Effectiveness of tax reform on entrepreneurship
| Pages | 94-111 |
| Published date | 17 December 2019 |
| Date | 17 December 2019 |
| DOI | https://doi.org/10.1108/JEPP-07-2019-0060 |
| Author | Chigozie Andy Ngwaba,SeyedSoroosh Azizi |
| Subject Matter | Strategy,Entrepreneurship,Business climate/policy |
Effectiveness of tax
reform on entrepreneurship
Chigozie Andy Ngwaba
Northern Illinois University, DeKalb, Illinois, USA, and
SeyedSoroosh Azizi
Purdue University Northwest, Hammond, Indiana, USA
Abstract
Purpose –The purpose of this paper is to investigate the effects of tax reform on entrepreneurship in
South Africa using repeated cross-sectional data from the World Bank.
Design/methodology/approach –The paper adopts a difference-in-difference estimation technique as well
as contrasting periods before and after the tax reform. This contrast is achieved by examining individuals in
the formal and informal sector and measuring the effectiveness of the reform on self-employment.
Findings –The results indicate that the tax reform had a positive and significant effect on the probability of
becoming self-employed in South Africa and is robust across different econometric specifications.
Originality/value –The authors use individual-level data to measure the effectiveness of a tax reform
policy on entrepreneurship. Utilizing the South African post-Apartheid tax reform as a natural experiment
allows the authors to identify the effects of taxes on the choice of becoming self-employed.
Keywords South Africa, Entrepreneurship, Tax reform
Paper type Research paper
1. Introduction
Entrepreneurs are of particular interest to researchers and policy makers since they play a
significant role in the economy by providing the much-needed energy behind job creation,
technological advancement, and overall economic growth and development (Bruce and
Gurley-Calvez, 2013). Researchers have investigated various factors that affect
entrepreneurship and found taxes to be one of the most important determinants of
entrepreneurial entry. However, empirical estimates of these effects remain inconclusive.
Reasons include differences in data and estimation techniques, the definition of
entrepreneurship, and the type of taxes being considered. Taxes are expected to mainly
affect the decision to enter into entrepreneurship or remain a wage-worker because most tax
laws treat entrepreneurial income differently from wage income. Furthermore, the taxation of
many forms ofentrepreneurial income depends onvoluntary compliancewhile most wage tax
payments are withheld by employers. (Bruce and Gurley-Calvez, 2013). Bruce and
Gurley-Calvez (2013) use a 12-year panel of tax returns data (1979–1990) drawn from the
University of Michigan Tax Research database to examine the effects of tax rate on
entrepreneurial activity. Resultsfrom their study showthat cuts in marginal taxrates faced by
entrepreneurs increase the probability of entry and are larger than those of the wage sector,
suggesting that tax cut across the board would increase entrepreneurial entry.
Bruce (2000) examines the impact of US income and payroll taxes on the decision of
wage-and-salary employees to become self-employed. Bruce exploits variations in the tax
treatment of wage and self-employment income using the Panel Study of Income Dynamics
(PSID) that is limited to only male heads of households between the ages of 25 and 54.
Results indicate that reducing an individual’s marginal tax rate on self-employment income,
while holding marginal wage tax rate constant, reduces the probability of entrepreneurial
entry. This is an unexpected result because most theoretical and empirical work shows the
Journal of Entrepreneurship and
Public Policy
Vol. 9 No. 1, 2020
pp. 94-111
© Emerald PublishingLimited
2045-2101
DOI 10.1108/JEPP-07-2019-0060
Received 3 July 2019
Revised 8 November 2019
25 November 2019
Accepted 25 November 2019
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/2045-2101.htm
JEL Classification —L26, H21
94
JEPP
9,1
opposite effect. The reason for this result could be because Bruce (2000) restricts his analysis
to the male head of households between the ages of 25–54.
Asoni and Sanandaji (2014) analyze the effect of taxes jointly on quality and quantity of
entrepreneurship. They use a dynamic forward-looking framework where individuals decide
to create firmsby taking into account all future utilities andoptions. Results indicatethat in a
dynamic setting with a high level of commitment, progressive taxes can increase entry into
self-employment while reducingaverage quality of the firm. Whenentry is associated with an
opportunity cost in terms of searching for better ideas, progressive taxes can decrease the
average quality of startups, while increasing their number. Progressive taxes compress the
returns to entrepreneurial activity, thus lowering the reward to high-quality ideas relative to
mediocre ones.
In any study of entrepreneurship, the most important challenge is deciding how to
measure entrepreneurial activity. Entrepreneurship, as a concept, cannot be measured
directly. However, entrepreneurship is a function that usually occurs within the contractual
form of self-employment (Henrekson and Sanandaji, 2009). Therefore, like previous studies,
we use the measurable, yet imperfect, proxy for entrepreneurship: self-employment.
The proposed study seeks to investigate the effects of the South African tax reform on the
probability of becoming self-employed. This is important because small business creation
tends to boost the economy through employment creation and this is usually the difference
between developed countries vs their developing counterparts. Hence, tax policy in developing
countries like South Africa seeks to create a conducive environment for small business
to thrive. Specifically, we use individual responses on surveys about the question of
self-employment from an 8-year repeated cross-section survey taken from 2000 to 2007, called
the Post-Apartheid Labor Market Series (PALMS) 1994–2012, to investigate whether South
African tax reform has any effect on the decision to become self-employed[1]. The goal of the
tax reform is to make the South African tax system more progressive and similar to
internationally acceptable standards by reducing the statutory tax rates and broadening
the tax base. Highlights of the reform include the introduction of a capital gains tax, the
introduction of taxes on fringe benefits and the restructuring of the tax system from a
source-based to a resident-based income tax system. We assume these reforms will have a
direct impact on wage income while having no clear impact on existing entrepreneurial income.
We compute a linear probability model to estimate the impact of tax policy changes on the
likelihood of becoming self-employed while controlling for factors that may influence individuals’
decisions to become an entrepreneur. Results indicate that the tax reform increases the
probability of entrepreneurial entry by approximately 3.1 percent, which is in line with estimates
from previous studies investigating an increase in wage taxes on entrepreneurial entry.
The rest of the paper is organized as follows: Section 2 gives a background of the
South African post-apartheid tax reform. Section 3 reviews previous literature on how taxes
affect the decision to be self-employed and Section 4 introduces the theoretical framework
for the study. Section 5 presents data and estimation techniques with Section 6 describing
the results, while Section 7 gives the concluding remarks.
2. Tax reform in South Africa
The peaceful transfer of power in 1994 to a democratically elected government marked the
end of the apartheid system in South Africa. Eliminating the apartheid’s socio-economic
legacy of income inequality and chronic poverty stood as a very difficult challenge to the
new South Africa (Kransdorff, 2010). During the apartheid regime, there were five different
tax administrations, including one for each of the homeland “states”of Transkei,
Bophuthatswana, Venda and Ciskei. The new government abolished the homelands and
placed the majority of the revenue-raising authority with the federal government while
granting the nine newly formed provinces considerable authority over public spending
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Tax reform
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