How do business owners respond to a tax cut? Examining the 199A deduction for pass-through firms

Abstract

We measure the responses of businesses and their owners to Section 199A, a deduction that reduced the effective tax rate on most U.S. pass-through business income beginning in 2018. Using tax records of individuals and businesses, we compare taxpayers with exogenously differing levels of exposure to the deduction, exploiting limitations within the statute. We find evidence of a 3 to 4 percent increase in reported business income eligible for the deduction during 2018 and 2019 for the more-exposed group relative to the less-exposed group. We also find some evidence of effects on specific hypothesized margins of adjustment. Partnerships reduced ineligible forms of compensation paid to owners by approximately 10 to 15 percent, in line with the incentives created by Section 199A, but S corporations did not reduce wages to owners. We find no evidence that Section 199A encouraged movements from employee to contractor status or increased contractor activity. Finally, we find little evidence of changes in real economic activity as measured by physical investment, wages to non-owners, or employment.