Entrepreneurial risk taking and capital tax design

People who work for their own businesses accounted for 20% of the UK's workforce in 2019 and were the fastest growing part of the UK's labour force in the prior two decades. Ensuring that people with good ideas start businesses and invest matters for economic growth, which drives overall living standards. But starting a business is often risky, even in normal times (self-employment declined during the pandemic), and business owners may not capture all of the societal benefits to their ventures ('spillovers').

Risk and spillovers can mean that new business investment is lower than would be ideal from society's perspective.

Governments often try to encourage entrepreneurship by taxing business owner-managers at lower rates than employees. The differences can be very large: a business owner-manager taking income as capital gains faces a 28% tax rate, compared with the top overall marginal rate on wage income of 53%. This encourages tax avoidance: people running their own companies can (and do) pay themselves in dividends or capital gains to avoid higher labour income tax rates.

Low capital tax rates also worsen inequality because business incomes are skewed to the top of the income distribution: 30% of the income of the top 0.1% comes from business ownership, compared with just 10% for those outside the top 1%.

The overarching aim of this research is to improve the design of the tax system to better alleviate the sources of under-investment in start-ups and small businesses, while reducing tax avoidance and inequality. Achieving this requires creating new datasets, developing state-of-the-art modelling techniques and actively engaging with policymakers.

We will use tax records to create the first dataset on the universe of UK business owner-managers (the self-employed and those who own and run companies) over the past 20-years. This will allow us to provide the most comprehensive description to date of who starts UK businesses, how individuals' incomes evolve before, during and after business ownership and which businesses drive growth.

We will estimate how people's decisions to start, and invest in, different types of businesses are affected by various tax policies.

A key part of our research will be the development of models of business start-up and investment. Models are valuable because they allow us to study the long-run impact of policy, unpack the mechanisms driving behaviour, and analyse alternative policy options that we have not seen implemented. We will advance the methodological frontier by modelling the sources of underinvestment in start-ups - including a range of risks and spillovers - and how these interact with different parts of tax policy.

We will study the effect of tax policies on all business owner-managers, while allowing for differences in the way people respond. A self-employed plumber is likely to make very different choices to a highly paid accountant, who will make different choices to someone attempting to launch a new product. A key challenge for governments is that policy cannot target only those who are 'entrepreneurial'.

Designing taxes for business owner-managers therefore inherently involves evaluating the trade-offs associated with policies (such as preferential tax rates) that apply to all business owners.

To ensure that our research directly informs policy, we will provide robust empirical evidence on how specific tax reforms could improve the taxation of small businesses and their owners. We will work closely with policymakers and the business community to ensure our evidence is of direct relevance to and feeds into policy making. We have developed strong relationships with the key stakeholders over many years, which makes this feasible.

Getting this area of tax design right is challenging, but critical. The current tax treatment of business owner-managers is not only poorly targeted at supporting investment but is also leading to tax avoidance and unfairness.