We study the design of the optimal tax system in an economy with heterogeneous en- trepreneurs and workers. Entrepreneurs, in line with the current US law, choose their legal form of organization ...between a pass-through entity and a C corporation, which determines the way their business income is taxed. The model captures a key trade-off between these forms, C corporations face double taxation of profits and fixed costs of operation but have easier access to external capital and face less investment risk, relative to pass-through entities. Our economy generates endogenously through the selection mechanism the predominant position of the pass-through business owners, the capitalists of the 21st century, in line with the data. We compute and analyze the optimal fiscal policy under two revenue neutral scenarios: (i) current US legal restrictions on business income taxation (ii) uniform tax code for business income. Under the first scenario we find that the reform maximizing social welfare of the population imposes very high corporate income tax inducing sizeable switch of businesses towards pass-through firms, which has detrimental aggregate effects. Maximizing only entrepreneurial welfare instead implies almost a at tax rate on pass-through businesses and the wedge between average taxes for two types of businesses. The optimal policy under the uniform tax code for business income strictly dominates in terms of welfare the optimal policy computed under the current legal framework. Maximizing only entrepreneurial welfare in this case calls for significant reduction of business income tax and shifting the economic activity towards C corporations, which improves the allocation of capital and labor in the economy and drives the aggregate output up.
Working Paper No. 21644 The non-pecuniary benefits of managing a small business are a first order consideration for many nascent entrepreneurs, yet the preference for business ownership is mostly ...ignored in models of entrepreneurship and occupational choice. In this paper, we study a population with varying entrepreneurial tastes and wealth in a simple general equilibrium model of occupational choice. This choice yields several important results: (1) entrepreneurship can be thought of as a normal good, generating wealth effects independent of financing constraints, (2) non-pecuniary entrepreneurs select into small scale firms, (3) subsidies designed to stimulate more business entry can have regressive distributional effects. Despite abstracting from other important considerations such as risk, financing constraints, and innovation, we show that non-pecuniary compensation is particularly relevant in discussions of small businesses.
Selection and the Role of Small Business Owners in Firm Dynamics: What makes small businesses small? Standard theories attribute size differences to efficiency, access to credit, or some combination ...of the two. I present new evidence on persistent earnings differentials of business owners relative otherwise similar wage and salary workers that are difficult to explain with these two sources of heterogeneity. I develop and evaluate a Hopenhayn (1992) style model of firm heterogeneity with an occupational choice, and I introduce varying preferences for business ownership consistent with the non pecuniary motives documented in Hurst and Pugsley (2011). The model nests both efficiency- and credit-based accounts of firm heterogeneity, and it allows me to isolate the role of each mechanism. I show how ignoring preference heterogeneity leads to an overestimate of the tightness of borrowing constraints and a miscalibration of the productivity process, in particular for small businesses. Finally, I evaluate an implication of the model when extended to sectors with varying fixed costs. Low fixed cost sectors will have a greater concentration of taste-driven business owners and thus larger earnings differentials. Empirically, I find evidence for this result when I compare earnings differentials in the services and manufacturing sectors. Are Household Surveys Like Tax Forms: Evidence from Income Underreporting of the Self-Employed: This chapter is joint work with Erik Hurst and Geng Li. There is a large literature showing that the self-employed underreport their income to tax authorities. In this paper, we quantify the extent to which the self-employed also systematically underreport their income in U.S. household surveys. To do so, we use the Engel curve describing the relationship between income and expenditures of wage and salary workers to infer the actual income, and thus the reporting gap, of the self-employed based on their reported expenditures. We find that, on average, the self-employed underreport their income by about 25 percent. This result is remarkably robust across data sources and alternative model specifications. We show that failing to account for such income underreporting leads to biased conclusions in existing measures of earnings and wealth differentials between the self-employed and wage and salary workers, precautionary savings, lifecycle earnings profiles, and earnings variation across MSAs. Our results also suggest that it is naive for researchers to assume that individuals will provide unbiased information to household surveys given their demonstrated tendency of providing distorted reports of the same information to administrative agencies.
From 1980 to 2012 the share of U.S. business receipts from businesses organized as pass-through entities (for example LLCs and S-corporations) rather than traditional C-corporations nearly triples. ...This paper investigates the origins of the secular rise of pass-throughs and evaluates it's macroeconomic consequences. We exploit the panel dimension of the administrative data from the Longitudinal Business Dynamics dataset to document a number of facts characterizing the pass-throughs and C-corporations and to estimate the transition matrices between the legal forms. We show that the entry margin and switching margin account for the most of the rise of pass-throughs. Further, using the Statistics of the U.S. Businesses we argue that the shift in the distribution of organizational forms is related to the structural transformation of the U.S. economy and to some other economic forces, such as rise in the dispersion of productivities, which account for within-sector increase of pass-throughs role. We quantify the impact of different economic forces using the structural macroeconomic model, in which entrepreneurs in both sectors choose endogenously the legal form of organization. We proceed to evaluate the macroeconomic consequences of growing importance of pass-through businesses for the U.S. economy with particular focus on the role of microeconomic heterogeneity for macroeconomic outcomes, propagation of aggregate shocks, misallocation and finally welfare.
Working Paper No. 17041 In this paper, we show that most small business owners are very different from the entrepreneurs that economic models and policy makers often have in mind. Using new data that ...samples early stage entrepreneurs just prior to business start up, we show that few small businesses intend to bring a new idea to market. Instead, most intend to provide an existing service to an existing market. Further, we find that most small businesses have little desire to grow big or to innovate in any observable way. We show that such behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs. Lastly, we show non pecuniary benefits (being one's own boss, having flexibility of hours, etc.) play a first-order role in the business formation decision. We then discuss how our findings suggest that the importance of entrepreneurial talent, entrepreneurial luck, and financial frictions in explaining the firm size distribution may be overstated. We conclude by discussing the potential policy implications of our findings.
From 1980 to 2012 the share of U.S.~business receipts from businesses organized as pass-through entities (for example LLCs and S-corporations) rather than traditional C-corporations nearly triples ...following a sequence of tax reforms that reduced the tax rate on business income that "passes through" to an entrepreneur's individual income tax form. We show this shift in the pattern of business organization is economically significant. We provide novel evidence, using firm-level administrative data, that the tax reforms had significant effects on the employment dynamics of the US firms. We also propose a reduced form decomposition of data from the Survey of Consumer Finances, which reveals the increase in pass through entities explains over 50 percent of the increase in the share of pre-tax income for the top 1 percent of households. Importantly, this increase is not just accounting: there is an economic trade-off when choosing a legal form that affects the investment behavior of the entrepreneurs. We develop a heterogeneous agent equilibrium model with workers, entrepreneurs and endogenous choice of legal forms to capture a key trade-off between tax benefits and diversification of investment risk. We test the model using confidential firm-level microdata from the U.S.~ Census, and with the model calibrated to capture the actual firm dynamics across legal forms following several tax reform episodes, we quantify the contribution of tax reforms through the business reorganization channel on the evolution of income, wealth and consumption inequality of workers and entrepreneurs.
The non-pecuniary benefits of managing a small business are a first-order consideration for many nascent entrepreneurs, yet the preference for business ownership is mostly ignored in models of ...entrepreneurship and occupational choice. In this paper, we study a population with varying entrepreneurial tastes and wealth in a simple general equilibrium model of occupational choice. This choice yields several important results: (1) entrepreneurship can be thought of as a normal good, generating wealth effects independent of any financing constraints, (2) non-pecuniary entrepreneurs select into small scale firms, (3) subsidies designed to stimulate more business entry can have regressive distributional effects. Despite abstracting from other important considerations such as risk, financing constraints, and innovation, we show that non-pecuniary compensation is particularly relevant in discussions of small businesses.
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