How Much Do Taxes Discourage Incorporation ?

The double taxation of corporate income should discourage firms from incorporating. We investigate the extent to which the aggregate allocation of assets and taxable income in the U.S. between corporate and non-corporate firms responds to the size of this tax distortion during the period 1959–86. In theory, profitable firms should shift out of the corporate sector when the tax distortion is large, and conversely for firms with tax losses. Our empirical results provide strong support for these forecasts, and imply that the resulting excess burden equals 16% of business tax revenue. 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 in the U.S. 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 excess burdens 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 timevarying tax distortion. We do this using aggregate data, by industry, in the U.S. during the period 1959–86, then use our estimates to project the effects of the 1986 tax reform on the size of the corporate sector. 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 find that some non-tax-rate policy changes caused shifts in the predicted directions between various forms. The measured effects are relatively small, however. For instance, cutting the tax rate on non-corporate income by :10 is forecasted to cause .2% 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 3% of gains and 4% of losses toward the more favored forms of