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

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.

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.

The authors add two contributions to the current literature: first, the author allow for intertemporal tax planning and second, the author allow the firm’s decision to employ labor to be correlated with the firm’s 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 firm’s 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.

This paper has been cited in publications published in Journal of Entrepreneurship and Public Policy.