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This paper estimates the extent to which self-employment income responds to changes in the net-of-tax share using a panel of tax returns that spans 1987–1996. The results suggest that the elasticity of reported self-employment income to the net-of-tax share is approximately .9, implying a real elasticity (net of any reporting response) of around .4. Estimated elasticities tend to be larger for higher income taxpayers, married males, and females. In addition, the elasticity of self-employment income is considerably larger than the elasticity wage and salary income estimated using the same methodology.

Knowledge of the extent to which the work behavior of taxpayers responds to changes in tax rates is a vital element in understanding the efficiency costs of raising revenue and the revenue effects of changes in tax rates. As a result, numerous studies have examined the effect of changes in tax rates on labor supply behavior. Further, a sizable literature has developed attempting to estimate a parameter that reflects the responsiveness of all sources of income together (or of taxable income, which comprises income less deductions and exclusions) to changes in tax rates.1 This paper adds to both of these literatures by using a panel of tax returns to examine the extent to which the income of a particular segment of the population, the self-employed, responds to changes in tax rates. Numerous studies have estimated the responsiveness of wage and salary workers' labor supplies to changes in wages and nonlabor income. This is likely due to the fact that the vast majority of individuals are wage and salary employees, and as Blow and Preston (2002) note, the hours and participation margins are the predominant margins along which work behavior of these individuals are likely to respond.2 This literature has tended to find very small hours elasticities for men and larger though still modest hours elasticities for women, with participation elasticities for women that tend to be larger than the hours elasticities.3 Much less attention has focused on the behavior of the self-employed, even though the self-employed are not a trivial share of workers in the United States. As an illustration, the Internal Revenue Service (IRS) reported that 12.7 million tax returns in 1994 paid some amount of self-employment tax, which amounted to 11% of all returns filed that year.4 In addition, the Small Business Administration reports that 60–80% of net new jobs are created by small businesses, and that small businesses create more than half of the non-farm private gross domestic product.5 As a result, small businesses are often viewed as the engines of innovation, job creation, and future growth in the economy. Despite this, papers that study labor supply tend to exclude the self-employed, and most of the papers that have examined self-employment behavior have limited their focus to whether tax rates affect the decision of whether or not to be self-employed.6 Several of these papers, including Long, 1982, Moore, 1983, Blau, 1987, Parker, 1996 and Scheutze, 1998 find that higher marginal tax rates lead to self-employment. However, Fairlie and Meyer (1999) find that levels of self-employment are unrelated to marginal tax rates over the period 1910–90, and Moore (2003) finds that tax changes in the late 1980s and 1990s do not appear to have had a consistent significant effect on the self-employment decision. Gentry and Hubbard (2000) find that the level of marginal tax rates does not have a consistent effect on entry into self-employment, but that more progressive taxation tends to decrease entry into self-employment. In two papers, Bruce, 2000 and Bruce, 2001 examines the response of entering into and exiting out of self-employment to differences in the tax rates that would be faced in wage work and self-employment, and finds that workers who switched into self-employment tended to be those who faced higher tax rates in self-employment than they would at a wage earning job. Compared to the large literature estimating the responsiveness of self-employment to taxes on the extensive margin, relatively little is known about the extent to which the incomes of self-employed individuals respond to changes in tax rates on the intensive margin. The responsiveness of self-employment income to marginal tax rates could take several forms. First and most importantly, there could be a real effect, in that higher tax rates might induce the self-employed to consumer more leisure and work fewer hours, exert less effort within a given set of hours, and invest less in their business given that the after-tax return to earning the marginal dollar has gone down. Second, there could be a reporting effect, in that the gap between the income of the self-employed individual (net of expenses) and the amount reported to the Internal Revenue Service may increase when tax rates are higher and the payoff from such tax avoidance is greater. Third, there could be a tax base effect, in which higher tax rates might lead a self-employed person to change their business form to a corporation (that is subject to the corporate income tax) if the resulting taxes would be lower.7 Recent papers that have examined the behavior of the self-employed have generally focused on one of these margins in isolation. In two papers, Carroll et al., 2000a and Carroll et al., 2000b, find that a higher net-of-tax share (one minus the marginal tax rate) increases the probability that an entrepreneur invests, the probability of hiring of outside help, and the total wage payments to workers. Carroll et al. (2001) find that a higher net-of-tax share increases the growth rate of gross receipts. Clotfelter, 1983 and Joulfaian and Rider, 1998 examine the extent to which higher marginal tax rates increase the underreporting of self-employment income. This study attempts to synthesize this literature by examining the extent to which the response along these and other margins aggregate up to an overall effect on reported self-employment income. Most closely related to this study are those of Blow and Preston, 2002 and Wu, 2005. Blow and Preston (2002) use a grouping estimator on repeated cross-sectional tax return data from the 1985–86 and 1995–96 UK Surveys of Personal Incomes to examine the responsiveness of self-employment income to tax rates. In OLS regressions, they find a negative effect of the net-of-tax share on self-employment income, but this turns positive and significant when instrumental variables are used. Wu (2005) uses data from the 1983 and 1989 Survey of Consumer Finances to estimate the responsiveness of rates of return to changes in tax rates, and estimates an elasticity in excess of 5. In contrast to these studies, this paper uses panel data, making it possible to include fixed effects to control for unobserved characteristics of individuals (such as tolerance for risk) that might affect both the amount of self-employment income and the marginal tax rate. In addition, those papers examined the effect of income tax rate decreases, whereas the major policy changes during the sample period in this paper (the Omnibus Budget Reconciliation Acts of 1990 and 1993) involved tax rate increases. Though estimates of the taxable income elasticity implicitly incorporate within them the responsiveness of the self-employment income to changes in tax rates, policymakers are interested in the extent to which entrepreneurial behavior in particular is affected by taxation. The estimation of an overall elasticity of self-employment income to marginal tax rates provides policymakers with a useful summary parameter to evaluate the effects of potential tax changes on all of the margins on which the self-employed can respond. Using a panel of tax returns that spans 1987–96, this paper applies estimation methods that have been used in estimating the overall elasticity of taxable income to the estimation of self-employment income in particular. The results suggest that the elasticity of reported self-employment income to the net-of-tax share is approximately .9, implying a real elasticity (net of any reporting response) of around .4. The results suggest that the responsiveness to taxes tends to be larger for higher income taxpayers, married males, and females. In addition, the elasticity of self-employment income is considerably larger than the elasticity of wage and salary income estimated using the same methodology. The paper proceeds as follow. Section 2 describes tax policy in the United States toward self-employment income. Section 3 presents the estimation methodology, Section 4 describes the dataset used, and Section 5 presents the estimation results. Section 6 concludes.

This paper used data from a panel of tax returns to estimate the responsiveness of self-employment income to tax changes. Results from the base specification suggest that the elasticity of reported self-employment income to the net-of-tax share is approximately .9, implying a real elasticity (net of any reporting response) of around .4. The estimated response tends to be larger for higher income taxpayers, married males, and females. In addition, the elasticity of self-employment income estimated here is considerably larger than that found for wage and salary income using the same methodology. Some caveats should be kept in mind when interpreting these elasticities and applying them to estimate the possible effect of tax changes. First, these results were estimated using taxpayers who earned self-employment income both before and after the tax change. If, as some papers suggest, there is also responsiveness to changes in tax rates on the extensive margin decision of whether to become self-employed, these results would not give the whole picture of the response of self-employment income to changes in tax rates. For example, if increases in tax rates lead more taxpayers to become self-employed (as some of the earlier literature has suggested), the estimates found here would be overestimates of the effect of the tax rate change on the total amount of reported self-employment income. Obviously, if increases in tax rates lead to decreases in self-employment (as some more recent papers suggest), the estimates here would be underestimates of the total effect of the tax change on self-employment income. However, since Moore (2003) finds that two of the tax changes used in this analysis, OBRA90 and OBRA93, did not have a consistent significant effect on the decision to be self-employed, the magnitude of this bias is probably small. Second, since the responsiveness of self-employment income appears to be larger for higher income taxpayers, any estimate of a possible tax change's effect on the amount of self-employment income reported and the amount of revenue collected would depend crucially on the structure of the tax change and the resulting distribution of tax rate changes across income groups. In particular, the results suggest that tax changes focused on lower income taxpayers will result in less of a behavioral response than tax changes focused on higher income taxpayers. Overall, the results in this paper suggest that changes in tax rates do have a substantial impact on the income of the self-employed. In addition, these results provide a self-employed worker counterpart to the often estimated elasticities of labor supply for wage and salary workers. Finally, the results here help to deepen our understanding of why and how much taxable income responds to tax rates.