Taxes and the Choice of Organizational Form

Abstract

One of the most basic distortions created by the double taxation of corporate income is the disincentive to incorporate. In this paper, we investigate the extent to which the aggregate allocation of assets and taxable income in the U.S. between corporate vs. noncorporate forms of organization during the period 1959-86 has responded to the size of the tax distortion discouraging firms from incorporating. In theory, profitable firms should shift out of the corporate sector when the tax distortion to incorporating is larger, and conversely for firms with tax losses. We also examine the extent to which easing of the conditions firms must satisfy to acquire sub-chaper S status has increased the amount of activity organized as sub-chapter S corporations. Our empirical results provide strong support for the theoretical forecasts, and hold consistently across a wide variety of specifications and measures of the tax variables. Measured effects are small, however, throwing doubt on the economic importance of tax-induced changes in organizational form.