Just cut top income-tax rate to spur B.C. entrepreneurship

Entrepreneurship remains a vital source of innovation, which helps grow economies and provides employment opportunities for British Columbians. Unfortunately, fewer businesses are starting in B.C. (and Canada as a whole), pointing to a long-term decline in rates of entrepreneurship. This down­ward trend could have negative and widespread effects on B.C.’s economic well-being.

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 tax rates affect entrepreneurship? Since B.C. has 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. First, 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 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.

Second, 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 rates can actually encourage entrepreneurship, even if it’s not productive entrepreneurship.

So, how do rising personal income-tax rates impact entrepreneurship in practice?

A recent Fraser Institute study sought to answer this question. It 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 used 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.

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 launch in B.C. due to the higher tax rate.

To put this in perspective, over the past 30 years an average of 25,305 new businesses started in B.C. each year. 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. Because the federal government also increased its top income-tax rate by four percentage points in 2016, British Columbians can expect an even steeper decline in entrepreneurship.

To spur entrepreneurship, reducing the top income-tax rate would be a good place to start. At the very least, if B.C. policymakers do not want to exacerbate the long-term decline in entrepreneurship, they should refrain from further increases in B.C.’s top income-tax rate.

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