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Being able to keep your money matters: how tax policy and limited liability laws affect entrepreneurship.

I. Introduction

Small businesses play a vital role in the economy. According to Kobe (2007), small firms account for approximately 50 percent of nonfarm real GDP and 50 percent of the job growth in the period from 1998 to 2004. Most small businesses owners pay personal income taxes on their profits rather than corporate taxes. As of May 2013, four years since the economic "recovery" began in June 2009, the national unemployment rate has remained high, in the mid-7 percent range. Many economists suggest tax cuts and less regulation as policies to boost economic growth and create jobs. In addition to calling for cuts in corporate income taxes, a growing number of proposals have been calling for cuts in personal income taxes.

Certain authors have found that higher income tax rates (federal and state) have either little or positive effects on self-employment (Long 1982; Blau 1987; Parker 1996; Cowling and Mitchell 1997; Robson 1998; Bruce and Deskins 2010). Opponents of tax cuts therefore use these findings to argue against any types of tax cut. Evidence suggests, however, that property, inheritance, and gift tax cuts can help entrepreneurship (Bartick 1989; Kreft and Sobel 2003; Bruce and Deskins 2012). Wealth is an important factor responsible for self-employment. Therefore, by reducing wealth taxes, entrepreneurs will feel more financially secure and have more incentives to invest. Income tax cuts should help wealth accumulation.

This paper contributes to the literature by studying the effect of business owners' outside wealth on their usage of financial leverage. It shows that entrepreneurs with limited liability protection tend to use more financial leverage because they have more wealth outside of their firms. This result remains unchanged after adjusting the measure of outside wealth by the amount of loans that owners obtain by using personal guarantees or out-of-firm personal assets as collateral. I find that economic freedom matters for small business. Specially, I find that property tax cuts, inheritance tax cuts, and limited liability allow small business owners to finance more projects.

II. Literature Review

Robson (1998) examines the determinants of the increase in self-employment in the United Kingdom and finds that rises in personal sector liquid wealth and housing wealth have significant effects on the growth of self-employment. Therefore, it seems logical that tax cuts, which are positive to wealth accumulation, should encourage entrepreneurship.

However, extant literature seemingly does not support proposals for using income tax cuts to encourage self-employment. (1) On one hand, one explanation of these findings is that potential entrepreneurs have less incentive to move out of wages jobs and avoid income taxes when these taxes are reduced. This offsets the positive effects of wealth accumulation on self-employment due to income tax cuts. On the other hand, research also finds that self-employment can be encouraged by wealth tax cuts. (2)

III. Data

I use data from the Survey of Small Business Finances 2003 (SSBF 2003) conducted by the Board of Governors of the Federal Reserve System on businesses with fewer than 500 employees. My main analysis excludes firms with unlimited liability because there is no clear distinction between entrepreneurs' firm wealth and out-offirm wealth without the protection of limited liability. Section V studies a sample that includes these unlimited liability firms and show that limited liability is an important factor that determines the relationship between outside wealth and financial leverage.

IV. Methodology

I hypothesize that entrepreneurs with more outside wealth use more leverage because they can absorb more risk of losing their firm investments. Therefore, I expect leverage to be positively related to DIV.

To estimate the effects of entrepreneurs' outside wealth on their firm-level financial leverage usage, my estimation model is:

[Leverage.sub.i] = [alpha] + [beta] * [DIV.sub.i] + [gamma] * [CV.sub.i] + [[epsilon].sub.i] (1)

in which Leveragei is the ratio of total loans to total assets for firm i. [DIV.sub.i] is the ratio of entrepreneur i's out-of-firm wealth to his total net worth. [CV.sub.i] is a vector of control variables. (4) [[epsilon].sub.i] is the error term. (5)

When some entrepreneurs use out-of-firm personal assets as collateral to obtain loans for their firms, that part of their personal assets is subject to the claims of the firms' creditors and is tied to their firms. I adjust out-of-firm assets by subtracting the amount of collateralized loans from the out-of-firm assets. DIV2 is the ratio of the adjusted out-of-firm assets to entrepreneurs' total net worth.

V. Results

Table 2 presents the mean, median, standard deviation, minimum, and maximum of key variables. The average DIV is 0.79, suggesting that, on average, 79 percent of owners' wealth is outside of their firms.

Table 3, Column 1 shows that the coefficient for DIV is approximately 0.830 at better than the 1 percent significance level, suggesting that the ratio of total loans to total assets increases by 0.830 percentage points when DIV increases by 1 percentage point.

This finding is consistent with the hypothesis that entrepreneurs who have more wealth outside their firms tend to use more leverage. (6)

Column 2 presents the estimation result of regression 1 using DIV2, the alternative measure of outside wealth. Column 2 shows that the coefficient of DIV2 is positive and significant at better than the 1 percent level, which is consistent with my prediction that entrepreneurs who have more personal wealth outside of their firms tend to use more debt financing. Using DIV2, I find that leverage increases by 0.425 percentage points as DIV2 increases by 1 percentage point. This result shows that the effect of outside wealth on leverage is reduced after adjusting for personal guarantees and out-of-firm assets as collateral because entrepreneurs actually tie more wealth to their firms than they seemingly do when using DIV.

I argue that limited liability is important because it allows risk taking without putting all of one's personal assets on the table. I use the generalized dummy variable technique developed by Gujarati (1970a, 1970b) to examine whether DIV has a different effect on leverage in firms with limited liability than in firms with unlimited liability. The modified model is:

[Leverage.sub.i] = [alpha] + [beta]1 * [DIV.sub.i] + [beta] * L[L.sub.i] + [beta]3 * [Interaction.sub.i] + [gamma] * [CV.sub.i] + [[epsilon].sub.i], (2)

where L[L.sub.i] is a dummy variable that is equal to 1 if firms are limited liability firms and 0 otherwise and Interactioni is the interaction term of DIV, and L[L.sub.;]. (7)

In Table 4, column 1 presents the estimation result of regression 2 that includes both limited and unlimited liability firms. The coefficient of DIV is not statistically different from zero, which suggests that outside wealth does not affect financial leverage in unlimited liability firms (L[L.sub.i] = 0) as expected. However, the coefficient of the interaction term is positive and statistically significant at better than the 1 percent level, which suggests that financial leverage is positively related to outside wealth for limited liability firms (L[L.sub.i] = 1). (8)

VI. Conclusion

Being able to keep your money matters. An entrepreneur's outside wealth affects his or her firm-level financial leverage. Limited liability also matters. While some authors argue that only taxes on wages matter for entrepreneurship, I find that outside wealth plays an important role in encouraging entrepreneurs' risk-taking, and wealth tax cuts enable more entrepreneurship.


Bartik, T. J. 1989. "Small Business Start-Ups in the United States: Estimates of the Effects of Characteristics of States." Southern Economic Journal, 5: 1004-18.

Blau, D. M. 1987. "A Time-Series Analysis of Self-Employment in the United States." Journal of Political Economy, 95: 445-67.

Bruce, D., and J. Deskins. 2012. "Can State Tax Policies Be Used to Promote Entrepreneurial Activity?" Small Business Economics, 38(4): 375-97.

Cole, R. 2013. "What Do We Know About the Capital Structure of Privately Held Firms? Evidence from the Surveys of Small Business Finance." Financial Management, 42(4): 777-813.

Cowling, M., and P. Mitchell. 1997. "The Evolution of U.K. Self-Employment: A Study of Government Policy and the Role of the Macroeconomy." Manchester School, 65: 427-42.

Frank, M., and V. Goyal. 2007. "Capital Structure Decisions: Which Factors Are Reliably Important?" Working paper, University of Minnesota and HKUST.

Georgellis, Y., and H.J. Wall. 2006. "Entrepreneurship and the Policy Environment." Federal Reserve Bank of St. Louis Review, 88(2): 95111.

Gujarati, D. 1970. "Use of Dummy Variables in Testing for Equality between Sets of Coefficients in Two Linear Regressions: A Note." American Statistician, 24(1): 50-52.

Gujarati, D. 1970. "Use of Dummy Variables in Testing for Equality between Sets of Coefficients in Linear Regressions: A Generalization." American Statistician, 24(5): 18-22.

Hausman, J. 1978. "Specification Tests in Econometrics." Econometrica, 46(6): 1251-71.

Kobe, K. 2007. The Small Business Share of GDP, 1998-2004. Small Business Research Summary No. 299. Washington, DC: Small Business Administration, Office of Advocacy.

Kreft, S. F., and R. S. Sobel. 2003. "Public Policy, Entrepreneurship, and Economic Growth." West Virginia University Department of Economics Working Paper 03-02.

Long, J. E. 1982. "Income Taxation and the Allocation of Market Labor." Journal of Labor Research, 3: 259-76.

Parker, S. C. 1996. "A Time Series Model of Self-Employment under Uncertainty." Economica, 63: 459-75.

Robson, M. T. 1998. "The Rise in Self-Employment amongst UK Males." Small Business Economics, 10: 199-212.

Survey of Small Business Finances Group. 2007. 2003 Survey of Small Business Finance Technical Codebook. Washington, DC: Division of Research and Statistics, Board of Governors of the Federal Reserve System.

Tianning Li

Hood College

(1) Some researchers have found that self-employment is positively related to federal income or payroll tax rates (Long 1982; Blau 1987; Parker 1996; Cowling and Mitchell 1997; Robson 1998), which supports the tax avoidance hypothesis. Georgellis and Wall (2006) find a U-shaped relationship between marginal individual income tax rates (federal plus state) and the proportion of working- age population as nonfarm proprietors. Bruce and Deskins (2012) suggest that state income taxes generally have no significant effects on entrepreneurial activities.

(2) Bartick (1989) suggests that property taxes are negatively related to small business start-ups. Kreft and Sobel (2003) show that growth rates in the number of sole proprietors are negatively related to the existence of inheritance taxes levied by states beyond the federal rate. Bruce and Deskins (2010) also find that the existence of a state-level estate, inheritance, or gift tax reduces a state's share of the national entrepreneurial stock. These findings, along with the work of Robson (1998), provide evidence that wealth accumulation plays an important role in encouraging self-employment.

(3) This paper's main analysis uses SSBF 2003 data, and it uses SSBF 1998 data as a robustness check.

(4) The control variables include firm i's financial statement variables (log of total assets, return on assets, liquidity, tangible assets, etc.), number of financial service providers, entrepreneurs' demographic information (experience, gender, and founder status), and firms' and entrepreneurs' personal creditworthiness. Table 1 defines the variables of regression 1.

(5) I assume heteroskedasticity and use robust standard errors in my regression.

(6) It is arguable that DIV might be endogenous. I run a Hausman test by using entrepreneurs' education as an instrumental variable. The test result suggests that endogeneity does not bias the regression result significantly. OLS (or WLS) is a more efficient approach than the two-state-least-square approach.

(7) The null hypothesis is that [[beta].sub.2] and [[beta].sub.3] are not statistically different from zero, which means the coefficients of [DIV.sub.i] and the intercepts are the same across limited and unlimited liability firms. This null hypothesis is consistent with the economic intuition that outside wealth affects entrepreneurs' willingness to use financial leverage only in limited liability firms; entrepreneurs' wealth is 100 percent tied to their firms in unlimited liability firms and thus does not affect the financial leverage on the firm level.

(8) As robustness checks, I exclude 85 firms that report partial year financial information and entrepreneurs that do not own more than 50 percent of the total shares. I also winsorize key variables at the 1st and 99th percentiles. Column 5, 6, and 7 show that the signs and magnitudes of DIV are comparable to those in my main analysis.
Table 1. Definitions of Variables

Variable                      Definition

Leverage                      Total loans divided by total assets

Outside Wealth (DIV)          The entrepreneur's out-of-firm wealth
                              divided by his total net worth

Outside Wealth 2 (DIV2)       The entrepreneur's out-of-firm wealth
                              adjusted for collateral divided by his
                              total net worth

Size                          Log of total assets

Growth Options (Employment)   Dummy variable for firms with
                              positive employment growth during
                              fiscal year 2003

Profitability                 Net income divided by total assets

Tangible Assets               Sum of inventory and book value of
                              land divided by total assets

Liquidity                     Cash divided by total assets

Firm Age                      Log of firm age

Financial Service Provider    The number of the firm's financial
                              service providers

Gender                        1 if the entrepreneur is female, 0

Founder                       1 if the entrepreneur is the original
                              founder, 0 otherwise

Owner Bankruptcy              1 if the entrepreneur declared personal
                              bankruptcy in the previous 7 years, 0

Firm Bankruptcy               1 if the firm declared bankruptcy in
                              the previous 7 years, 0 otherwise

Experience                    Log of the entrepreneur's experience
                              in his current business (in years)

Table 2. Summary Statistics

Variable                   Mean    Median   Std. Dev.   Min.    Max.

Leverage                    0.44    0.20    0.81         0.00    9.49
Outside wealth (DIV)        0.79    0.88    0.23         0.00    1.00
Outside wealth 2 (DIV2)     0.71    0.84    0.34         0.00    1.00
Size                       13.14   13.25    2.12         6.40   17.32
Growth Options              0.25    0.00    0.43         0.00    1.00
Profitability               0.73    0.14    2.26        -4.40   24.55
Tangible Assets             0.19    0.08    0.24         0.00    1.00
Liquidity                   0.21    0.11    0.25         0.00    1.00
Firm Age                    2.58    2.77    0.88         0.00    4.63

Table 3. Multivariate Results

                      1             2            3

                    SSBF          SSBF         SSBF
                    2003          2003          1998

Outside Wealth      0.830                      0.783

(DIV)            (13.84) ***                 (8.76) ***

Outside                           0.425

(DIV2)                         (12.44) ***

Constant            0.643         1.279        0.315
                 (2.58) ***    (5.75) ***      (0.93)

Observations        2,091         2,091        1,319

R-squared           0.11          0.10          0.08

                      4             5

                 SSBF 2003,    SSBF 2003,
                 No Partial    Winsorized

Outside Wealth      0.834         0.743

(DIV)            (13.85) ***   (11.62) ***



Constant            0.657         1.060
                 (2.58) ***    (4.07) ***

Observations        2,055         2,233

R-squared           0.11          0.109

Column 1 presents the regression 1 result, with Leverage as our
dependent variable, on the sample excluding credit-constrained firms
and outliers in SSBF 2003. Column 2 uses Outside Wealth 2 (DIV2),
which is the outside wealth to total wealth after adjusting for
collateral, as the alternative variable of interest. Column 3 shows
the regression 1 result using data from SSBF 1998. Column 4 shows the
regression 1 result excluding companies that report only partial year
financial information. Columns 5 shows the results of regressing
Leverage on Outside Wealth (DIV) by using the winsorized data.

** Significant at 10%; ** significant at 5%; *** significant at 1%.
Robust t statistics are in parentheses.

Table 4. Regression 2 (Test on Unlimited Liability Firms)

                                    1            2
                                  Pooled     Unlimited

Outside Wealth (DIV)              0.150        0.168
                                  (0.67)      (0.63)

Limited Liability Dummy (LL)      -0.415
                                (2.53) **

Interaction                       0 .700
                                (3.33) ***

Constant                          0.964        0.906
                                (3.19) ***   (1.88) *

Observations                       3206        1115

R-squared                          0.08        0.06

Column 1 shows the estimation result of regression 2 using the data
set of both limited and unlimited liability firms. The coefficient of
Interaction is positive and significant, suggesting that outside
wealth affects financial leverage only in limited liability firms
(Limited Liability Dummy = 1). The coefficient of Outside Wealth
(DIV) is not statistically different from zero, suggesting that
outside wealth does not affect financial leverage in unlimited
liability firms. Column 2 shows the estimation result of regression 1
using a subset of data that contains only unlimited liability firms.
The coefficient of Outside Wealth (DIV) is not statistically
different from zero, suggesting that outside wealth does not affect
financial leverage in unlimited liability firms. This is consistent
with the result in Column 1.

* Significant at 10%; ** significant at
5%; *** significant at 1%. Robust t statistics are in parentheses
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Author:Li, Tianning
Publication:Journal of Private Enterprise
Date:Mar 22, 2014
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