Entrepreneurship dips when income taxes rise

Recent increase hurting Alberta, say Ergete Ferede and Charles Lammam.

Entrepreneurship remains a vital source of innovation, which helps grow economies and provides employment opportunities for Albertans. Unfortunately, several recent studies have found fewer businesses are being started in Alberta (and Canada as a whole), pointing to a long-term decline in rates of entrepreneurship. This downward trend in entrepreneurship could have negative and widespread effects on Alberta’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 Alberta has recently increased its top personal income tax rate from 10 per cent to 15 per cent, these are timely questions.

A higher income tax rate can affect entrepreneurship in two ways. On the 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. Put differently, 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.

That said, how do rising personal income tax rates impact entrepreneurship in practice? A recent Fraser Institute study sought to answer this question. Specifically, 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 Albertans. Increasing the top personal income tax rate is associated with lower rates of entrepreneurship. In Alberta, for every one percentage point increase in the top personal income tax rate (holding all else constant), 275 fewer new businesses would enter the economy over the long-term (in this context, approximately a four-year span).

However, the Alberta government in 2016 increased its top personal income tax rate by five percentage points. Based on the study’s findings, we estimate that 1,374 new businesses will not start up in the province due to the higher tax rate.

To put this in perspective, over the past 30 years, an average of 22,778 new businesses started in Alberta each year. Relative to the average number of businesses created each year, increasing the top income tax rate by five percentage points will reduce the number of new businesses by six per cent. Because the federal government also increased its top income tax rate by four percentage points in 2016, Albertans can expect the decline in entrepreneurship to be steeper.

The Canadian economy has experienced a decline in entrepreneurship for years. If Alberta 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 Alberta policy-makers do not 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