Taxation and the quality of entrepreneurship

We study the effect of taxation on entrepreneurship, investigating how taxes affect both the number of start-ups and their average quality. We show theoretically that even with risk neutral agents and no tax evasion progressive taxes can increase entrepreneurial entry, while reducing average firm quality. So called “success taxes” encourage start-ups with lower value business ideas by reducing the option value of pursuing better projects. This suggests that the most common measure used in the literature, the likelihood of entry into self-employment, may underestimate the adverse effect of taxation.