Income Taxes and Entrepreneurship | Hoover Institution

Quick Overview

Ellen McGraten's joint project with the IRS focuses on modeling US business owners who actively manage pass-through entities (sole proprietors, partners, S-corporations) to improve tax policy and administration, concluding that income taxation is significantly less distortionary than capital taxes in their current model framework.

Key Points: The research project with the IRS targets actively managed business owners (pass-through entities) because they constitute a large part of the tax gap, reporting about half of their income through underreporting or overexpensing. The latest installment focuses on income taxes, concluding that "the income tax taxation is much less distortionary than capital taxes," contrasting with previous work that included capital gains. The researchers are upgrading their modeling methods, moving from models that transition over 450 years (steady state to steady state) to methods that better handle transitional dynamics and fit both macro and micro data. The key characters in the model are business owners, as standard survey data poorly captures the 'dollars in entrepreneurship' by missing the very right and left tails (high earners and loss-makers). The model introduces 'sweat capital' (like a dentist's customer base) as an inelastically supplied factor built through owner effort, distinguishing it from human capital which is inherent and non-transferable. For calibration, the model aims to match National Income and Product Accounts (NIPA) and micro moments from IRS data, noting that NIPA imputes about half of business income based on audit estimates. When modeling the effect of tax rate changes, the transition dynamics show a very different outcome when sweat capital is variable (elasticity matters) compared to when it is fixed (inelastic, like an old Lucas 1978 model).

Context: Ellen McGraten presents findings from an ongoing joint research project with the Internal Revenue Service (IRS) concerning the taxation and administration related to US business owners, specifically those operating as sole proprietors, partners, or S-corporation owners (pass-through entities). This work builds upon prior research concerning sweat equity, aiming to develop better theoretical models and utilize administrative tax data to inform tax policy redesign.