Does progressive taxation on corporate income discourage entrepreneurship? At first glance, the answer seems in the positive, since as tax pressure on business increases, business activities become less profitable and, therefore, less attractive. On the other hand, one might also argue that tax progressivity affects large-size companies. Thus, big firms might vanish and small firms (small-size entrepreneurs) might be overrepresented.
This paper uses a simple theoretical model to examine the interaction between progressive taxation, effort and wealth creation. It is shown that progressive taxation, while not affecting the behavior of entrepreneurs with less profitable opportunities, leads entrepreneurs benefiting from good or fairly good opportunities to reduce effort in order to lower the tax burden they would face should they maintain higher levels of effort.
By studying a sample of Italian firms during the 2001-2010 period, it is shown that progressive taxation weakens entrepreneurial effort (quality) when such effort is intense. For low-quality entrepreneurship, this effect is virtually absent.
In this light, the authors conclude that progressive taxation has a negative impact on innovation and prevents firms from growing and reaching efficient size. Hence, the negative consequences for growth.
IREF Working Paper No. 201501: Mina Baliamoune-Lutz and Pierre Garello