How Many Entrepreneurs Can Government Create?

In his address to Congress last week, President Obama acknowledged the vital role entrepreneurs play in our economy when he said that the answers to our problems lie at least partially “in the imaginations” of these enterprising souls. Later in the speech he announced a new loan fund designed to help finance “entrepreneurs who keep this economy running.”

A few days later, however, the President released a new budget with sharply higher tax rates for upper income households, which will ultimately mean higher taxes on entrepreneurial earnings, and higher taxes on the capital that finances start-ups. Entrepreneurs who heard what the president said, and then saw his budget, can be excused for recalling what T.S. Eliot once observed in a different context: “Between the word and the deed falls the shadow.”

Lately, America’s entrepreneurs are wondering just how dark the shadow will get for them. And the rest of us should wonder what kind of an impact our federal policies will have on entrepreneurial activity, and by extension on the economy in general.

There’s little doubt that the President was correct that entrepreneurs help drive our economy. Start-ups accounted for about 3 percent of all jobs in the U.S. economy annually from 1980 through 2005, according to new business dynamics research by the Bureau of Labor Statistics and the Kauffman Foundation. Given that annual job growth averaged 1.8 percent over that time, the net jobs added by new ventures proved vital to our economy’s advances.

Americans sense the importance of smaller firms, especially start-ups. In a Zogby poll last week, 63 percent of those sampled said they thought small business owners and entrepreneurs would lead us out of our current economic difficulties, compared to 31 percent who expressed confidence in our government leaders to find the answers to our economic problems, and 21 percent who thought executives of big businesses would show us the way to a new economic future.

But small firms can only lead the way if government does not inhibit them. A 2005 study by economists Donald Bruce and Tami Gurley, for instance, found a significant correlation between tax rates and entrepreneurial activity. Notably, the pair found that increases in tax rates on wages and entrepreneurial income (for example, income from a sole proprietorship or partnership) reduce the number of start-ups and hasten the number of entrepreneurs who give up their businesses, while tax cuts have the opposite effect, that is, they spur more entrepreneurship. The study estimated that every one percentage point cut in tax rates generates 1.5 percentage points more in entrepreneurial activity and reduces by nearly 4 percentage points the likelihood that those who are already engaged in a start-up will exit the field. Tax increases decrease entrepreneurial activity by like margins.

The authors don’t delineate all of the ways that higher taxes play out in the economy’s entrepreneurial sector, but entrepreneurs themselves will gladly explain it for you. Sramana Mitra, who has founded three companies and is the author of the book Entrepreneur Journeys, observes that, “bootstrapped entrepreneurship,” that is, entrepreneurship at its most basic level, which is often self-funded, “is the true weapon of mass reconstruction.” Few in government understand this dynamic, she suggests, which may be one reason why the Obama administration’s answer to reigniting start-up activity is to create a loan fund that would finance a relatively few new ventures, rather than to focus on tax and regulatory changes that can potentially influence millions of start-ups.

According to Mitra, since most start-ups fund their businesses initially out of their savings and those of their families and friends, not from capital provided by professional investors, personal income tax rates matter so much more to them than venture capital initiatives.

“More often than not, an angel turns out to be the entrepreneur’s uncle, who is a doctor making $400,000 a year and can afford to invest in the nephew’s audacious dream and unproven idea,” Mitra writes. “Thus, the government should be very careful how these $400,000-a-year uncles are treated from a tax policy point of view. The choice may well be between $250,000 being invested in a start-up, versus that $250,000 going into the government’s pocket as income tax.”

In his speech, the president offered a different vision when he said that it was government which “catalyzed private enterprise” with big, bold investments and sweeping agendas—from the national highway building program of the 1950s to the Moon race of the 1960s. Government, in other words, doesn’t just provide the broad outlines for a stable society in which entrepreneurs can survive—like a fair judicial system to enforce contracts—but will help us pick our next generation of winners and losers.

In seems, in other words, that in the process of redefining capitalism, we are also reworking our fundamental definition of what it means to be an entrepreneur--for better or for worse.