Entrepreneurship, firm entry, and the taxation of corporate income: Evidence from Europe

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Abstract

Can tax policy foster the creation of new companies? To answer this question, we assemble a novel country-industry level panel database with data on entry (by incorporation) for 17 European countries between 1997 and 2004. Our analysis is based on recent models of how corporate taxation affects firm's incorporation decision. We compute effective average tax rates and study how the taxation of corporate income affects entry rates at the country-industry level. Drawing on the political economy literature, we account for the possible endogeneity of taxation. We find a significant negative effect of corporate income taxation on entry rates. The effect is concave and suggests that tax reductions affect entry rates only below a certain threshold tax level. Our results are robust to alternative measures of effective taxation and to the use of alternative and additional explanatory variables.

Introduction

The creation of new companies by entrepreneurs who seek to profit from exploiting business opportunities is a fundamental force for economic growth. This process, first identified by Schumpeter, 1975, Schumpeter, 1982 and formalized by Aghion and Howitt (1992), has been documented since Hause and du Rietz (1984).

Economic policies aimed at fostering the entry of new companies are high on many governments' agenda for their potential benefits for innovation, competition, employment, and growth (see Aghion and Howitt (2006)). Several recent studies have looked at this issue from a variety of angles, exploiting the increasing availability of firm-level data to assess the impact of different economic policies on entry and economic activity.1 This literature focuses on the effects of labor, credit, and product market regulations on entry and on the characteristics of entrants and incumbents.

We fill a clear gap in this literature by looking at a policy instrument that has received surprisingly little attention so far: corporate income taxation. Taxation is a flexible policy instrument; it is easier to change tax rates in the budget law than to embark in a structural reform of labor or product markets, both in terms of legislative approval and of bureaucratic implementation. Moreover, tax reductions can provide substantial monetary benefits that may have a material effect on entrepreneurial decisions.

Our study is motivated by the theoretical model of Cullen and Gordon (2007), who suggest that corporate income taxation affects the incorporation decision through three potentially countervailing channels, whose net outcome is not a priori clear, neither in terms of size nor in terms of functional form. Theoretical models that account for strategic and general equilibrium effects also suggest that the taxation of corporate income should deter entry. We then build our effective corporate income tax measures using the methodology of Devereux and Griffith, 1998a, Devereux and Griffith, 1998b. We study the effect of corporate taxation on entry rates in a panel data setting, exploiting the longitudinal variation in the data and controlling for other time-varying institutional and regulatory factors. Our approach allows to overcome the well-known weaknesses of purely cross-sectional studies, thus providing a more solid foundation to our conclusions.

An important and novel contribution of this paper is that we consider that taxation is unlikely to be an exogenous policy instrument, but that it rather reacts to current (or past) business conditions. We account for this source of endogeneity by using several instrumental variables borrowed by the political economy literature (see Pagano and Volpin (2005)). While some recent studies include taxation as a determinant of the incorporation decision (see Barrios et al., 2008, Djankov et al., 2010, Klapper et al., 2006), to the best of our knowledge our study is the first to take into account the endogeneity of tax policy in this context. Moreover, we consider that the entry decision is likely to be influenced not only by taxation but also by other policy measures. For this purpose, we include in the analysis a summary measure of other economic policies which are likely to influence the creation of new businesses, and we consider that this, too, is potentially endogenous.

Our empirical investigation therefore advances in several dimension the recent strand of purely cross-country studies that study the effect of policy measures and country characteristics on the incorporation decision and on the characteristics of entrants (see Ciccone and Papaioannou, 2007, Demirgüç-Kunt et al., 2006, Desai et al., 2003; Djankov et al., 2002, Klapper et al., 2006, Perotti and Volpin, 2007). In particular, a concurrent study by Djankov et al. (2010) analyzes a cross-section of 85 countries. They use survey-based information to build the tax burden of a ‘standard’ company with similar characteristics across all countries (the company produces and sells flower pots). This approach allows a direct comparison of the tax burden across countries using the ‘effective’ tax rate which applies to the chosen ‘standard’ company. However, it also limits the generality of the results, since the behavior of the ‘standard’ company may not be representative of a country's businesses. They find that the average entry rate over the years 2000 to 2005 is negatively affected by an increase in the 2004 corporate tax rate. Measured at the mean, a 10 percentage point decrease in the effective corporate tax rate is associated with an increase in the entry rate of 1.4 percentage points, compared to an average entry rate of 8 percent.

We develop our analysis assembling a novel firm-level panel dataset which covers 17 West European countries in the period between 1997 and 2004. The dataset is derived from the Amadeus database published by Bureau van Dijk, which contains data on over 9 million European companies and has already been studied by Klapper et al. (2006) in the context of entry regulation. These data allow us to measure in a precise and consistent way, the entry of incorporated firms and to build measures at the country-industry-year level, thus bringing the analysis to a more disaggregate level than most previous studies.

Europe offers a particularly interesting testing ground, both for the quality of these data and for the fact that relatively similar economies have experienced a diversity of tax and other economic policies over the last decade. Several European countries reduced statutory tax rates during the last decade, while at the same time also changing the effective tax base, creating a variety of situations which we exploit econometrically.

We measure the effective average corporate tax rate using detailed yearly information for each country from Ernst & Young, a major multinational tax consultancy. Building on Devereux and Griffith (1998a), we account for the effects of corporate taxation at the local level, for alternative capital structures of entering firms, for personal taxation, and also for alternative measures of the tax burden, thus measuring taxation in a more precise way than previous studies.

What do the data tell about the effect of corporate taxation on entry? There is strong evidence that corporate taxation has an effect on entry rates that is statistically significant and economically relevant. This evidence is consistently robust across a variety of specifications. Two results stand out. One is the non-linear effect of taxation on entry: a tax reduction affects entry only below a given threshold level. The effect is economically non-negligible. In our preferred specification, a reduction of the corporate tax rate from the median (30.08%) to the first quartile (27.57%) implies a 0.880 percentage point increase in the entry rate. We interpret this result on the basis of Cullen and Gordon (2007). They identify two distinct channels through which lower corporate taxation should increase entry by incorporation (through “income-shifting” from personal to corporate taxation, and through “risk subsidy” to entrepreneurial activity), and one channel that has the opposite effect (through “risk-sharing” with the government). In Section 2 we argue that there are good reasons for the first two channels to have a stronger effect at lower levels of taxation, and for the “risk-sharing” to prevail at higher levels. A second intriguing result is that a reduction of the effective corporate tax rate is more effective in countries with a good institutional infrastructure, which we measure with the quality of accounting standards since these determine the extent to which profits can be hidden from taxation. On the whole, these findings point to the importance of corporate taxation for the creation of new successful businesses, and suggest the inclusion of tax policy measures in future research.

The rest of the paper is organized as follows. Section 2 provides a conceptual framework. Section 3 describes the data. Section 4 computes the entry rates. Section 5 computes effective tax rates. Section 6 presents our results and is followed by a brief conclusion.

Section snippets

Theoretical framework

We start by providing a simple theoretical framework to motivate our analysis and help interpret our results. The framework is based on some well known contributions to the literature that fit well our empirical framework. We focus on two issues. First, we want to identify the channels through which the taxation of corporate income is likely to affect the entry decision, so as to guide our empirical modelling. Second, we want to put our results in context and consider how entry might affect

Entry data

Our first data source is the Amadeus database published by Bureau van Dijk Electronic Publishing. The database is updated monthly and our analysis is based on each year's December issue, from 2000 to 2007. Amadeus collects company accounts from 38 European countries, covering financial information, industry activity codes, legal form, legal status, ownership, and date of incorporation. In principle, all non-financial companies required to file accounts should enter the database. The coverage

Computing entry rates

We build our sample of companies with the goal of obtaining a homogeneous, comparable set of firms across countries, across industries, and over time. Table A1 in Appendix A describes the steps we follow in selecting the firms that we include in the dataset. Our approach closely follows the strategy of Klapper et al. (2006).

First, we include 17 Western European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Norway Portugal,

Computing effective marginal tax rates

Obtaining a meaningful measure of actual corporate income taxation is not a trivial task. The statutory tax rate is not a satisfactory measure because taxation depends also on the tax base, i.e. taxable corporate income.

An alternative measure is given by the average tax rate, computed as the ratio of tax payments to taxable income. However, such ‘implicit’ tax rates are backward-looking as they reflect the effect of taxation on past corporate profits and investment decisions.

A third approach is

Descriptive evidence

We start our analysis by describing our data. Table 1 provides the definitions and sources of all variables. Table 2 reports descriptive statistics for the whole sample. Table 3 reports descriptive statistics by country for entry rates and for our two main independent variables. In addition, Fig. 1, Fig. 2, Fig. 3 describe the evolution over time of the main variables of interest.11

Conclusion

In this paper we pose ourselves a research question which is also relevant from a policy perspective: whether, and to what extent, lowering corporate income taxation can foster entrepreneurship by inducing the entry (by incorporation) of new companies. To answer this question, based on recent theoretical models of how taxation may affect entry, we have exploited a newly constructed dataset which allows us to improve significantly on the existing literature. In particular, the availability of

Acknowledgements

We thank Thorsten Beck, William Gentry, José Mata, Giovanna Nicodano, Elias Papaioannou, Javier Suarez and participants to a seminar at the Tilburg Centre for Law and Economics (TILEC), to the Second RICAFE2 Conference (Riga, October 2007), to the 4th IGIERCSEF Symposium on Economics and Institutions (Anacapri, June 2008), and to the Conference on “The role of firms in tax systems” (Ann Arbor, April 2009) for useful comments. Theo Jurrius provided able research assistance. We also thank Patrick

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