Researchers often try to estimate the prevalence of entrepreneurship by looking at the rate of self employment. As we discussed in a previous article for the Cayman Island Financial Review, the results tend to be misleading.
The U.S. has for example a lower rate of self-employment than most other industrialized countries, but is clearly more entrepreneurial. Within the U.S., the self employment rate in Silicon Valley is half that of the average of California. Due to this methodological flaw, previous research has not been conclusive on the effect of taxes, regulation and other institutional factors on entrepreneurship.
In order to overcome these obstacles, we have constructed an international database of individuals who have amassed a billion dollar fortune through entrepreneurship – the SuperEntrepreneurs. Measuring high-impact entrepreneurship directly is not only interesting from a purely academic perspective.
It also has real world relevance, by enabling us to better understand how institutions can affect private enterprise. One institution that has a direct and positive link to entrepreneurship is the protection of private property.
Without property rights, firms stay small and informal
In rich Western countries today, it is easy to take strong protection of property rights for granted. However, historically in the West, and in most of the rest of the world today, property rights have been, and are, far from secure.
Property rights matter because individuals will rarely invest the massive amounts of time and money needed to creating an entrepreneurial company if there is an imminent risk that their firm will be taken from them in the event it becomes valuable. In economies with weak protection of property rights and corrupt states, firms tend to stay small and informal. This of course inhibits high growth entrepreneurship.
Another reason is that in countries with weak institutions and low levels of interpersonal trust, firms cannot rely on the web of contracts and trustworthiness essential to effectively manage their employees. When the level of trust and contract protection in a society is low, it becomes more important to monitor employees closely or rely on your own or your family’s labor.
This encourages small firms to stay small. The British economist Alfred Marshall anticipated the advantage of smaller firms: “The master’s eye is everywhere; there is no shirking by his foremen or workmen, no divided responsibility, no sending half-understood messages.” Where hired strangers cannot be trusted, entrepreneurs will find it much harder to expand their firms rapidly around innovative ideas.
Property rights reward talented entrepreneurs
In economies with weak institutions, firms rely on the capital of the owner, or at best from family networks, which again inhibits growth. External capital from banks, venture capital and initial public offerings will not be provided if property rights do not protect investors.
However there is no guarantee that the person with the most original innovation or with the best managerial talent is the same individual that happens to have a rich uncle. With weak institutions, it is mostly the already rich rather than the most talented who are able to found new firms. This is not only unfair but also quite inefficient.
Similarly, high-tech companies which rely on technological innovations must be assured that the technology or product will not simply be copied by competitors once created. Nobel prize winner Douglas North thus argued that intellectual property rights in particular was the key advantage that enabled Western Europe to be the birthplace of the Industrial Revolution.
Without a guarantee that intellectual property rights are protected, firms will not invest millions of dollars required to generate new technology. In our study, we find a clear link between property rights – as measured by the International Property Rights Index – and the level of SuperEntrepreneurship per capita around the world. The countries which have the strongest property rights tend to have more high-impact entrepreneurs.
Taxes, a necessary evil
Another key factor influencing the rate of high-impact entrepreneurship is taxes. Taxes may be the single most important intervention by the state in modern economies. In most developed countries total tax revenues range between 30 and 50 percent of national income.
Taxes are needed to finance education, defense, a social safety net and many other worthy causes. At the same time, taxes undoubtedly reduce the incentive to work and to invest in physical and human capital. Taxes are therefore a necessary evil. The need to balance the need for revenue and the damaging impact of taxes on the economy is perhaps the biggest challenge of modern welfare states.
Some commentators have questioned if successful entrepreneurs are affected by taxes. Are entrepreneurs not mainly interested in creating something new? Would an extraordinarily rich person really care about having 5 billion dollars instead of 10 billion?
To answer how taxes affect entrepreneurs we need to think carefully about the entrepreneurial process itself. First, we must remember that successful entrepreneurship is quite rare. Perhaps hundreds of potential entrepreneurs enter the market, fail and incur losses of capital and effort for each one that becomes extraordinarily wealthy. It is generally hard or impossible to know which firm will be the successful one beforehand.
Taxes, risk and reward
Entrepreneurial success is a fabulous prize that motivates many to try, for a few to succeed. If taxes diminish the value of this prize, fewer individuals will make the effort and take the risk to win. Someone who is guaranteed a profit of 10 billion dollars if they start a business would not be deterred by 50 percent or even 90 percent taxes. But no one is ever guaranteed such profits.
Trying your luck as an entrepreneur is not costless. Besides needing to invest his or her savings, the nascent entrepreneurs must likely quit a job for an extended time period.
Entrepreneurs with high potential typically have attractive alternative options to pursue high-paying, secure careers in larger companies. Their income, security and seniority must be given up to start a firm, which will more often than not fail, leaving a stain on their curricula vitae.
Potential entrepreneurs must make choices between a high risk, high effort option with little likelihood of success, and generally high paying and secure jobs that match their skills. Indeed most potential entrepreneurs choose the secure path, never leaving the company hierarchy. If taxes eat away a sizable part of the return from the rare cases of great success, the calculus between these choices is changed.
Entrepreneurs are in part motivated by wealth
Warren Buffet argued for raising the capital gains tax somewhat because he has never seen anyone turn down a profitable investment opportunity due to the tax implications. This may be true. It does however miss the point since high taxes can make a previously profitable investment unprofitable.
Nor can we console ourselves with clichés such as truly creative people not caring about money. It seems to us that the more honest truth is that most businessmen do care about wealth, if for no other reason than as the objective metric for success in society and among their peers.
Entrepreneurs by nature tend to be competitive, economically oriented in their thinking and responsive to incentives. Research has consistently shown that business owners reduce their output more in reaction to taxes than workers; they are, in the terminology of economists, more responsive.
This is likely due to a combination of entrepreneurs having more control over their reported income, more control over effort and being more responsive to economic incentives.
For many entrepreneurs, wealth is a signal of success to aim for, a sign of recognition by peers and by society, and therefore represents more than merely the material goods that wealth can buy. Indeed 73 percent of entrepreneurs surveyed reported that economic profits were motivating factors.
Even for entrepreneurs who only care about their firm and disregard the private profit motive, taxes are likely to matter. This is because taxes limit the ability of the firm to grow, to attract capital and to attract talent.
Even if you do not care about taxes, taxes care about you. In our study, we indeed do find a clear relation between taxes on profit and the share of high-impact entrepreneurs in our list. The nations that have the highest tax rates tend to be the same that have the lowest rates of entrepreneurship.
The sum of well-meaning regulations can become burdensome
The third institutional factor that is strongly linked to the rate of SuperEntrepreneurship is regulation. Every nation regulates business. A certain amount of regulation is necessary in a modern economy in order to ensure that firms pay taxes, that minority owners are protected, that hazardous products are not sold, that employees are not taken advantage of, that consumers are not deceived and that production does not pollute the environment. There is however a tendency for regulations to over-expand.
Each individual regulation may seem reasonable in out of itself, for example making sure that business have gender equality plans, that the firm notifies the municipality of its existence, that it proves it has a bank account and that it signs up with the chamber of commerce. Taken together however, these well-meaning regulations can grow exponentially and inhibit business startup.
This is especially true as startups do not have the resources to hire full time employees to deal with regulations like large firms. Regulations can also inhibit the rate of growth, take energy from the entrepreneur that could instead be used to develop the venture and can also force the firm to make poor business decisions in order to comply with some rule or regulation. All of this can be true even if the regulations are reasonable and well-meaning.
To make matters worse, in many countries regulations arise not in order to ensure desirable social outcomes, but in order to facilitate government control and even corruption. Economist Herman De Soto documented the massive red tape in his home country of Peru that meets startups. In a moving account De Soto describes how excessive regulation helps strange entrepreneurship in Peru and traps the poor in a less efficient underground economy from which few can escape.
|Profit tax rates2||World||Negative|
|Charitable givings as share of GDP4||OECD countries||Positive|
Sources: 1: International Property Rights Index, 2: World Bank data, 3: OECD index, 4: John Hopkins Nonprofit Sector Project data.
To measure regulation we rely in our work on the World Bank “ease of doing business” index – an ambitious ranking of countries in terms of regulations compiled in part by interviewing thousands of businessmen and experts in most countries of the world.
We find that countries with a heavy regulatory burden have fewer entrepreneurs per capita. The findings are replicated when using an alternate regulatory index for the OECD countries. Even when controlling for tax rates and per capita income, more regulation is associated with fewer SuperEntrepreneurs.
Reducing red tape, strengthening private property and reforming the tax system are thus instruments that policymakers can utilize in order to encourage high-impact entrepreneurship. Additionally, we find that policies that strengthen high-impact entrepreneurship might increase philanthropy.
The reason is that charitable giving as a share of GDP is higher in countries with a high share of SuperEntrepreneurs per capital. All this might seem intuitively true to many business leaders. In the world of academics however, the difficulties in measuring entrepreneurship correctly have led to a situation where it has become difficult to conclusively show the link between, for example, taxes and entrepreneurship.
Policymakers who favor high taxes have utilized this to question the case for low taxes.
We are currently seeking funding to continue our work in better measuring high-impact entrepreneurship, in collaboration with the Center for Policy Studies. Amongst others, we aim to systematically analyze how entrepreneurs benefit society at large through innovation, job creation and creation of other social goods.
Another aim is to distinguish between crony capitalists and constructive entrepreneurs. Our preliminary analysis shows that countries with free market policies are dominated by individuals who become rich by creating even greater value for society at large. Countries with high levels of state involvement and weak market institutions on the other hand encourage individuals to gain wealth at the expense of others. In all systems, individuals are motivated by wealth.
The institutions that exist determine whether this happens through innovative entrepreneurship, or the kleptocracy we are today seeing in countries such as Russia.
Tino and Nima Sanandaji have written the book “SuperEntrepreneurs” for the Center for Policy Studies in London.