Welfare Benefits, Taxes and Entrepreneurship: An economic paradox?

Is the size of the state sector as measured by taxes and/or expenditures related to entrepreneurship?

I've been thinking about these issues for some time now and I've decided to address some of them in this post.

Introduction

Entrepreneurship is the new management paradigm (Timmons and Spinneli, 2009). It could also be described as an emerging economic one, too. Indeed, productive entrepreneurship is an essential factor of the economic performance of a country, and hence cross-country differences in the degree of productive entrepreneurial activity are likely candidates for explaining part of observed cross-country differences in economic performance (Davidsson and Hendrekson, 2001). As Minniti and Lévesque (2008) argue, entrepreneurship is increasingly seen as a vital force in economic development. However, there has been little room for the entrepreneurial element in theoretical mainstream economics (Baumol, 1993; Kirchhoff, 1994; Kirzner, 1997).

Entrepreneurs contribute to economic growth through generating, disseminating and applying innovative ideas; increasing competition and providing diversity among firms; enhancing economic efficiency and productivity (Audretsch and Thurik 2004). They are also an important engine for job creation, being responsible for anything from one-third to 70% of job creation in the economy (Kirchhoff 1994). Entrepreneurship has therefore a significant role to play in the economic drivers of a country. Consequently, it affects the entrepreneur’s relationship with the economy by way of taxation and expenditure as both a contributor to taxation but also a victim of it. Indeed, this post will argue that taxation and the welfare state’s expenditures has a negative impact on entrepreneurial activities in the economy. The logic is that the bigger the state/welfare sector, the more inhibited entrepreneurial culture will be in the economy.

The post is divided in two parts. Part 1 will consider the definition of entrepreneurship. This will lay the foundation for Part 2 which will consider (i) the effect of taxation on entrepreneurship and (ii) the effect of state expenditure on entrepreneurship.


Part 1: Entrepreneurship: Definitional Aspects

Entrepreneurship is a way of thinking, reasoning and acting that is opportunity obsessed, holistic in approach, and leadership balanced for the purpose of value creation and capture (Timmons and Spinneli, 2009). Arguably, entrepreneurship results in the creation, enhancement, realization, and renewal of value, not just for owners, but for all participants and stakeholders. Entrepreneurship can occur – and fail to occur – in firms that are old and new; small and large; fast and slow growing; in the private, not-for-profit, and public sectors; in all geographic points; and in all stages of a nation’s development, regardless of politics (Timmons and Spinneli, 2009, p.101).

Thus, in order for an activity to be defined as entrepreneurial it needs to be novel at least in some sense, but whether it is novel because it applies new knowledge or uses existing knowledge in new ways does not matter (Henreksson, 2005). However, as Glancey and McQuaid (2000) argue, entrepreneurship is invariably defined narrowly and it cannot be said to capture the wide-ranging and complex functions suggested outside mainstream economics.

Part 2: Relationship between Entrepreneurship and State Sector

The role of the state sector has long been perceived with suspicion by many privatisation advocates. Under the new economic paradigm, the entrepreneurship advocates may echo such sentiments as well. This part will consider the relationship between entrepreneurship and the state sector through two lenses: taxation and expenditures.

(i) Taxation Effect

Estrin et al (2009) argue that one of the three institutional dimensions which are likely to influence high-growth expectations entrepreneurship is the scale of the state as captured by the fiscal dimension. The primary issue with taxation is that it inhibits the accumulation of the necessary liquidity or capital to invest in a start-up entrepreneurial activity. For instance, a high tax rate on wage income makes it difficult to save a substantial portion of income that can subsequently be used for equity financing (Davidsson and Hendrekson, 2001) in the creation of a new venture.

Albeit focusing on the Swedish experience, Hendrekson (2001;2005) attempts to explain why the quantitative effect of a certain individual or firm specific factor may vary across institutional setups. One important prerequisite for the emergence of a great deal of entrepreneurship and the existence of a sizable number of high growth firms is that key industries and sectors of the economy are available for entrepreneurial exploitation (Davidsson and Hendrekson, 2001, p.17). For instance, several features of the pre-90’s Swedish tax system disfavoured smaller less capital-intensive firms and discouraged entrepreneurship and family ownership in favour of institutional forms of ownership. During an extended period of time there were extreme differences in taxation for different sources of finance and owner categories. Indeed, debt was the most favoured and new share issues the most disfavoured and households/individuals were taxed substantially more heavily than other owner categories (Davidsson and Hendrekson, 2001).

Thus, taxation regulations benefiting debt financing vis-a-vis to equity financing and institutional ownership relative to individual ownership systematically favoured large, real capital intensive, publicly traded and well-established firms (Davidsson and Hendrekson, 2001). Arguably this is detrimental to the entrepreneurial process as the availability of equity financing is critical for both start-ups and the expansion of existing firms (Holtz-Eakin, Joulfaian and Rosen, 1994).

In order to analyze how the tax system affects entrepreneurial behaviour it is not sufficient to focus on the taxation of individual owners of firms. To a large extent the return on entrepreneurial effort is taxed as wage income. Indeed, a large part of the income accruing from closely held companies has to be paid out as wage income. Furthermore, a great deal of the entrepreneurial function is carried out by employees without an ownership stake in the firm (Davidsson and Henrekson,, 2001). Consequently, a true entrepreneurial culture requires intrapreneurship. This is likely to demand a great deal of flexibility in the choice of remunerative schemes such as “high-powered incentives” (Stevenson, 1985) including stock-option scheme (Davidsson and Henrekson, 2001). However, in some jurisdictions, such as Sweden, the of use of stock options to encourage entrepreneurial behaviour among employees is highly penalized by the tax system, since gains on options are taxed as wage income when the stock options are tied to employment in the firm (Davidsson and Henrekson, 2001). There, the taxation of entrepreneurial income (including stock options) continues to be high, the steep rate of labour taxation reduces the rate of return on human capital investment and the scope for entrepreneurial expansion of household-related services, and the labour market remains highly regulated (Ibid). High taxation on Venture Capitalist firms also constrains the entrepreneurial process. From such a tax incidence it follows that the government’s relationship (fiscal-wise) with entrepreneurship is in a sense negative. However this does not imply that the government should give support to individual entrepreneurs, “since they do not have the competence to pick winners” (Saxenian, 1996).

If taxation of entrepreneurial income is made no more severe than taxation of interest income and business income of portfolio investors, this will strengthen the incentive for entrepreneurship or expansion of operations when this is socially profitable. Likewise, a high rate of labour taxation is, in many instances, likely to be an impediment to entrepreneurial activity, especially in the household-related service sector (Davidsson and Henrekson, 2001). Research by Henreksson (2005) demonstrates the extraordinary extent to which the Swedish tax system favoured, and still favours, institutional ownership and discouraged direct household ownership of firms, which is a prerequisite for entrepreneurial firms, at least in the early phase of their life cycle.

(ii) Welfare state effect (expenditures)

Lindbeck (1988) defines the term ”welfare state” as the entity responsible for the array of publicly financed provision or subsidization of personal services, notably for health, education, child care and care of the elderly, and for social-security systems, transfers and subsidies. The architects behind the build-up of the welfare state scarcely considered that it would have detrimental effects on the entrepreneurial function (Henreksson, 2005). The expansion of the welfare state was a salient feature of almost all industrialized countries, in particular during the 1960s and 1970s (Castles 1998).

In general, studies of the impact on economic performance of a large welfare state find that the overall effect of public programs is to give rise to harmful economic disincentive effects (Agell 1996). Indeed, productivity is partially the product of the accumulation of investments by private firms (or not-for-profits) in the economy. However, public expenditures and taxation that deter such investments by creating marginal tax and benefit wedges, or that reduce incentives to save and accumulate capital in other ways, reduce growth (Henrekson, 2005). But what exactly are these expenditure provisions?

For instance, welfare state provisions such as unemployment benefit remove a number of savings motives for the individual. As long as unemployment insurance, income-dependent pensions and sick-leave benefits, higher education and highly subsidized health and care services are provided by the government, most of the essential savings motives for the average person disappear. There are numerous research results suggesting that such disincentives to savings and individual wealth accumulation are likely to lower the propensity to entrepreneurship (Henrkesson, 2005). Low private savings also exacerbate the inherent problem caused by asymmetric information, since wealth-constrained would-be entrepreneurs are unable to signal forcibly to outside investors by means of making sizeable equity infusions of their own (Henreksson, 2005) or even obtain debt finance from say a bank.

Due to the de facto monopolization by the public sector of the production of many income-elastic services vast areas of the economy have remained unexploited as sources of commercial growth. In particular in the health sector, it is easy to imagine how a different organizational mode could have provided a basis for the emergence of new high-growth firms (Henreksson, 2005).

Indeed, a large percentage of all work, most notably household work, is performed outside the market. Cross-country comparisons of industry-level employment also point to considerable scope for substitution of certain economic activities between the market and nonmarket sectors (Davis and Henrekson 2005). For Sweden, studies indicate that more time is spent on production in the household than in the market. According to the 1997 Service Sector Taxation Report (SOU 1997:17), 7 billion hours were devoted to household work in 1993, while production of goods and public and private services accounted for only 5.9 billion hours. Henrekson (2005) demonstrate that relative employment in the US is considerably greater in household-related services when compared to Sweden, such as repair of durable goods, hotel and restaurant, retail sales, laundry and household work. The Swedish experience may again illustrate how taxation has a detrimental effect on entrepreneurship. Indeed, one could ask why Sweden does not show a similar trend in creating start-ups/entrepreneurial businesses in the household sector. A fundamental reason emanates from high rates of personal taxation. Personal taxes raise the full price of goods and services. For many goods (e.g., high-tech products like computers), a high price may cause the consumer to forego a purchase, or to buy a lower quality version of the good. Consequently, high rates of taxation of labour tend to make it more profitable to shift a large share of the service production to the informal economy, in particular into the “do-it-yourself” sector. As a result, the emergence of a large, efficient service sector competing successfully with unpaid work is less likely in a large welfare state than in countries with lower rates of labour taxation (Henreksson, 2005). This means that tangible opportunities for entrepreneurial business development become less accessible. In other words, higher rates of personal taxation discourage the market provision of goods and services that substitute closely for home-produced services, which reduces the incidence of entrepreneurial activity in the household area.

The literature (Storey 1994) draws a distinction between two types of entrepreneurship: “necessity based” and “opportunity based”. The former is when the entrepreneur is pushed into the venture because he has no other alternative i.e. to survive. The latter form is when the individual is pulled into the opportunity. In the labour market, the “social safety nets” affect what is considered a reasonable wage, the unions’ wage claims, and the kinds of businesses that entrepreneurs are willing to invest in and commence (Henreksson, 2005). To the extent that social safety nets in welfare states push up reservation wages, they affect both types of entrepreneurship. They discourage necessity-based entrepreneurship by providing an alternative source of income at a reasonable level and they curb opportunity-based entrepreneurship by pushing up reservation wages so that many activities that are (initially) low-productivity activities are largely barred from entrepreneurial exploitation, since entrepreneurs have low incentives to start businesses that presuppose wages below the level guaranteed by the ultimate safety net.

(iii) Further remarks

The aforementioned analysis suggests that a larger state sector will militate against entrepreneurial activity. Taxes and welfare provisions may affect entrepreneurial entry via their direct impact on expected returns to entrepreneurial activity and its opportunity cost (Estrin et al, 2009). High and increasing marginal level of taxes may weaken incentives for entrepreneurship by reducing potential gains. Moreover, a burdensome tax system (Aidis and Mickiewicz 2006), and one that works against capital income and benefits debt financing when compared to to equity financing (Davidsson and Henrekson 2002), has been identified as restraining firm growth (Estrin, 2009).

Furthermore, in synthesis, it is argued that high levels of welfare support provide alternative sources of income and may therefore reduce the net expected return to entrepreneurship. As a preliminary conclusion this therefore implies that entrepreneurial activity may be inversely related to the size of the state sector (Estrin, 2009, p.7). However, one must consider that expenditure in education and infrastructure are essential to enable entrepreneurs to carry on their businesses. Therefore, it is arguable that the size of the state sector is selectively inversely related to entrepreneurship activity.


Conclusion

This post has considered whether the state sector as measured by taxation and expenditure is related to entrepreneurship. The immediate response to that inquiry is to be answered in the positive. Both high taxation and expenditure are signs of a large state sector such as welfare states found in the economies of Sweden and, to a certain extent, England. Both high taxation and high expenditure by the state (i.e. unemployment benefits) translates into inhibited entrepreneurial behaviour by individuals and thus undermines entrepreneurship in the economy.



It is important both to extend the economic arenas in which competent entrepreneurs can thrive, and to improve the institutions and rules of the game determining the incentive structure for entrepreneurs (Hendrekson, 2001). A continued almost exclusive reliance on taxation for the financing of key services like education, health care (such as the NHS), child care and care of the elderly can, for the reasons explored in this post be expected to become increasingly problematic (Henreksson, 2005) not only for the state’s ability to control its finances but also in its ability to craft an economy that breeds and nourishes entrepreneurships. There seems to be some room for a welfare state to reform itself in ways that promote entrepreneurship, while the core of the welfare model remains intact. However, a vibrant entrepreneurial culture and the set of institutions that underpins such a culture are very remotely related to the welfare state culture and its institutions, perhaps they are even negatively related (Henreksson, 2005).