Top marginal statutory rates mainly affect productivity
Top marginal statutory rates on labour income have an ambiguous impact on TFP via entrepreneurship by affecting risk taking by individuals. On the one hand, high top statutory income taxes reduce the post-tax income of a successful entrepreneur relative to an unsuccessful one and can reduce entrepreneurial activity and TFP growth.
On the other hand, high tax rates provide for increased risksharing with the government if potential losses can be written off against other income (tax payments), which may encourage entrepreneurial activity (Myles, 2008). However, Gentry and Hubbard (2000) suggests that the higher is the difference between the marginal tax rates when successful and unsuccessful (a measure of tax progressivity) the lower is risk-taking as the extra tax that applies to high profits is greater than the tax saving that is produced by losses, effectively reducing the strength of the risk-sharing effect.
Industry-level evidence covering a sub-set of OECD countries suggests that there is a negative relationship between top marginal personal income tax rates and the long-run level of TFP (see Box 4 for details). The magnitude of the estimated impact of a change in top personal income taxes differs across countries depending on the composition of their business sectors, increasing with the proportion of industries with structurally high entry rates.
One possible policy implication may be that countries with a large share of their industries characterised by high firm entry (or wishing to move in this direction) may gain more from lowering their top marginal tax rate than other countries. However, it is likely that some other policies and institutional settings, such as product market regulation, have a more direct impact on entrepreneurship (Scarpetta and Tressel, 2002; Brandt, 2005; Conway et al. 2006).
Additionally, the magnitude of the impact of tax reform may depend on the stance of these policies. Indeed the empirical analysis shows that the negative impact of top marginal tax rates on TFP is stronger in countries with a high level of the OECD indicator of product market regulation (PMR), suggesting complementarities between taxation and product market policies.
Capital income taxes may affect investment and entrepreneurship through savings and firms’ financing
Taxes on personal capital income may affect private savings by reducing their after-tax return. However, as discussed in Section 3.1, the effects of this on savings, and particularly on investment, are uncertain. Nonetheless, differences in the personal income tax treatment of different forms of savings can be expected to distort the allocation of savings and reduce the growth potential of the economy.
As most OECD countries do favour certain types of savings (such as owner-occupied housing, private pension funds) over others (such as bank deposits), there is scope to increase growth by reducing these distortions.
High capital gains taxes may affect both the demand for venture capital through entrepreneurs’ career choice and the supply of funds (e.g. Poterba, 1989). Since venture capital is one important source for financing high-technology firm start-ups, financial support for these start-ups may be hindered by high capital gains tax, thus lowering the potential contribution of new firm entry to TFP growth.
However, there is little empirical evidence of this link. More generally, policymakers face difficult choices in relation to capital gains taxes (see OECD, 2006c). In particular, exempting capitals gains from taxation provides opportunities for tax avoidance by transforming taxable income into tax-free capital gains, but the application of capitals gains tax can “lock-in” investments and prevent the efficient reallocation of capital because (for reasons of practical administration) capital gains are taxed on realisation. It is, therefore, unsurprising that OECD countries differ widely in their taxation of capital gains.
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