The Impact of Tax Incentives on the Economic Activity of Entrepreneurs

Abstract

Based on existing evidence, we know little of how taxation of small businesses affect the economic activity of their owners. To shed new light on this topic, this paper studies the effect of two Finnish tax reforms in 1997 and 1998 on economic growth, employment and profit margins of small businesses. The reforms affected the income tax burden of business owners by changing the share of income taxed as capital income. The tax changes applied only to noncorporate firms, leaving corporations out. Therefore we are able to use difference-indifferences strategy to estimate a causal impact of tax incentives on economic activity of small businesses. The change in incentives grew with the size of the firm, enabling us to study heterogeneous treatment effects. The results imply that lighter taxation leads to a modest increase in turnover and profit margin of firms, but no significant increase in employment. Government institute for economic research (VATT)