SERIES HOW DO BUSINESS OWNERS RESPOND TO A TAX CUT ? EXAMINING THE 199 A DEDUCTION FOR PASS-THROUGH FIRMS

We measure the shortand medium-run responses of businesses and their owners to Section 199A, a deduction that reduced the effective tax rate on most U.S. pass-through business income beginning in 2018. Using tax records of individuals and businesses, we compare taxpayers with exogenously differing levels of exposure to the deduction, exploiting limitations within the statute. We find little evidence of an increase in reported business income eligible for the deduction during 2018 or 2019. With appropriate caveats about parallel trends in the disruptive COVID period, we also find no effect in 2020 and at most a modest effect in 2021. We do find some evidence of effects on specific hypothesized margins of adjustment. Partnerships reduced ineligible forms of compensation paid to owners by approximately 10 percent, in line with the incentives created by 199A, while S corporations reduced wage compensation to owners by at most 3 percent. We find no evidence that 199A encouraged movements from employee to contractor status or increased contractor activity in 2018. Finally, we find little evidence of changes in real economic activity as measured by physical investment, wages to non-owners, or employment. Lucas Goodman Office of Tax Analysis Department of Treasury 1500 Pennsylvania Avenue NW Washington, DC 20220 Lucas.Goodman@treasury.gov Katherine Lim Minneapolis Federal Reserve Bank 90 Hennepin Avenue Minneapolis, MN 55401 katie.lim@mpls.frb. org Bruce Sacerdote 6106 Rockefeller Hall Department of Economics Dartmouth College Hanover, NH 03755-3514 and NBER Bruce.I. Sacerdote@dartmouth.edu Andrew Whitten Office of Tax Analysis Department of the Treasury Washington, DC 20220 andrew.whitten@treasury.gov In 2018, over 18 million individual taxpayers directly benefited from section 199A, a new deduction created by the Tax Cuts and Jobs Act (TCJA). The following year over 22 million benefited (Internal Revenue Service, 2021). Section 199A generally allows a deduction for 20 percent of “pass-through” income, a category that comprises the vast majority of income from the self-employed and smallto mid-sized businesses as well as an increasing share of income from larger businesses. The deductions are concentrated among high earners: in 2019 over two-thirds of 199A deduction amounts were claimed by taxpayers with more than $200,000 in adjusted gross income (AGI), and over one-third were claimed by taxpayers with more than $1,000,000 in AGI (Internal Revenue Service, 2021). In this paper, we estimate individual and business behavioral responses to section 199A using administrative tax data through 2021. We analyze the total effect of the deduction on reported passthrough income as well as specific margins across which taxpayers can potentially convert non-qualifying income into qualifying income. We also study the deduction’s effect on real inputs to production, including business investment and employment. With some exceptions, we do not find evidence of large responses to the 199A deduction. This contrasts with critical predictions made by some commentators that section 199A would prompt a wave of tax avoidance, encouraging workers to move from employee to contractor status and causing business owners to shift income and perhaps restructure businesses to obtain a greater deduction (Duke, 2018; Kamin et al., 2019; Kleinbard, 2019). 1 Our results also stand somewhat in contrast with optimistic predictions that the business tax cut would encourage economic activity, although it is too early to observe long-run effects (Hassett and Hubbard, 2002; Barro and Furman, 2018). 2 Both the optimistic and pessimistic predictions were plausible a priori given the magnitude of the tax cut implicit in section 199A: the deduction effectively reduces marginal tax rates on qualifying income by between two to seven percentage points, with larger cuts for higher-income taxpayers. However, at least in the first four years of data available, the observed effects on taxpayers’ behavior have been modest. We test for behavioral responses along a number of margins, using data on both the pass-through entity and the individual owner. First, we look for increases in individual income of a sort that would be eligible for the deduction if statutory requirements are met; we term this income “potential qualifying business income,” or “potential QBI” for short.3 We see no such increase in the time series. But in a counterfactual world without section 199A, it is possible that potential QBI would have fallen in 2018. To better identify 199A’s effects, we use two difference-in-differences research designs based on statutory limitations that restrict 199A eligibility. Specifically, taxpayers with income above a threshold ($415,000 for married couples in 2018) face two limitations: for these owners, income derived from a specified service trade or business (SSTB; e.g., medical or legal services) does not qualify for the deduction, and income derived from a non-SSTB is limited according to a function of the business’s wages paid and capital employed. Lower-income taxpayers face neither of these restrictions. Our first strategy restricts to owners in industries where the two limitations are most binding and compares owners above the income threshold (whose deductions are likely limited) to those below the income threshold (whose deductions tend not to be limited), based on lagged income. Our second strategy 1Senate testimony by Kamin (2018) summarizes the possible perverse incentives and tax avoidance effects from 199A. This testimony discusses both the incentives for workers to switch from employee to contractor status and the incentives for businesses to restructure to create additional tax units that meet 199A’s industry and capital and wage requirements. 2Barro and Furman (2018) show that if one applies existing estimates of how business investment responds to the marginal tax rate, making 199A permanent would increase the long run capital stock of pass-through businesses by 3 percent, with corresponding increases in productivity per worker. 3Potential QBI is a subset of pass-through income that excludes income that is always ineligible for 199A: guaranteed payments paid by partnerships to partners as well as certain types of income from interest, dividends, and other investment income.