Thursday, July 30, 2009

A Criticism of the Taxpayer's Alliance's "Tax and Entepreneurship"

Since getting in to politics I've spent a fair bit of time reading policy reports of various sorts, some are long winded and tedious, some are quite insightful and offer up good ideas. The most recent one I've read though is the Taxpayers Alliance report "Tax and Entepreneurship" and I have to say that it's a work of utter drivel.

So, let's start with the main findings of the report on how the tax system affects entepreneurship:
  • It may reduce the amount of capital they can access from their own wealth or their family. In particular, existing research suggests that receiving an inheritance leads to higher levels of self-employment. Inheritance Tax, in particular, may reduce the extent that entrepreneurs can obtain finance without the risks that come with a bank loan.[their highlighting]

  • The tax system undermines the large rewards that justify the risks attached to starting a new business. Indeed, further to this they state that under the present system suffer a marginal tax rate of around 90%, introducing the 50% tax could increase this to 92% and even using Entepreneurs Relief they still face a marginal rate of 86%.
Harsh stuff, but let's examine these two ideas a little more closely.

Inheritance as a source of capital
The argument here is that starting a business requires some form of initial investement and that the lack of this initial investment is a hurdle to many intent on starting a business. There is a lot of literature to back this up including the one quoted by the report, "What makes an entepreneur?" by David Blanchflower and Andrew Oswald. Inheritance here is viewed as a way of providing this initial capital without the risk attached to a bank loan, inheritance tax reduces this and thus reduces the amount of starting capital.

There's a few obvious observations here, the first is that the effect of inheritance on self employment is still not especially substantial, for example, Table 3 on the Blanchflower & Oswald paper (page 34 on the PDF) shows that in 1981 a 23 year old male who had recieved no gift or inheritance but lived in the South East would have a 16.3% probability of being self employed, an individual in Scotland who had inherited £5,000 would only have an 11.7% probability of being self employed. Table 4 (page 36) shows that for older individuals (age 33) an inheritance makes only a small difference. The general conclusions from the paper seem to be that while inheritance does increase the likelihood of self employment, it is far from being a major factor. A second point here is that inheritance tax only affects a small number of estates (around 7% I think), very few new entepreneurs are likely to benefit from such a tax cut. In addition, for the a majority of entepreneurs, an investment of this kind of magnitude is often not necessary. Table 3 in Blanchflower & Oswald emphasises that relatively small inheritances (£5,000 in 1981(£) which is between £13,400 and £27,300 in todays money according to measuring worth).

The obvious conclusion here is that while an inheritance is likely to be a positive influence in terms of encouraging self employment, it tends to only have a small effect. In addition the kind of inheritances needed to encourage self employment are not especially large. The case for inheritance tax as a barrier to entepreneurship in this instance is not made.

Marginal Taxes
As far as the numbers go here, I can give you a short version or a long version.

The short version: The numbers in the report are completely meaningless.

The long version: The calculations in the report appear to have been taken from this blog post by Greg Mankiw (a Harvard Economics Professor). He devised a formula that went along the lines of:

(1-t1)( (1+r(1-t2)(1-t3))^T )(1-t4)

Explanation t1 is income tax, t2 is corporation tax, t3 is capital gains and t4 is inheritance tax, r is the rate of return and T is the number of years. The TPA use t1=0.40 t2=0.28 t3=0.18 and t4=0.40 a return of 10% and a time in years of 35 years. There are so many flaws with using a formula like this, so I'll point out some obvious ones. The first is that it completely ignores tax thresholds which are a pretty vital part of any calculation, the second is that capital gains don't fall under income tax so the income tax component of this completely irrelevant.

Further to this, the numbers that you get out of the formula depend entirely on the numbers you put into it, for example the 90% marginal tax rate that the TPA use depends entirely on their choice of 10% yearly growth of the business over a 35 year period. The resulting tax rate varies depending on whether I use a different time period, as shown below.

Or alternatively if I use a different annual growth figure.

The resulting marginal tax rate depends entirely on the figures plugged into the formula, the size of the figures is simply a consequence of the exponential growth that you get when you do compound interest calculations. And of course this completely ignoring the fact that most businesses are unlikely to grow in the exponential manner suggested. The whole calculation is of little relvance to most entepreneurs.

And In Conclusion...
There are a few other little gripes I've got with the contents of the report, but from what I've demonstrated above I think it's safe to conclude that. A) The benefits to entepreneurship from a reduction in inheritance tax are minimal at best B) The marginal tax rate figures derived in the report depend entirely on the figures plugged into the initial equation and are almost completely meaningless. What we have here is a report that draws conclusions based on incredibly shakey reasoning and really exists for no other reason than to attract positive press coverage for a bunch of policies that will benefit the well off.

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