Seminars

Small businesses including high-income professionals choose to operate as corporations or passthrough entities such as sole proprietorships on the basis of non-tax and tax considerations. Incorporation may offer businesses lower effective tax rates on income earned and distributed to the owner-manager, as well as opportunities to defer taxes to the future. We show how taxes affect labor and investment decisions over the life cycle and derive a ``sufficient statistics'' formula for the impact of incorporation on social welfare. Using longitudinal administrative tax data in 2001-17, we study the businesses of Canadian physicians and dentists. We identify the causal effects of taxes using a triple-difference design that exploits a 2006 reform that facilitated incorporation by doctors in Ontario. incorporation rates in the treated group rose sharply after the reform compared to a matched control group of doctors in other provinces and business owners in other industries. Employment and business investment rose. Combined personal-plus-corporate incomes rose initially following the reform and then fell gradually for doctors in their 50s and 60s. Effective tax rates fell marginally, mainly due to the shifting of income to family members. Doctors accumulated substantial retained earnings inside their corporations, suggesting they are used as deferred-tax retirement savings vehicles. Taken together, these results are consistent with both tax avoidance through a corporation and real response via business expansion after incorporation