# Income Taxes and Entrepreneurship | Hoover Institution Source: https://www.youtube.com/watch?v=T9PhxDZNZsE Recap page: https://rapidrecap.app/video/T9PhxDZNZsE Generated: 2026-02-24T08:33:06.995+00:00 --- ## 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. ## Detailed Analysis The presentation outlines a sophisticated dynamic model designed to analyze how income taxes affect actively managing business owners, who are a major focus for the IRS due to significant reporting discrepancies. McGraten asserts that income taxation proves much less distortionary than capital taxation in their current modeling setup. The core of the model involves two sectors: pass-through businesses and other businesses/government, with households making occupational choices between running a business or being paid employees. A critical element is 'sweat capital' (like customer bases), which owners build through effort (disutility of effort) and which is distinct from non-transferable human capital. The researchers are 'upping the game' by moving toward models that incorporate realistic transitional dynamics over shorter periods and match both macro (NIPA) and micro (IRS audit) data, specifically aiming for moments like the top 10% of owners holding 70% of business income. A key modeling choice involves using a non-Gaussian distribution for innovation shocks to capture the right tail of business income volatility observed in IRS data, whereas a simple Gaussian AR1 process suffices for paid employees. The analysis suggests that allowing sweat capital to be variable (elastic) yields much different results regarding selection and welfare gains upon tax reform compared to assuming it is fixed (inelastic). The effective tax rate on business owners (TABI) is approximated around 20%, significantly lower than the effective rate for workers (roughly 37%). ### Project Focus and Data Use - Joint project with IRS targeting actively managing business owners (pass-through entities) due to their contribution to the tax gap - Data pulled specifically looks at sole proprietors, partners, and S-corp owners filing Schedule C, 1065, or 1120S. ### Modeling Improvements - Moving beyond steady-state to steady-state models with 450-year transitions to focus on better transitional dynamics - Aiming to fit models to both macro data (NIPA) and micro tax administrative data. ### The Business Owner Model Components - Agents choose between running a business or paid employment based on stochastic ability (kappa and Z) - Business value includes transferable financial assets and non-transferable sweat capital (customer base) built via owner effort. ### Income Tax vs. Capital Tax Findings - Major conclusion is that income tax taxation is much less distortionary than capital taxes - The current model focuses only on income taxes, setting aside capital gains analysis for future, 'bigger fire hose' models. ### Calibration and Moments - Want operator is to match NIPA and micro moments from IRS data, including matching the highly skewed income distribution of business owners - IRS data reveals business owners report about half their income via underreporting or overexpensing, which NIPA imputes. ### Elasticity and Transition Dynamics - The curvature of the disutility of effort function determines the elasticity critical for policy analysis - Comparing fixed (inelastic) vs. variable (elastic) sweat capital reveals major differences in selection and impact when tax rates change.