Taxation of Business Income

An NBER conference on Taxation of Business Income took place in Cambridge on October 3. Research Associates Joshua Rauh of Stanford University and Owen M. Zidar of Princeton University organized the meeting, sponsored by the Smith Richardson Foundation. These researchers' papers were presented and discussed:

Sebastian Bustos, Harvard University; Dina Pomeranz, University of Zurich; Juan Carlos Suárez Serrato, Duke University and NBER; Jose Vila-Belda; and Gabriel Zucman, University of California, Berkeley and NBER

Monitoring Tax Compliance by Multinationals Evidence from a Natural Experiment in Chile

Sabrina T. Howell, New York University and NBER, and Filippo Mezzanotti, Northwestern University

Financing Entrepreneurship through the Tax Code: Angel Investor Tax Credits

Many jurisdictions seek policy tools to stimulate high-growth entrepreneurship. Angel investor tax credits, which subsidize startup investment by wealthy individuals (i.e. "angels"), are an attractive option because they allow the market to "pick winners" and have relatively low administrative burdens. This paper studies these programs using state-level event studies and a within-program comparison of tax credit beneficiary firms with their rejected counterparts. Howell and Mezzanotti find no evidence that angel tax credits have significant effects on local entrepreneurial activity. The programs may have a limited effect in part because a large share of investor-company pairs benefiting from the tax credits do not suffer from the severe information asymmetry that is believed to cause financial constraints among early stage, risky, and potentially high-growth startups. Indeed, just 9.5 percent of beneficiary companies did not previously raise external equity, have no executive receiving an investor tax credit, and have activities related to the IT/Web/Computer sector.

Jennifer Blouin, University of Pennsylvania, and Leslie Robinson, Dartmouth College

Double Trouble: How Much of U.S. Multinationals' Profits are really in Tax Havens?

Scott R. Baker, Northwestern University and NBER; Stephen Teng Sun, Peking University; and Constantine Yannelis, University of Chicago and NBER

Corporate Taxes and Retail Prices

Baker, Sun, and Yannelis study the impact of corporate taxes on barcode-level product prices, using linked survey and administrative data. Their empirical strategy exploits the dichotomy between the location of production and the location of sales, providing estimates free from the endogeneity of state tax changes as well as confounding demand shocks. The researchers find significant effects of corporate taxes on prices with an elasticity of 0.27. The effects are largest for lower-price items and products purchased by low-income households. Approximately 41% of corporate tax incidence falls on consumers, suggesting that models used by policymakers significantly underestimate the incidence of corporate taxes on consumers.

Audrey Guo, Santa Clara University

The Effects of Unemployment Insurance Taxation on Multi-Establishment Firms

Guo investigates whether and to what extent state-level differences in business taxes influence the location decisions and labor demand of multi-establishment firms. In the United States each state administers its own unemployment insurance (UI) program, and cross-state variation leads to significant differences in the potential UI tax costs faced by employers in different states. Using U.S.Census data on the locations of multi-state manufacturing firms for identification, he finds that high tax plants were more likely to exit during economic downturns, and less likely to hire during the recovery. Moving a given plant's outside option from a high tax state to a low tax state would increase its likelihood of exit by 20% during the Great Recession. These findings suggest that decentralized administration of UI taxes may contribute to jobless recoveries and additional misallocation in the economy.

Chatib Basri, University of Indonesia; Mayara Felix, MIT; Rema Hanna, Harvard University and NBER; and Benjamin A. Olken, MIT and NBER, "Tax Administration vs. Tax Rates: Evidence from Corporate Taxation in Indonesia" (NBER Working Paper 26150)

Developing countries collect a far lower share of GDP in taxes than richer countries. Basri, Felix, Hanna, and Olken ask whether changes in tax administration and tax rates can nevertheless raise substantial additional revenue - and if so, which approach is most effective. They study corporate taxation in Indonesia, where the government implemented two reforms that differentially affected firms. First, they show that increasing tax administration intensity by moving the top firms in each region into "Medium-Sized Taxpayer Offices," with much higher staff-to-taxpayer ratios, more than doubled tax revenue from affected firms over six years, with increasing impacts over time. Second, using non-linear changes to the corporate income tax schedule, the researchers estimate an elasticity of taxable income of 0.59, which implies that the revenue-maximizing rate is almost double the current rate. The increased revenue from improvements in tax administration is equivalent to raising the marginal corporate tax rate on affected firms by about 23 percentage points. Basri, Felix, Hanna, and Olken suggest one reason improved tax administration was so effective was that it flattened the relationship between firm size and enforcement, removing the additional "enforcement tax" on large firms. On net, their results suggest that improving tax administration can have significant returns for developing country governments.

Cailin R. Slattery, Columbia University

Bidding for Firms: Subsidy Competition in the U.S.

In the U.S., states compete to attract firms by offering discretionary subsidies, but little is known about how states choose their subsidy offers, and whether such subsidies affect firms' location choices. Slattery uses an oral ascending (English) auction to model the subsidy "bidding" process and estimate the efficiency of subsidy competition. The model allows state governments to value both the direct and indirect (spillover) job creation of firms when submitting bids, and firms to take both subsidies offered and state characteristics into account when choosing their location. To estimate his model, Slattery hand-collects a new and unique dataset on state incentive spending and subsidy deals from 2002-2016. He estimates both the distribution of states' (revealed) valuations for firms that rationalizes observed subsidies, and firms' valuations for state characteristics. In order to allow states to value potential spillovers, Slattery estimates the effect of subsidy-winning firms' locations on the entry decision of smaller firms, using a discrete choice entry model. He provide the first empirical evidence that states use subsidies to help large firms internalize the positive spillovers, in the form of indirect job creation, they have on the states. Moreover, subsidies have a sizable effect on firm locations. In particular, Slattery finds that without subsidies approximately 68% of firms would locate in a different state, and the number of anticipated indirect jobs created would decrease by 32%. With subsidies, total welfare (the sum of state valuations and firm profits) increases by 22%, but this welfare gain is captured entirely by the firms.

Max Risch, University of Michigan

Does Taxing Business Owners Affect Their Employees? Evidence from a Change in the Top Marginal Tax Rate

Risch analyzes the role of the firm in mediating responses to income taxation. The majority of business income in the United States is earned by pass-through entities. He studies how a recent increase in the top marginal personal income tax rate faced by pass-through business owners affected the compensation of their employees. Risch uses a new linked owner-firm-employee dataset and panel difference-in-differences methods to compare the earnings of employees in similar firms, but whose owners were differentially exposed to the tax change. He estimates that approximately 18 cents per dollar of new tax liability was passed through to employee earnings. This resulted from lower earnings growth among employees attached to their firms, not compositional changes in employment. The results show behavioral responses to the business income taxation embedded in the personal income tax system and imply that the incidence of the personal income tax was not fully borne by those directly subject to the tax change.

Christine L. Dobridge, Federal Reserve Board; and Paul Landefeld and Jake Mortenson, Joint Committee on Taxation

Corporate Taxes and the Wage Distribution: Effects of the Domestic Production Activities Deduction

Dobridge, Landefeld, and Mortenson investigate how corporate tax changes affect workers' wages. To identify the effect, they use a unique dataset of U.S. worker-level W-2 filings matched with corporate tax returns and study the implementation of the Domestic Production Activities Deduction (DPAD). The researchers find a corporate tax rate reduction has a substantial effect on the distribution of within-firm wages. Wages of workers at the top of their firm's wage distribution rise relative to those at the bottom of the distribution. Dobridge, Landefeld, and Mortenson estimate a semi-elasticity of average wages of 1.1 with respect to the DPAD marginal tax rate reduction, while the change in the median wage is small and statistically insignificant. Furthermore, they estimate a semi-elasticity of 1.0 at the 95th percentile of workers' wages and 2.5 at the 99th percentile. These results are especially pronounced for small firms. Looking at overall employment effects, the researchers see no change overall, but the number of employees rises at small firms and declines at large firms. Their findings have implications for the progressivity of the U.S. tax code and for analyzing the effect of tax policy on the U.S. income distribution.

Enrico Moretti, University of California, Berkeley and NBER, and Daniel Wilson, Federal Reserve Bank of San Francisco

Taxing Billionaires: Estate Taxes and the Geographical Location of the Forbes 400

Moretti and Wilson study the effect of state-level estate taxes on the geographical location of the Forbes 400 richest Americans and its implications for tax policy. First, they use a change in federal tax law to identify the tax sensitivity of the ultra-wealthy's locational choices. Before 2001, there was no cross-state variation in effective estate tax rates on billionaire's estates due to a federal credit. This credit was phased out between 2001 and 2004, resulting in substantial variation between states with and without estate taxes. The researchers find the number of Forbes 400 individuals in estate tax states fell by 35% after 2001 compared to non-estate tax states. They also find that billionaire's sensitivity to the estate tax increases significantly with age. Second, using data on obituaries of Forbes 400 decedents and state-level estate tax revenues, Moretti and Wilson estimate the effective tax rate reflective of Forbes wealth mismeasurement, charitable and spousal deductions, and tax avoidance/mitigation measures. The effective rate is found to be a little over half of the statutory rate. Lastly, the researchers estimate the revenue costs and benefits for each state of having an estate tax, either just on billionaires or the population of federal estate taxpayers. The benefit is the one-time tax revenue gain when a wealthy resident dies, while the cost is the foregone income tax revenues over their remaining lifetime. Moretti and Wilson find that, despite the high estimated tax mobility elasticity, the benefit exceeds the cost for either a broad or billionaire-only estate tax for the vast majority of states. The cost-benefit ratio is higher for states with higher personal income tax rates.

Lucas Goodman, Katherine Lim, and Andrew Whitten, US Department of the Treasury, and Bruce Sacerdote, Dartmouth College and NBER

Impacts of the 199A Deduction for Pass-through Owners

The Tax Cuts and Jobs Act (TCJA) introduced a novel income deduction for owners of pass-through businesses: Section 199A. As of 2018, taxpayers are now generally able to deduct 20 percent of Qualified Business Income (QBI) from their taxable income. Thus, for the first time, business owners and the self-employed face lower effective tax rates than wage earners. Goodman, Lim, Sacerdote, and Whitten estimate behavioral responses to this 199A deduction on a wide range of individual and business outcomes using currently available administrative tax data for tax year 2018. These responses include (i) formation of new pass-through entities, (ii) shifting of S-corp owner compensation between W-2 wages and business profits, (iii) shifting partner compensation from guaranteed payments towards QBI, and (iv) movement from W-2 employee status to contractor status.

The provisions of the 199A deduction include limitations for high-income individual owners that are based on the business’s industry, amount of capital, and wages paid. These limitations phase out the deduction for some owners, enabling the researchers to construct comparison groups of similar individuals (and businesses) that are more and less likely to benefit from the 199A deduction. Specifically taxpayers above a phase-out range (for married filing jointly this starts at $315,000 and ends at $415,000) do not qualify for the deduction unless the pass-through business meets two tests: the business cannot be a Service Sector Trade or Business (SSTB; e.g., medical or legal services) and the deduction cannot exceed the lesser of 50% of the owner’s share of W-2 wages paid or the sum of 25% of wages paid plus 2.5% of the owner’s basis of qualified property.

Goodman, Lim, Sacerdote, and Whitten examine the creation of new pass-through entities using a weekly measure of applications for new Employer Identification Numbers (EINs) from 2013 to mid-2019. They test for trend breaks in seasonally adjusted applications for sole proprietorships, LLCs, S corporations, and partnerships following the passage of 199A. Preliminary results indicate there was no significant increase in new businesses with employees post-TCJA; however, the researchers do see a small increase in sole proprietorships with zero employees in 2018.

Goodman, Lim, Sacerdote, and Whitten examine the shifting of S-corp compensation from wages to QBI by constructing several difference-in-differences estimates. They compare outcomes before and after 199A for SSTBs vs. non-SSTBs, for owners above vs. below the 199A phase-out, for businesses with one vs. many owners, and for businesses whose deduction is constrained by the wage limitation vs. not. Preliminary findings suggest that those S corporations that have an incentive to increase wages under 199A (due to the above wage limitation) paid more wages in 2018 relative to those that have no such incentive.

Goodman, Lim, Sacerdote, and Whitten study guaranteed payments to partners within the set of SSTBs (where most guaranteed payments occur). They ask whether the fraction of partnerships offering guaranteed payments above a minimum level varies before vs. after 199A and above vs. below the 199A phase-out. SSTBs with owners below the income thresholds would have an incentive to pay partners in profits rather than guaranteed payments because only profits qualify for the deduction.

A key question surrounding 199A is whether more workers will be characterized as independent contractors rather than employees in order to capture the deduction. The researchers study this question by examining the trend in workers changing their status while working for the same firm (EIN) as well as the overall trend in workers changing their worker classification, including those that move between firms. First, Goodman, Lim, Sacerdote, and Whitten use the universe of workers who transition between employee (W-2) status and contractor (1099-MISC) status within the same paying EIN, which in 2016 represented over half a million workers. Next, they use a sample of individuals and characterize the baseline level of movement between independent contractors and employees. Goodman, Lim, Sacerdote, and Whitten ask whether the passage of 199A is associated with an increase in the number of employees who switch to contractor status. They also examine whether the changes between 2017 and 2018 differ between workers who are predicted to be above vs. below the 199A phaseout.

Overall Goodman, Lim, Sacerdote, and Whitten provide an early look into the effects of the pass-through deduction on taxpayer and business behavior in 2018.

Cailin R. Slattery and Owen M. Zidar

Evaluating State and Local Business Tax Incentives

Slattery and Zidar describe and evaluate state and local business incentives in the United States. They use new data sets at the firm and state level from Slattery (2019) to characterize these incentive policies, describe the selection process that determines which places and firms give and receive incentives, and then evaluate the economic consequences. In 2014, states spent between $5 and $216 per-capita on incentives for firms in the form of tax credits, job training, grant programs, and infrastructure spending. Recipients are usually large establishments in manufacturing, technology, and high-skilled service industries, and the average discretionary subsidy is $157M for 1,660 promised jobs. Firms accept deals from places that are richer, larger, and more urban than the average county, and poor places provide larger incentives and spend more per job. Comparing “winning” and runner-up locations for each deal in a bigger and more recent sample than in prior work, the researchers find that average employment within the 3-digit industry of the deal increases by nearly 2000 jobs. There is some weak evidence of employment spillovers and establishment entry within the broader sector, but there is no detectable impact on overall county-level employment or economic growth. At the state level, increases in incentive spending tend not lead to increases in establishment entry as poorer places are more likely to provide larger incentives. Overall, while Slattery and Zidar find some evidence of direct employment gains from attracting a firm, they do not find strong evidence in support of local tax incentives increasing broader economic growth at the state and local level.

NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us