Taxes Don't Determine Rates of Entrepreneurship, So Let's Determine What Does

The Kauffman Foundation just released a report on Entrepreneurship that, among other things, gives the rate at which people in each state have started businesses. I was tickled to see that Montana topped the list of states; not only that, but even among the metropolitan regions, only the Bay Area (San Francisco, et al) had a higher rate of entrepreneurship than Montana. (It's a good year for Montana. This year they bumped Colorado from number one on the list of fittest states, as measured by average body fat percentage.)

The top 5 states for entrepreneurship are:
1. Montana
2. Alaska
3. South Dakota
4. California
5. Colorado

The bottom 5 are:
51. Iowa
50. Rhode Island
49. Indiana
48. Minnesota
47. Washington

Of course the sum of Republicans' argument is that the less that government interferes with business, the lower governments keep tax rates, the more business formation and job creation there will be. And it's true that Alaska and South Dakota - number 2 and 3 on the list - have no state income tax, which would seem to buttress the Republican argument. Further, the worst state - Iowa - has a pretty hefty tax rate of nearly 9%. So points go the GOP for that.

But then the simplicity of this argument wanes in the face of facts as we look at the rest of the list. California has the highest tax rate of any state and is ranked 4th. Additionally, Washington state  has a zero rate and is still 5th from the bottom.

So what does the relationship between state income tax rates and rates of entrepreneurship look like? If Republicans' are right, we see should at least a rough correlation between a state's tax rate and its rate of business formation. Here's a graph that shows the relationship between the two variables:

The line that Exel fits to this data does slop downwards - suggesting that as tax rates go up, the rate of business formation falls. The Republicans are right. If everything else were equal, entrepreneurs would choose to start a business in a state with lower taxes.

But it also turns out that this relationship seems to explain only 1% of the difference in rates of entrepreneurship. Polls have suggested - as does this data - that taxes aren't very important in the list of consideration for aspiring entrepreneurs.They're more interested in finding a place where they themselves want to live and where they can find good employees. It's true that low taxes that leave more money in their pocket are likely to attract them. It's also true that low taxes that leave a community unable to provide a great education or high quality of life are likely to repel entrepreneurs. On their own, taxes simply aren't much of a determinant of where businesses get started.

Arguing for lower taxes is akin to saying, "We don't have a clue why entrepreneurs choose, or emerge out of, some communities but not others." Or more precisely, "We can explain about 1% of why states differ."

Communities serious about increasing the rate of entrepreneurship - and that should include any community serious about job and wealth creation - should first admit that the problem is more complicated than the simple matter of tax rates and then dive into discovering what does. The longer they waste time debating a dead issue, the longer they'll defer a genuinely profitable discussion.