The impact of personal income tax rates on the employment decisions of small businesses

Published date12 March 2018
Pages74-104
DOIhttps://doi.org/10.1108/JEPP-D-17-00030
Date12 March 2018
AuthorKathleen Grace
Subject MatterStrategy,Entrepreneurship,Business climate/policy
The impact of personal income
tax rates on the employment
decisions of small businesses
Kathleen Grace
Department of Accounting, Business and Finance, Wofford College,
Spartanburg, South Carolina, USA
Abstract
Purpose Small businesses file taxes in accordance with the personal income tax code because they are
considered flow-through entities. Thus, personal income tax reforms directly affect the incentives small
business owners face regarding employment and operations. The paper aims to discuss these issues.
Design/methodology/approach The authors use the changes in personal income tax rates during the
1993 and 2001-2003 reforms and micro-level data to estimate the effect of statutory tax rate changes on small
business employment decisions.
Findings The authors add two contributions to the current literature: first, the author allow for
intertemporal tax planning and second, the author allow the firms decision to employ labor to be correlated
with the firms wage bill decision. Estimation of a Heckman selection model for wage bills shows that the
probability that a business will employ labor is 1.18 percent higher when current tax rates increase by one
percentage point and 0.70 percent lower when future rates are expected to increase by one percentage point.
Among firms that already employ labor, the median wage bill elasticity with respect to current tax rates is
0.64. These estimates are larger than those reported in previous research because my model includes future
taxes and allows for correlation between the firms employment and wage bill decisions. Omitting the
intertemporal tax responses biases the estimates of previous researchers upwards, whereas assuming the two
firm decisions are independent biases estimates towards zero.
Originality/value This paper has been cited in publications published in Journal of Entrepreneurship
and Public Policy.
Keywords Employment, Smallbusiness, 1993 tax reform, 2001 tax reform, Elasticity of demand for labor,
Heckman, Intertemporal tax planning,Personal income taxes, Schedule c,Tax changes, Wage bill
Paper type Research paper
1. Introduction
Small businesses are considered flow-throughentities for income tax purposes.
The business owners wage income and business profits are taxed at the same marginal
rate. Business owners can use their own labor solely or in conjunction with outside labor, a
tax-deductible business expense, in the operations of the firm. Changes in tax rates affect the
firm in two distinct ways: by altering the returns of the entire business entity and by
inducing relative price changes in the production mix between outside labor and the owners
labor. When tax rates increase, the returns to the business decrease and production and
labor demand decline through the scale effect. However, the price of outside labor falls
relative to owner labor, so that if the owners effort can be replaced by employed labor, the
substitution effect may lead small firms to employ more outside labor.
Small businesses constitute a large portion of the US economy. Roughly 7.5 percent of all
workers, or 10.3 million people, were self-employed in 2003, and an additional 4.9 million
people owned an incorporated business while reporting wages from another job
(Hipple, 2004). Small businesses account for a vast percentage of new job creation. Birch
(1987) estimates that firms with fewer than 20 employees accounted for 82 percent of new
job creation between 1981 and 1985[1].
The effect of personal marginal income tax rates on the employment decisions of small
businesses is a relatively unexplored topic, yet small businesses account for 94 percent of
Journal of Entrepreneurship and
Public Policy
Vol. 7 No. 1, 2018
pp. 74-104
© Emerald PublishingLimited
2045-2101
DOI 10.1108/JEPP-D-17-00030
Received 30 November 2017
Revised 28 December 2017
Accepted 1 January 2018
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2045-2101.htm
74
JEPP
7,1
all businesses filing with the IRS[2]. I examine changes in the employment and wage bill
decisions of small businesses in response to changes in current and future tax rates when
selection on unobservable is assumed to occur among employers.
I seek to identify the two distinct effects of changes in current and future tax rates on the
probability of employing labor and total wage bills due to the relative change in the price of
owner effort. The probability of employing labor and total wage bills are not independent
decision processes; therefore, a Heckman selection model is specified for pooled cross-
sections from the NBER Public Use File on individual income tax returns from 1992 to 2005
for sole proprietors filing a Schedule C.
The Heckman two-step model allows for the presence of a limited dependent variable
(employers) and correlated processes for choosing to employ and then wage bill choice.
The first step of the Heckmanaddresses the decision to employoutside labor. I estimate that a
one percentage-point increase in current tax rates increases the probability of employing
outside labor by 1.18 percent, while a onepercentage-point increase in themarginal statutory
tax rate next year decreases the probability of employing labor today by 0.70 percent.
The second step of the model comprises a regression that accounts for selection on
unobservables by firms employing labor, and estimates the wage bill elasticity with respect
to current and future tax rate changes. The mean and median wage bill elasticities with
respect to current tax rates are 0.17 and 0.64, respectively. Increases in future tax rates
make production today more attractive relative to production tomorrow, indicating that
firms anticipating higher future taxes shift production intertemporally.
2. Income tax background
In 1992, Presidential Candidate Bill Clinton campaigned on a promise to raise taxes on the
wealthiest Americans. In the aftermath of the election, the Omnibus Budget Reconciliation
Act of 1993 (OBRA-93) was signed into law. OBRA-93 increased personal income-taxes on
Americans reporting adjusted gross incomes in excess of $140,000[3]. Married taxpayers
filing jointly with AGI greater than $250,000 faced marginal tax rates of 39.6 percent instead
of 31 percent. Those with AGI greater than $140,000 but less than $250,000 faced a marginal
tax rate of 36 percent instead of the previous 31 percent.
Most tax reforms, like the 1993 reforms, are announced months or years in advance[4].
With rational expectations or perfect foresight, future taxes are known with certainty and
any deviations are random noise. Under the rational expectations theory, deviations from
the equilibrium path would be random and only occur when tax payers are surprisedby
relatively higher or lower tax rates than expected.
Whereas OBRA-93 increased tax rates, the Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA) lowered personal income tax rates for most taxpayers. Tax rate
decreases were anticipated to phase in gradually through 2006. Rates initially decreased to 39.1
percent from 39.6 percent for the top tax-bracket and were scheduled to decline gradually to 35
percent over five years[5]. In May 2003, in an attempt to stave off recession, Congress passed
the Jobs and Growth Tax Relief Reconciliation Act of 2003 ( JGTRRA). JGTRRA accelerated the
tax decreases previously scheduled for 2006, making them effective immediately[6].
Calculating the appropriate effective tax rate is not a straight forward process for
business owners. The NBERs TAXIM model is useful for analysis on an individuals
taxable income but does not adjust for any line-items found on the business schedules
(Schedule C, Schedule E, Schedule F). Ideally, I would like the business owners marginal tax
rate without his wage bill and other business expenses which is not possible. The correct
tax rate for decision making depends on the particular issue under consideration: marginal
tax rates, average tax rates or statutory tax rates could be the most relevant rate for
behavioral changes. A part-time business owner working full-time for another firm may be
most sensitive to marginal tax rates. Any additional income earned by the part-time
75
Impact of
personal
income tax
rates

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