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Taxes, the structure of incentives, and why I’m worried about the plan for health reform funding

When I was a Ph.D. student studying entrepreneurship, one of the most influential articles I read was by economist William J. Baumol.  Entitled “Entrepreneurship: Productive, Unproductive and Destructive”, it basically suggested that a nation gets the type of entrepreneurship it rewards.  Countries that reward productivity-enhancing risk-taking richly encourage those with entrepreneurial inclinations to pursue those activities.  Countries, in contrast, that reward other kinds of activities, such as politicking, status-seeking through religion or study, or worst of all, counterproductive activities like drug dealing and other forms of corruption—tend to encourage those with entrepreneurial talents to pursue those sorts of activities, to the detriment of more productive entrepreneurship. 

Baumol’s observation haunts me as I peruse the extensive coverage of the frantically rushed efforts to overhaul 17% of the nation’s economy in one fell swoop in the form of a major change in how medical care is allocated and paid for.  Without examining the merits of the health aspects of the plan, I wish to express grave concern with this wholesale and ill-considered redistributive move.  Perhaps without intending to (or more likely, without having ever given it a thought), the plan currently being sped along by the House Democrats is going to fundamentally alter what Baumol called the ‘structure of incentives’ that shape how entrepreneurs allocate their energies. 

Let’s start with the basics:  Under the House plan, medical care would be paid for by a surtax on those families with household income above $350,000 in 2011, a surtax which can go to as high as 5.4%, in addition to the tax increases already scheduled to kick in in 2011.  Further, the plan would impose mandatory health insurance coverage for employees on all businesses with more than 25 of them, or a fine of 8% of payroll.  Employers with more than $400,000 in payroll would basically have to pay at least 25% above salary to hire an additional person.  Research suggests that a great many Americans with incomes above $350,000 are entrepreneurs and small business owners – in many cases, they operate sub-chapter S corporations in which profits are cashed out at the end of each year and taxed at the individual rate.  That money, which looks like discretionary income to headline-hungry politicians, is often plowed back into the business.  It’s not going for luxuries – in many cases, it’s going for working capital, inventory, marketing, and other unglamorous business necessities. 

So what does Baumol’s theory tell us is likely to happen?  Well, the first predictable consequence is that an awful lot of entrepreneurial energy is going to be spent, not productively, but unproductively, as small business people and those falling into the higher-tax categories spend their time not producing new innovations but figuring out how not to fall into the maws of increased tax and regulatory burdens.  Following right on that as a predictable consequence is that those who are able to do so will do business in such a way that they don’t fall into the higher-taxed categories.  Rather than pay individual rates, small businesses will incorporate and pay the lower 35% corporate rate.  Further, get ready for the new conglomerates – thousands of businesses employing exactly 24.5 people, all interconnectedly doing business with one another rather than falling foul of the over 25 employee stricture.  And with small business growth having led us out of most recessions in the past, get ready for this sector to add jobs far more slowly and with far greater caution than it had previously –  a big blow to an economy that desperately needs a vibrant and growing small business sector. 

At a more macro level, a huge body of research points to the same conclusion (remarkably, for academic research).  The effects of higher individual taxes on rates of entrepreneurship are without an exception, negative.  It is well accepted, and has been for decades, that the desire to have a vibrant entrepreneurial economy is at odds with the desire to operate a welfare state, due in large part to the way in which welfare states allocate resources – when the upside to undertaking the risks of entrepreneurship decrease, while the downside of not doing much at all are limited, it becomes hard to justify making the effort.  If it is possible to live quite a comfortable life without too much bother, why take on the long hours, the worry and the headaches of small business ownership?  You don’t need to take my word for this – the following excerpt is from an academic study, looking at the structure of incentives for entrepreneurship in Sweden, probably the worlds’ best known welfare state.  Here is what the author concludes:

Sweden, allegedly the most extensive of all welfare states, is the object of the empirical analysis. It is shown how key welfare state institutions tend to reduce economic incentives both for opportunity-based and necessity entrepreneurship. Both aggregate economic performance and data on firm growth and direct measures of entrepreneurial activity are broadly consistent with the identified structure of payoffs. A number of measures can be implemented to strengthen entrepreneurial incentives within extensive welfare states, but the fact still remains that an entrepreneurial culture and a welfare state are very remotely related. As a result, the respective cultures are unlikely to be promoted by a similar set of institutions (Magnus, 2005, p. 437).

So here is the really chilling part about the proposed tax hikes.  The Wall Street Journal on July 17 (“A Reckless Congress” page A14), citing research by the OECD and the Heritage Foundation found that the top average US tax rate (combined state federal marginal tax rate) would hit 52% should the Obama budget and House health-care plan become law.  In some states, such as New York and New Jersey, the rate would be 56.92% and 57.07%, respectively.  What’s the marginal tax rate in Sweden? 56.44%. 

All this and the US taxpayer would not enjoy the benefits of a true welfare state – excellent, inexpensive, state-funded universities, ample unemployment benefits, child assistance benefits and, yes, government funded universal health care. 

Those of us, myself included, who believe that it is entrepreneurship that drives economic vibrancy should be doing everything in our power to persuade the stewards of our country’s well-being to stop this train wreck in the making.  Or perhaps the Journal editorial writers said it best:

The world is looking on, agog, and wondering why the United States seems intent on jumping off this cliff.


Baumol, W. J. 1990. Entrepreneurship:  Productive, Unproductive, and Destructive. Journal of Political Economy, 98(5): 893-921.

Magnus, H. 2005. Entrepreneurship: a weak link in the welfare state? Industrial and Corporate Change, 14(3): 437.

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