Responses of the Self-Employed to the 2001 Tax Act

The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced individual income tax rates for most taxpayers. The conventional wisdom, and evidence from earlier reductions in marginal tax rates, suggests that such reductions are associated with expansions of small businesses. In this paper I investigate how the business decisions of self-employed taxpayers responded to the 2001 rate cuts. I use a five-year panel of tax return data, beginning in tax year 1999, and I instrument for tax changes by applying post-reform tax law to pre-reform reported income. I find no evidence that the 2001 tax cuts are associated with an increase in the probability that a self-employed person hires workers, or with an increase in gross receipts of the business. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) lowered taxes for most taxpayers. Gale and Potter (2002) estimated that the average federal tax rate would fall from 26.3 percent to 24.1 percent, and that the largest tax cuts would be experienced by those at the top of the income distribution. Some changes originally scheduled to be phased in over a number of years were accelerated by the Jobs and Growth Tax Relief Reconciliation Act of 2003. Upon signing the 2003 bill, President Bush stated, “Today we are taking essential action to strengthen the American economy...We’re helping small business owners looking to grow and to create more new jobs.” In this paper I use a panel of tax return data from 1999 ∗Department of Economics, Williams College. This paper uses data generously made available to me by the staff of the Joint Committee on Taxation. The views presented are those of the author and should not be attributed to the staff of the Joint Committee or to any member of Congress. I have benefited from the comments and assistance of many JCT staff members, and of my discussant, Kate Harper. I owe particular thanks to Jim Cilke for constructing the tax calculator used here. Kiefer et al. show that the size of the 2001 tax cuts also differed with demographics. Married taxpayers experienced larger cuts than single taxpayers, due to marriage penalty relief provisions. Tax cuts were larger for filers with dependent children, due to the expansion of child-related credits.