Taxes, Incorporation, and Productivity

Abstract

U.S. businesses can choose to be C-corporations or pass-through entities in the forms of S-corporations, partnerships (notably LLCs), and sole proprietorships. C-corporate status conveys benefits from perpetual legal identity, limited liability, potential for public trading of shares, and ability to retain earnings. However, legal changes have enhanced pass-through alternatives, for example, through the invention of the S-corporation in 1958 and the improved legal status of LLCs at the end of the 1980s. C-corporate form is subject to a time varying tax wedge, which offsets the productivity benefits. In a theoretical framework, firms’ productivities associated with C-corporate and pass-through status are distributed as bivariate log-normal. The tax wedge then determines the fraction of firms that opt for C-corporate status, the level of economy-wide output (productivity), the share of total output generated by C-corporations, and the sensitivity of this share to the tax wedge. This framework underlies the empirical analysis of C-corporate shares of business economic activity. Long-difference regressions for 1968-2013 show that a higher tax wedge reduces the C-corporate share of net capital stocks, equity (book value), gross assets, and positive net income, as well as the corporate share of gross investment. The C-corporate shares also exhibit downward trends, likely reflecting underlying legal changes. We infer from the quantitative findings that the downward movement in the tax wedge since 1968 has expanded economy-wide productivity by about 4%.