04/12/2011 10:13 am ET Updated Jun 12, 2011

Cutting Taxes Will Boost Entrepreneurship: Kauffman Foundation

What's the secret sauce for job creation? Step one is to identify who actually creates jobs (hint: entrepreneurs), and it seems like all parties in Washington finally agree on this one. Step two is to find the best way to, if you can forgive the term, stimulate them.

Imagine my surprise when a colleague sent me a congratulatory email for being cited in the 2011 Economic Report of the President on step one. Democrats historically look out for workers, while Republicans tend to look out for corporations. The problem is, entrepreneurs are neither and/or both at once. Chapter seven of this year's ERP is fully dedicated to the issue of entrepreneurship, and I was tickled that my paper -- part of the Kauffman Foundation's series on job creation -- was mentioned.

In that paper, I traced a relatively new government series that lets us track job creation not just by company size and location but by age. That means for the first time ever, these "Business Dynamics Statistics" from the Census Department can confirm how important young firms, even brand new startups, are in the big picture. As a former frequent founder, I was confident entrepreneurs are responsible for a sizeable portion of the roughly 175,000 jobs per month created on average in America over the last forty years. I would have guessed 30-40 percent. I really believed that startups don't just drive innovation, we drive jobs, too. As Carl Schramm, the Kauffman Foundation's president says, startups "punch above their weight."

But even I was surprised by the reality revealed by the data. It's not just 40 percent, not just 60 percent, not even 100 percent. It turns out that startups -- American companies in their first year of existence -- create 150 percent of new jobs in the U.S. How can that be? Easy, since existing firms lose jobs, across the board. Startups create an average of 3 million jobs. Existing firms lose an average of 1 million. As you might guess, existing firms lose millions more during downturns, whereas startups keep charging ahead.

Now that that's settled, there's just one problem with the truth in Washington. You can have all the facts on your side, but if you don't have a lobbyist, the deck is stacked against you. Unlike big business and big labor, newly birthed firms will never be organized enough to lobby for their point of view in the halls of Congress. Startups will never have the capacity to throw fundraisers for incumbents in 2012. How could they, since next year's startups don't even exist yet?

It's up to Senators and Representatives to study the issue and to simply do the right thing. Hey, stop laughing. I'm sure there are some elected representatives out there who still care about the right thing. In fact, one state legislator asked me earlier this year to testify before his fellow members on this issue. It was almost funny when one of the seasoned legislators was incredulous that nobody had told him this news before. He'd been whispered to for decades that this and that targeted spending program to stimulate industry X or sector Z was the way forward.

Now the search is on to identify what policies will actually benefit startups.

What I'd like to do here is reveal the one proven -- if not altogether secret -- policy that is guaranteed to promote startup job creation. And forgive me for the change of punditry pace, but this is founded on empirical research, not comfortable ideology (though it may look so.)

So, here it is: Cut Taxes.

Actually, the formula is more complicated than that. Often Congress will "cut taxes" by offering a targeted tax credit for a special interest (e.g., cherry-flavored solar panels). But such good intentions will pave the way to fiscal doom. Just ask Alan Simpson and Erskine Bowles. Those gentlemen co-chaired the President's fiscal commission and did the nation a great service with their recommendations that balancing the budget was inseparable from fundamental tax reform. This means gutting the layers of tax expenditures, even your cherished mortgage interest deduction.

Ed Prescott, the Nobel-awarded economist, observed over a decade ago that the path to prosperity is not so much paved by government. Rather, that the absence of "barriers to riches" makes some environments more growth-friendly. This philosophical outlook has ample room to grow in the minds of Congress, to say the least. Less is more.

To understand the barriers to startups, put yourself in the shoes of a potential American entrepreneur. Half a million Americans start a new company each year. They typically hire five employees, in addition to themselves. At its heart, this startup leap is a choice between safe employment and risky adventure. While the myth that most startups fail dissuades many, the loss of stability, of steady pay, of health insurance, are not. But every ounce of policy that makes employment at a steady job even more of a comfort zone makes the startup choice less likely.

Congress does the economy no favors by "protecting" workers from employers with heavy labor regulations and high corporate taxes. But the taxes entrepreneurs fear most are not corporate, since many startups these days are sole proprietorships or Limited Liability Companies (LLCs). They pay individual taxes, the good old 1040, not corporate taxes. More often than not, they're paying the top marginal rate.

The theory is that when the top marginal tax rate goes up, entrepreneurship goes down. In 2000, Glenn Hubbard and Bill Gentry examined tax records and found that higher progressivity lowers the probability of an individual choosing entrepreneurship over corporate employment. A year later, Bob Carroll and co-authors found that entrepreneurial profits were lower in states with higher marginal tax rates.

Over the last couple of years, I've been conducting economic experiments to see if progressive taxes affected entrepreneurial behavior, and early (unpublished) results confirm the empirical studies, with a surprising twist: Making taxes more progressive (that is, raising tax rates on the rich while lowering them for everyone else) lowers the incentive for people to take risks that might make them rich. But the surprise was that higher flat-rate taxes had no effect on entrepreneurial behavior.

The facts point to a solution sure to please no one. Taxing the rich will hurt the economy, but raising taxes on everyone won't. The implication is that Congress could adopt a flat tax with a relative high rate and actually enhance job creation while helping to balance the budget.

It's not magic. It's economics.