Designing policy aimed at encouraging entrepreneurial activity

Lead Research Organisation: Institute for Fiscal Studies
Department Name: IFS Research Team


Over the last decade, 40% of the growth in the UK's workforce has come from people working for their own businesses. On the face of it, this would appear to be a good thing as it is commonly believed that small businesses are the engines of growth and employment. However, the data reveal huge variation in the small business population: most do not employ people nor invest; 60% of the newly self-employed exit within four years; the UK has a well-documented long tail of low productivity businesses. Part of the rise in the number of business owners reflects growing numbers working in so-called 'gig economy' jobs, leading to concerns that work is becoming more precarious.

The UK tax system strongly encourages work to be conducted through self-employment or incorporation rather than through employment. The UK is not alone in having tax policies explicitly aimed at encouraging entrepreneurship by boosting small business start-up and growth: many governments do this. There are some sensible rationales for encouraging entrepreneurship: the trial of new ideas (even if they fail) can have benefits to wider society, and some entrepreneurs have difficulty financing investments. These factors lead the market to produce fewer entrepreneurs than would be socially desirable. However, in practice, polices tend to be poorly motivated by vague notions that we need more small businesses or more risk taking because they are good for growth. It is difficult for policy to precisely target 'entrepreneurial activity' and poor targeting leads to unintended consequences, such as the relabelling of activities, tax avoidance, inequalities between workers doing similar types of work, and distorting people's decisions over their type of work.

This research will provide a comprehensive study of how specific features of the tax and broader policy environment affect the decision to start a business, including how to organise that business (e.g. to incorporate or not), and the ongoing decisions (such as investment) that affect subsequent growth and survival. We will use and develop state-of-the-art techniques in combination with novel panel data from UK administrative tax records.

Two considerations will be key to our research. First, the effect of policy cannot be studied adequately at a snapshot in time: an individual's choice today about whether to start a business will depend on his/her expectations of its future productivity, the investments he/she might make, and how policy encourages or discourages these future decisions. We will explicitly model the interdependence of these decisions and how this affects the conclusions drawn about the efficacy of different policies.

Second, it is crucial to explicitly account for the big differences in people's behaviour and responses to the policy environment. For example, someone operating as a self-employed electrician is likely to behave differently to an individual attempting to design and market a new product. Someone embarking on a brand new venture with highly uncertain success is likely to be more concerned about the insurance offered by the tax and benefit system than someone who faces much lower risk and earnings uncertainty. We will put these differences across people at the core of analysis.

Our overarching goal is to provide robust empirical evidence on how polices can be better targeted at correcting the market failures associated with entrepreneurship and how unintended costs can be minimised. We anticipate this research will make substantial academic contributions; we will maximise the impact of our work by publishing in top international peer-reviewed journals. A key objective of this research is to provide evidence that will directly inform policy. We will relate our findings to the design of specific policies that are of interest to policy makers. We will provide non-technical accessible outputs for a wider audience, and engage directly with policy-makers and stakeholders.

Planned Impact

A key objective of this research is to provide evidence that will directly inform policy in the UK and elsewhere. The foundation of this evidence will be frontier academic research that uses state-of-the-art techniques and novel data. While this will be of independent interest to a broad range of academics and researchers (described in 'Academic Beneficiaries'), we see it as vital that the lessons are communicated to policy makers and users in ways that relate empirical findings to specific policy levers. The IFS has an unparalleled track record in communicating directly to policy makers as well as to the broader policy community. We describe our strategy in 'Pathways to Impact'.


Our results will be of direct relevance and use to those involved in making policy (including civil servants, advisors and politicians), and through this, those affected by the policy-making process. Our research sits at the intersection of topical policy debates, including the desire to encourage entrepreneurial activity and its associated benefits, concerns about tax avoidance, particularly among high income individuals, and issues about the changing nature of work and the growth in the 'gig economy'.

There is considerable evidence of UK policymakers' direct interest in these topics. For example, concerns relating to the changing nature of work and rise in self-employment led the government to commission the Taylor Review, which concluded that the current tax structure "is not justified, or sustainable, nor is it conducive to the goal of a good work economy". In 2017 the government tried to amend self-employed tax rates in order to reduce tax avoidance and although they U-turned following political backlash, the Chancellor has said he "continues to believe that" reducing the tax differences between legal forms "is the right approach". However, any policy reforms must be balanced against the desire, stated explicitly in the government's Industrial Strategy, to have a "tax environment that rewards entrepreneurship". Our project will directly inform these issues, including the trade-offs involved in creating a tax system that incentivises entrepreneurship while also reducing opportunity for tax motivated changes in behaviour. The research will inform our ongoing discussions on the effects of policy on business start-up and growth with senior civil servants, including at HM Treasury and HM Revenue and Customs.

User community

As evidenced by the 2017 UK policy U-turn, the success of reforms depends not only on providing robust evidence and achieving buy-in from policy makers but also in ensuring that evidence and understanding is shared with the wider policy community. Understanding the drivers of self-employment and finding policy levers that support entrepreneurial activity without encouraging precarious forms of work in the gig economy is of interest to many groups, including: tax and accounting practitioners and the associated professional bodies (the Chartered Institute for Taxation and institutes of chartered accountants, ICAEW and ICAS); employment lawyers; representative bodies for business of all sizes, such as the Federation of Small Business and representatives of the self-employed (IPSE) and contractors (PRISM); unions; other third sector organisations and think tanks. These groups are already heavy consumers of IFS' work and would benefit from the access to the new evidence and policy advice that this project will produce.


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Kate Smith (2019) Newspaper article by Kate Smith in "Expensive, distortionary and inequitable: time to sort out the way we tax business owners"

Description A key aim of our research is to impact the design of tax policy, and, specifically, how it applies to business owners. An important finding of our work is that owner-managers of closely held incorporated businesses retain significant profits within their companies when faced with higher personal tax rates on dividend income. This allows them to take advantage of preferential capital gains tax treatment ('Entrepreneurs' Relief') when they liquidate their company. We find that this profit retention does not lead to higher capital investment in small businesses, but does allow business owners to significantly reduce their tax liability. These tax savings are particularly large for higher income business owners and thus reduce the overall progressivity of the tax system. This research has been influential with policymakers - both the PI and Co-I have had discussions with members of the relevant teams in HMT and HMRC about reforms to the system. The UK government directly cited our findings in the March 2020 Budget, which reduced the lifetime amount of gains eligible for Entrepreneurs' Relief and renamed it Business Asset Disposal (BAD) relief.
First Year Of Impact 2020
Sector Government, Democracy and Justice
Impact Types Economic

Description Kate Smith, Discussion with civil servants at HMT about how company owner-managers respond to tax
Geographic Reach Local/Municipal/Regional 
Policy Influence Type Participation in a advisory committee
Impact Fed into the reform of Entrepreneur's Relief in the March 2020 Budget (more details in Impact Narrative).
Description Observation, "Low rates of capital gains tax on business income lead to large tax savings but do not boost investment" by Kate Smith, Helen Miller 
Form Of Engagement Activity Engagement focused website, blog or social media channel
Part Of Official Scheme? No
Geographic Reach Local
Primary Audience Policymakers/politicians
Results and Impact Our new research shows that company owner-managers respond to changes in income taxes by adjusting how and when they take money out of their company and not by changing the amount of income they create or how much investment they do.
Year(s) Of Engagement Activity 2019