How do personal income taxes affect entrepreneurial investment decisions?

In a recent study published in “International Tax and Public Finance” Davud Rostam-Afschar and three colleagues analyzed how personal income taxes influence the amount of capital that entrepreneurs invest in their own businesses. Their findings indicate that entrepreneurs do not diversify their portfolios and hold on average 40% of their wealth in their own business. When taxes are reduced, fewer households hold private equity in businesses. This results from the fact that these businesses are not worthwhile at lower rates. At the same time, lower taxes increase investments in productive businesses.

 

Innovation, economic growth, and job creation depend on the willingness of entrepreneurs to take risky investments. Taxes influence the decision in what assets entrepreneurial households invest their income and how much they invest in a certain type of asset. Assets could be owner-occupied housing, property rented out, financial assets (e.g. cash, stocks and bonds), life insurance, tangible assets (e.g. gold, jewelry, coins, or valuable collections) and private equity that entrepreneurs hold and invest in their business. We were interested in the impact of taxes on the investment behavior of entrepreneurs. More specifically, we investigated how income taxes affect the share of personal capital that entrepreneurs invest in their business.

 

 

Wealth in Germany is concentrated in entrepreneurial households

For our research we used Germany as an example. In Germany only 8% of the population hold capital directly invested in private companies. This group invests 40% of their wealth in their own business. Although entrepreneurial households are a minority, they hold a large share of aggregate wealth. They are much wealthier on average than other households: their average net worth is more than five times as large as that of non-entrepreneurs. Using German panel data that includes the value of an own business we estimated the tax effects on asset classes in entrepreneurial portfolios.

 

 

Tax effects go in opposite directions

In our research we focused on the effects of the marginal personal income tax rate on the personal capital allocation of entrepreneurs. We looked at the decisions of the entrepreneur concerning her assets and distinguished two types of margins: an extensive and an intensive margin. The extensive margin concerns whether the entrepreneur decides to hold an asset or not. The intensive margin refers to how much of this asset she holds.

Our estimates show that tax effects could have positive and negative signs at the extensive margin and intensive margin, respectively. Lower personal income tax rates decrease the probability of owning a business but increase the conditional share of personal capital that entrepreneurs invest in their own business. We explain this finding with partial sheltering of business income from taxation. Higher tax rates can make it worthwhile to own a business only for tax sheltering but at the same time make marginal investments less profitable in productive businesses. In the latter case, there is no sufficient incentive for entrepreneurs to invest more as the expected return is not large enough after taxes. Overall, whether and how much a household invests in their own business partially depends on the personal income tax rate.

 

 

Impact

Our theoretical model and empirical results offer novel insights for policymakers. Not only is wealth in Germany highly concentrated among entrepreneurs, but entrepreneurs also invest the largest share of their wealth in their business instead of diversifying it across asset classes. This may be profitable if the personal income tax rate increases the expected returns and is sufficiently high. Our analysis supports this, since lower taxes are found to drive out some businesses. At the same time, lower tax rates seem to increase investments in other businesses that are sufficiently productive. However, while temporary tax holidays or permanently lower tax rates may sort out the productive from the unproductive businesses, lower tax revenues may limit the ability of governments to provide services and redistribution.

 

Read the publication “The effects of income taxation on entrepreneurial investment: A puzzle?” by Frank M. Fossen, Ray Rees, Davud Rostam-Afschar and Viktor Steiner published in “International Tax and Public Finance”.

 

More Information

We quantify the effects of an individual’s marginal personal income tax rate on his or her portfolio choice, i. e. the shares of personal wealth invested in six asset classes, including own businesses. We extended the standard theoretical portfolio choice model by allowing for tax sheltering of private business income. For our empirical analysis we used data from the German Socio-Economic Panel (SOEP), an annual household survey that collected detailed data on the personal wealth composition in 2002, 2007 and 2012, and includes the market value of own businesses and the other most important asset types of private persons in Germany. We estimated simultaneous demand equations for the six asset classes, eliminated unobserved individual fixed effects, and we identified tax effects through changes in the tax code over time. We also controlled for selection into entrepreneurship by exploiting one of the most important reforms of occupational licensing affecting firm entry in Germany in 2004. This reform concerned up to one million businesses—somewhat less than 1/3 of all businesses in Germany.

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