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Of Income and Taxes: The Unique Position of the Entrepreneur

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A few years ago, something caught the attention of two economists at the University of Minnesota.

The researchers, part of the Heller-Hurwicz Economics Institute at the UMN Twin Cities College of Liberal Arts, were reviewing an influential past study that found entrepreneurs, on average, make a much lower income than hired employees. In the course of doing so, they noticed the work was based on survey data—and realized the limitations of survey methodology may have thrown off the findings.

Now, Anmol Bhandari, PhD, assistant professor of economics and Ellen McGrattan, PhD, professor of economics and HHEI director are taking a fresh approach to investigating the subject. In their research proposal to the Internal Revenue Service, they are interested in tapping a mixture of tax data and audit studies to take a quantitative look at entrepreneurs’ income, how that income changes over their careers, and how it compares to the income of hired employees.

“One thing we’re looking for is whether the typical finding in survey data that paid employees make more than self employed is robust,” Bhandari said.

Why could there be a discrepancy from the survey data? One reason, Bhandari said, is the high chance that the data will be “top-coded”—that is, missing many of the highest income values—because of who responded to the survey. The most successful entrepreneurs are likely to be busier with their businesses and less willing to devote their time to surveys. Without their responses factored in, the data would appear to show the average entrepreneur making less money than they actually do. Another reason could be that entrepreneurs cheat on taxes. Using publicly available data, Bhandari and McGrattan estimate a large tax evasion, with entrepreneurs often paying just 20 cents on the dollar in taxes, while hired employees pay closer to 40 cents on the dollar.

As Bhandari and McGrattan continue their exploration of the IRS data and audit studies, they hope to advance the current knowledge around what drives someone to become an entrepreneur and determine more about the unique ways that entrepreneurs contribute to the economy.

Taxes and the Value of ‘Sweat Equity’

A large part of the public discussion around entrepreneurs centers on taxation of business incomes. Figuring out how to improve tax compliance among entrepreneurs is a good first step, but policymakers should be more cautious, Bhandari said, about following calls to increase taxes on them overall. Those in favor tend to believe successful entrepreneurs would have succeeded regardless of circumstances, and thus it makes sense to increase taxes on the wealthy (including entrepreneurs) and use them to better fund social security, lower taxes on workers, and other programs supported by a redistribution of wealth. A differing view believes wealthy entrepreneurs got where they are based not only on their own skills, but on conditions that incentivized (or at least didn’t discourage) the hard work they would need to put in.

The latter view is centered on the concept of “sweat equity,” a term for the increase in a company’s value through its owner’s hard work. Entrepreneurs invest an enormous amount of sweat equity to build their business’s reputation and client list, while hired employees often do not go similarly “above and beyond” because there is no comparable financial reward for doing so. A family dentist who runs their own business, for example, is likely to create more personal connections with patients—and to benefit more directly from resulting business growth—than a larger clinic where many dentists are employed. The “intangible assets” built through sweat equity do more to boost the company’s overall value than more concrete assets like its facilities and equipment.

Sweat equity is a key reason Bhandari said he and McGrattan would argue against raising taxes on entrepreneurs—at least until the point where additional data would support the idea. Right now, they fear a higher tax burden may discourage people who are capable of bringing innovative products and services to market from actually doing so. The ample time and work required to succeed would have less payoff down the road.

“Think about someone who could be working as a paid employee, but wants instead to become an entrepreneur,” Bhandari said. “If you tax entrepreneurship a little bit more, they would get less out of every hour they spend on it. That person is going to say, ‘it doesn’t sound worthwhile,’ and they are going to go do something else.”

 

Heller-Hurwicz Turns 10

This year, the Heller-Hurwicz Economics Institute marks its 10th anniversary, celebrating one decade of bridging field-shaping economic research with policy that promotes the public good.

HHEI was founded to conduct rigorous, transformative research away from the pressures of Washington and Wall Street, focusing on areas where there is potential to break new ground, advance economic theory, and apply it to policies and institutions that will address global challenges. Its primary research focuses include climate change, financial regulation, and social insurance.

Learn more about research at HHEI.

Kevin Coss

Kevin Coss

Kevin is a writer with the Office of the Vice President for Research.

coss@umn.edu

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