How Much Do Taxes Discourage Incorporation ? by Je rey

One of the most basic distortions created by the double taxation of corporate income is the disincentive to incorporate. In this paper, we investigate the extent to which the aggregate allocation of assets and taxable income in the U.S. between corporate vs. non-corporate forms of organization during the period 1959--86 has responded to the size of the tax distortion discouraging firms from incorporating. In theory, profitable firms should shift out of the corporate sector when the tax distortion to incorporating is larger, and conversely for firms with tax losses. Our empirical results provide strong support for these theoretical forecasts, and hold consistently across a wide variety of specifications and measures of the tax variables. The economic magnitudes of the effects are small, however, throwing doubt on the economic importance of tax--induced changes in organizational form. Address. Department of Economics, University of Michigan, Ann Arbor, MI 48109-1220. Email: MacKie-Mason: [email protected]; Gordon: [email protected]. How Much Do Taxes Discourage Incorporation? Jeffrey K. MacKie-Mason and Roger H. Gordon One of the most basic distortions created by the double taxation of corporate income is the disincentive to incorporate. However obvious this distortion may be, most papers investigating the distortions created by the corporate tax have taken as exogenous a firm’s choice whether or not to incorporate, assuming for example that some industries are inherently corporate while others are inherently non-corporate. A variety of nontax factors, described below, can certainly influence a firm’s choice of organizational form, causing some to favor incorporating and others not. But are these nontax factors so dominant that taxes do not in practice influence a firm’s choice of organizational form? As Gravelle and Kotlikoff (1989, 1990) emphasize, tax--induced changes in firms’ choices of organizational form in principle can create large excess burdens. The size of these distortions in practice depends on the extent to which firms respond to these tax incentives. In this paper, we calculate how the tax distortion discouraging firms from incorporating has varied over time, then estimate the extent to which the allocation of assets and taxable income between corporate vs. non-corporate forms of organization has shifted in response to this time--varying tax distortion. We do this using aggregate data, by industry, in the U.S. during the period 1959--86. In theory, taxes should induce profitable firms to shift out of the corporate sector when the tax distortion to incorporating increases, and conversely for firms with tax losses. Our empirical results provide strong support for these theoretical forecasts, and hold consistently across a wide variety of specifications and measures of the tax variables. We also found that some non--tax--rate policy changes caused shifts in the predicted directions between various forms. The measured effects are small, however, throwing doubt on the economic importance of tax--induced changes in organizational form. For instance, cutting the tax rate on non-corporate income by :10 is forecasted to cause no more than one--half of one percent of total assets to shift out of corporate form. The effect is larger for the location of taxable gains and losses, with the same tax change leading to a shift of approximately 5% of gains and losses toward the more favored forms of organization. Overall, non-tax determinants of organizational form appear to dominate, though further research will be needed to determine which factors are most important. In this paper we examine theoretically how the tax law distorts a firm’s choice of organizational form. We also discuss some non--tax factors that are believed to affect the choice of organizational form. We then examine We are grateful to Laura Kalambokidis, Linda Burilovich, Sharon Parrott, David Eaton, Tracy Hudson, Steve Pincus, Bill Boyle from the IRS, and especially Jane MacKie-Mason for assistance in creating the data set for this paper. Yong Yang provided superb econometric support. We have had helpful discussions with Jane Gravelle, Joel Slemrod and Mark Wolfson and seminar participants at NBER, Stanford Business School, Hoover Institution, UC Berkeley, UCLA, Rochester Business School, Toronto, and Michigan. Financial support for the data collection was provided by the Office of Tax Policy Research and the Rackham Graduate School at the University of Michigan. The paper was written while MacKie-Mason was a National Fellow at the Hoover Institution. Previous versions of this paper were circulated with the title ‘‘Taxes and the Choice of Organizational Form.’’ 1 As shown below, to yield the large excess burden simulated by Gravelle and Kotlikoff (1989, 1990) requires asset shifts that are nearly 30 times as large.