Tax progressivity and self-employment: evidence from Canadian provinces

Abstract

We examine the effects of personal income tax progressivity—in the sense of rising marginal income tax rate—on self-employment. The impacts of income tax progressivity on self-employment depend on the relative effects of taxing success and the presence of tax evasion opportunities. Empirical estimates using Canadian provincial data for the period 1979–2006 indicate that there is a negative association between income tax progressivity and self-employment. This suggests that the adverse impact of income tax on entrepreneurial risk-taking outweighs the tax evasion opportunities for the self-employed. An important implication of our results is that a reduction in income tax progressivity encourages self-employment. The empirical estimates are robust to the various sensitivity checks.

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Fig. 1

Notes

  1. 1.

    The tax system may also encourage risk taking by entrepreneurs by treating income from self-employment more favourably than wage income.

  2. 2.

    Chen et al. (2002) and Schuetze and Bruce (2004) provide excellent surveys of the empirical literature on taxation and entrepreneurship.

  3. 3.

    The self-employed can also deduct personal consumption from business income (for example, business use of automobiles).

  4. 4.

    The details of the theoretical model are available upon request.

  5. 5.

    See Kamhi and Leung (2005) for a detailed analysis of self-employment and its various components in Canada.

  6. 6.

    Complete data set on the share of the agriculture sector in the own-account self-employment rate is not available.

  7. 7.

    Ideally we would prefer to use cluster-robust standard errors. However, due to the small number of clusters in our dataset (just ten provinces) cluster robust standard errors would be downward biased. See Wooldridge (2003) and the reference contained therein.

  8. 8.

    Given the average income tax rate, a one percentage point increase in the marginal income tax rate leads to a fall in the value of RIP by about 0.0035 (say from 0.8462 to 0.8427).

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Acknowledgments

Funding for this project was provided by Donner Canadian Foundation. I would like to thank Bev Dahlby for his comments on an earlier version of this paper.

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Correspondence to Ergete Ferede.

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Appendix

Appendix

See Appendix 1 Table 5.

Table 5 Definitions of variables and data sources

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Ferede, E. Tax progressivity and self-employment: evidence from Canadian provinces. Small Bus Econ 40, 141–153 (2013). https://doi.org/10.1007/s11187-011-9350-7

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Keywords

  • Self-employment
  • Tax progressivity
  • Occupational choice

JEL Classifications

  • H24
  • J23
  • J24
  • L26