship between income tax and the self-employment rate as a measure of "entrepreneurship."(1) If anything, the evidence is that lower tax rates lead to a reduction in self-employment.

The explanation that is usually put forward to account for these findings is that higher tax rates lead individuals to take up self-employment to take advantage of the greater opportunities for tax avoidance and evasion that self-employment is presumed to afford relative to paid employment (i.e., wage earning). However, in the specification of the relationship between self-employment and income tax, no distinction is typically made between the marginal and the average tax rate. For example, Blau (1987) uses measures of the marginal tax rate in his study of the determinants of U.S. self-employment, and Evans and Leighton (1989) use the average tax rate. Although the prevailing view seems to be that such a distinction is largely irrelevant, there is a growing literature that suggests that changes in the marginal and average tax rates have differing and possibly opposing effects on economic activity, so that the difference in specification is in fact likely to be important.(2)

In this paper we explore the relationship between self-employment and changes in the marginal and average income tax rates. We pick up on the suggestion of Robson (1998) that these tax rates will have different effects on the incentive to be self-employed. A high marginal tax rate may discourage entrepreneurial activity by reducing the returns from effort and thereby provide a disincentive for self-employment. In contrast, a high average tax rate may encourage evasion and thereby provide an incentive for individuals to take up self-employment because the opportunities for evasion are usually considered much greater in this mode.

We develop a model in which individuals choose the level o...

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