Income Taxation and Business Incorporation: Evidence from the Early Twentieth Century

If the corporate income tax is set at a different rate from non-corporate income tax, it can play an important role in a firms choice of organizational form. The impact and interdependency of income tax incentives are crucial factors to take into account when designing efficient tax policies. In this paper I exploit the substantial variation in income taxes across U.S. states in the early twentieth century to estimate these sensitivities. The potential endogeneity of state taxes is addressed using an IV approach. The results demonstrate that the relative taxation of corporate to personal income has a significant impact on the corporate share of economic activities. Raising the entrepreneurs tax cost of incorporation by 10% decreases the mean corporate share of economic activities by about 11-18%. In addition, higher personal tax rates may affect the share of corporate activities through tax evasion and tax progressivity.