Reducing corporate taxes triggers high-quality entrepreneurship

This paper investigates the impact of corporate taxes on entrepreneurial activity using a quasi-natural experiment in Portugal. Before 2001, the corporate tax rate levied on start-ups in Portugal was 34%. The “Portuguese Tax Benefits for Inland Regions” (Benefícios Fiscais à Interioridade) implemented in 2001 reduced the corporate tax rate to 25% for all start-ups located in inland regions. After 2004, the tax rate was further reduced to 15%, and after 2007 it was reduced to 10%. In 2012, the tax benefits were abolished and the corporate tax rate was increased to 25%.  Figure 1 compares the corporate tax rates faced by start-ups located in inland (the treated group) and coastal (the unaffected, control group) municipalities before, and after the tax reform.

The policy targeted municipalities with a lower purchasing power and population density. To ensure the comparability between inland and coastal municipalities, the paper restricts the analysis to borderline municipalities. To circumvent the possibility that the tax system may be endogenous to firm entry, the paper takes advantage of a quasi-natural experiment and adopts a difference-in-difference estimation using an instrumental variable approach. The instrument for tax reform adoption takes into consideration whether the political affiliation of the mayor is the same as the party that proposed the tax benefits bill. To test the relationship between corporate taxes and entrepreneurial activity, the analysis combines rich municipality-level data with individual- and firm-level data for the period of 1997 to 2011, using a detailed mandatory survey. The data also allow to explore new research avenues related with the characteristics of the start-ups and founders who entered the market due to the reduction in corporate taxes.

Results indicate a positive and statistically significant increase in the number of monthly start-ups and in the number of new jobs in inland municipalities. To understand the economic significance of the results, full nationwide implementation of the tax reform would generate approximately 29,150 firms and 223,500 jobs over three years. After the abolition of the tax benefits, the paper finds a negative and statistically significant decrease in the number of start-ups in inland municipalities.  Additionally, the paper finds that those firms whose entry is plausibly induced by the tax reform tend to be relatively larger, more productive, owned by relatively older and more educated entrepreneurs, and that these firms are more likely to survive during the first three years after entry than the preceding cohorts of entrants. The estimated positive impact of the tax reform is more noticeable in the construction and trade sectors and is more pronounced during the first years after the reduction of corporate taxes.

These results suggest that the positive and significant impact of lower corporate taxes on entrepreneurship is driven by those individuals who are endowed with a greater level of ability and with required knowledge to take advantage of the opportunity created by the tax reform and to understand the complexity of the tax system.

Click here to go to the paper by Ana Venâncio, Victor Barros, and Clara Raposo.