The tax effect on taxable income from privately held businesses.

• Author: Wu, Shih-Ying

1. Introduction

   The implications of the tax elasticity of taxable income have been carefully discussed by Feldstein (1997, 1999). As he points out, the conventional approach to evaluating policy focuses on the substitution between labor and leisure, and it usually underestimates the actual deadweight loss because it ignores the effect of the income tax rate on tax avoidance and evasion. Taxpayers can reduce their tax burden through changes in the forms of compensation, through changes in the patterns of consumption, or even through tax evasion. The change in taxable income captures all aspects of an individual's behavioral responses, which include responses of labor supply, forms of compensation, patterns of consumption, and others. Hence, the compensated change in taxable income gives all of the information necessary for evaluating the deadweight loss of changes in the income tax rate.

   The total effect of a tax on government revenue is one of the concerns in designing a tax, and so most empirical studies on the tax elasticity of taxable income focus on taxpayers as a whole (see, e.g., Feldstein 1995; Auten and Carroll 1999; Long 1999; Moffitt and Wilhelm 2000). Nevertheless, the distinction between the tax elasticities of taxable income from different sources has implications for policy design. As described by Slemrod (1998), the characterization of an optimal tax system must include not only the tax rates, but also a variety of other instruments because the elasticity of taxable income depends on the design of other instruments such as the definition of a tax base as well as tax rates. Feldstein (1997) also indicates that in order to evaluate the efficiency effect of a tax change on taxable income, more evidence is required regarding the extent to which corporate income tax liabilities and personal income tax liabilities are affected by each other.

   One of the reasons for needing all the information above is that whether the existing excess burden of individual tax increases are overstated depends on the magnitude of the shift in income between corporate and personal tax bases (Gordon and Slemrod 2000). This study estimates the tax elasticity of taxable income from privately held businesses (hereafter PHBs) and, thus, provides information for understanding the behavioral responses of PHBs to tax changes. (1) Although PHBs have been discussed from various perspectives, the implications of the tax elasticity of taxable income from PHBs have been ignored. (2) Based on data from the motor carrier industry, Enis and Ke (2003) estimate the effect of a tax on the amount of corporate income that shareholders of privately held C corporations shifted to their personal income tax base, providing direct evidence of the magnitude of income shifting. In contrast, this study makes use of a sample of businesses, which are subject only to a personal income tax, and so the estimated tax elasticity of the taxable income is purged from the income shifting between corporate and personal income bases.

   The decision to establish or participate in privately held businesses is determined by the expected returns of managerial activity and the expected returns from tax avoidance and evasion. (3) The former depends on market structure, entrepreneurship, innovation, or the competitiveness of products. By contrast, the latter involves legal activities such as income shifting or illegal activities such as underreporting of taxable income. The existence of tax avoidance and evasion alters the tax elasticity of taxable income because the extent of tax avoidance and evasion affects the effective tax rate and the cost of investment. Although this study cannot distinguish real responses of labor supply and investment from avoidance and evasion responses to tax changes, an estimate of the tax elasticity of taxable income from PHBs has its own policy implications as noted above (Feldstein 1999).

   The remainder of this study is organized as follows. Section 2 illustrates the effect of a tax on taxable income from PHBs. Aside from considering the effect of real responses to tax on the taxable income from PHBs, this section also illustrates several avenues through which the ownership of PHBs facilitates avoidance and evasion activities. Section 3 develops a simple theoretical model to analyze the effect of a tax on PHB investment and taxable income. In particular, tax avoidance and evasion are incorporated in the model. Section 4 specifies an econometric model and describes the data set and the measurement of the variables used in the estimation. Section 5 presents and discusses the results of regressions. Section 6 concludes.

2. Effect of Tax on Taxable Income from PHBs

   Tax changes affect PHB income in various ways. In response to a tax change, households can adjust their investment and employment in PHBs. They can also change their effort in managing PHBs, affecting the returns of PHBs. Households can further take up avoidance or evasion activities in order to reduce their tax burdens.

   As noted above, potential entrepreneurship in PHBs has raised concerns about the effect of a tax on investment in PHBs. Carroll et al. (2000a) analyze the effect of sole proprietors' personal income taxes on their decisions to make capital investments. Based on panel data from individual income tax files for 1985 and 1988, they find that a 5 percentage point increase in marginal tax rates reduces the proportion of sole proprietors' new capital investment by 10.4%. Carroll et al. (2000b) investigate the effect of personal taxes on sole proprietors' hiring decisions and wage bills. Based on the same data, they find that an increase in personal income tax reduces both the probability of hiring and the wage bills paid. Their results imply that raising the sole proprietor's net-of-tax price by 10% raises the mean probability of hiring by about 12%, while the net-of-tax price elasticity of the median wage bill is 0.37. Therefore, the findings of Carroll et al. (2000a, b) indicate that a decrease in the tax rate causes sole proprietors to increase their investment and employment. The results also demonstrate that a tax decrease increases sole proprietors' before-tax income from their businesses.

   Bruce (2000, 2002) investigates the tax effect on the decision of an employee to become self-employed and the decision of a self-employed person to close the firm and take a wage-and-salary job. Based on data from the 1970-1991 waves of the Panel Study of Income Dynamics (PSID), Bruce (2000) finds that individuals with higher marginal tax rates when in self-employment are more likely to become self-employed. Bruce (2002) also demonstrates that a higher relative marginal tax rate on self-employment income does not necessarily increase the probability of exiting self-employment to take a wage-and-salary job. As he indicates, this somewhat confusing result is consistent with the concept that higher taxes--accompanied by lump-sum transfers--serve as insurance against the greater risk associated with self-employment. Overall, the findings in Bruce (2000, 2002) imply that individuals are more likely to become self-employed, which means participating in one form of PHBs in response to an increase in personal income tax rates.

   Households can also pursue avoidance or evasion activities to reduce their tax burdens. As noted by Andreoni, Erard, and Feinstein (1998), the extent of tax avoidance by participants in PHBs is likely to be relatively large because of the characteristics of PHBs and the lack of information on reporting. Households can engage in tax avoidance activities through legal arrangements. Such legal arrangements include income shifting, the selection of S corporation status, the use of net operating losses, and others. In contrast, illegal evasion can take the form of underreporting taxable income. A tax burden can be reduced by income shifting, which can be accomplished in many ways. Income can be shifted among members of the same household in the form of wage payment to individuals with lower tax rates to take advantage of the differences among their tax rates. Moreover, members of PHBs are able to take advantage of the standard deduction, which was originally intended for people of low income, by ensuring that every member of the family receives a minimum income from PHBs. Through income shiftings they can thus reduce the tax burden in their individual income tax returns.

   Businesses that frequently or continually incur tax losses, especially those in their starting period, can be organized as sole proprietorships, partnerships, or S corporations so that the owners can deduct the tax losses from their personal tax returns (Ayers, Cloyd, and Robinson 1996). The Tax Reform Act of 1986 (TRA86) reduced the possibility of offsetting losses by prohibiting individual taxpayers from offsetting losses from "passive activities," in which they did not actively participate, against either "active income" or "portfolio income" from other sources. Nevertheless, the losses from passive activities can still be offset against income from other "passive activities" (West Publishing Company 1986).

   PHBs, as well as other forms of businesses, can also take advantage of benefits such as "creative" interpretations of tax codes. For instance, a business owner is entitled to deduct all ordinary and necessary business expenses incurred in a trade or business, including any reasonable compensation paid to employees. Carefully combining the exclusion and deduction provisions enables employees to be provided with real economic benefits that are never taxed, while providing the employer with an immediate deduction that is equivalent to the costs of the benefits (Sommerfeld and Jones 1991). Such benefits include group-term life insurance, health and accident plans, meals, and lodging. Although some tax-sheltered opportunities are not available to the self-employed proprietor or partner...