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Article Excerpt
INTRODUCTION
The purpose of this paper is to derive standardized measures of labor and capital income that account for the different reporting requirements and levels of compliance faced by different forms of organization. Such an exercise facilitates estimates of how much capital income is subject to employment taxes, specifically, those levied under the Federal Insurance Contribution Act (FICA) and Self-Employment Contributions Act (SECA). Similarly, it facilitates estimates of how much labor income escapes FICA and SECA taxes.
Economists have long argued that economic incidence is different from the statutory incidence of a tax--in this paper, we show an additional reason why that is true. According to the standard view of incidence, if, in long-run equilibrium, total labor compensation equals the marginal revenue product of labor, then an increase in employer-paid employment taxes cannot increase total compensation. Therefore, the tax must necessarily reduce before-tax compensation, making it fully incident on labor. This paper emphasizes that there is a second reason why economic incidence can differ from statutory incidence, namely that different entity types are taxed on their labor and capital income in different ways, have different reporting requirements and, therefore, have differing incentives for taxpayers to mischaracterize their income with the intention of reducing liability. Ultimately, tax filing requirements may cause capital income to be subject to the employment tax as if it were labor income. Furthermore, taxpayer behavior may cause labor income to be taxed (or not taxed) as if it were capital income, and vice versa.
In this paper, we concern ourselves with four basic types of entity:
* C corporations that file Form 1120, 1120 A, or an 1120 consolidated return, (1)
* S corporations (Form 1120S),
* Partnerships and LLCs (Form 1065), and
* Sole proprietorships (Schedule C or F of Form 1040).
For each entity type, we discuss how the tax law treats capital and labor income, and what incentives are created for the taxpayer.
It helps to distinguish between "reported" labor and capital income and "true" labor and capital income. We define reported labor income as any income currently included in either the FICA or SECA tax base (ignoring the cap on taxable earnings). True labor income, in contrast, is the amount that would be subject to FICA or SECA taxes if the owner were an employee being compensated fairly for his or her services. (2) In each case, capital income is the difference between net operating business income (recalculated as if the business were a sole proprietorship) and labor income. Rental income and portfolio income, such as interest, dividends, and capital gains, are omitted from the analysis. (3)
We take two approaches to characterizing capital and labor income. In one approach, we attempt to determine the extent to which the partnership rules create a mismeasurement of capital and labor income when taxpayers accurately report their income. We do so by assuming that medium to large corporations have strong incentives to accurately report capital and labor income. We then examine how their currently reported capital and labor income would be treated if they filed as a partnership. In this approach, we ignore taxpayers' incentives to change the pattern of reported income.
In the second approach, we attempt to impute to taxpayers the true capital and labor income that is implied by their structural characteristics. To do this, we perform econometric analyses of privately held C and S corporations. (4) Most corporations have an incentive to misreport labor income, but doing so requires them to collude--an activity whose success becomes less likely as the number of owners increases. To account for the ability to collude, we incorporate information about numbers of shareholders into the econometric analysis. We use the econometric results to impute true capital and labor income to C and S corporations, and apply the results from S corporations to partnerships and sole proprietorships. By comparing results from the second approach with results from the first approach, we also get a sense of the extent to which taxpayer behavioral response may affect reported labor and capital income.
RELATED LITERATURE
To our knowledge, no other paper has attempted to take into account the differing filing requirements and incentives applicable to different entity types in providing an accurate measurement of true, underlying capital and labor factor incomes. Two streams of the literature are related to this paper. One stream focuses on measuring effective tax rates or payments and includes such notable contributions as those by Gravelle (1994), Mackie (2002), Gordon, Kalambokidis and Slemrod (2004), and U.S. Congressional Budget Office (2005). However, those papers generally start with the assumption that the tax return data accurately reflect sources of income, and focus on developing measures of effective capital income tax rates or payments. This paper is motivated in part by that literature, and by the observation that capital income is measured inconsistently across entity types because of differing tax reporting requirements and incentives. Measurement of effective tax rates on capital (or labor) can only be as useful as the accuracy of the measurement of the underlying income sources subject to those tax rates. Potentially, results of this paper might be useful in re-examining effective tax rates.
A second stream of related literature focuses not on effective tax rates, but rather on incidence. It is well known that a tax whose statutory incidence is on capital might be partially shifted to labor, in the sense that it causes reduced labor income. Examples in the literature abound and are summarized by Kotlikoff and Summers (1987). Again, mismeasurement of labor and capital (either before or after a tax-law change that provides signals about incidence effects) leads to the potential for mismeasurement of incidence; the present paper may be useful in this regard.
CURRENT LAW EMPLOYMENT TAXATION BY ENTITY TYPE (5)
The most straightforward tax rules are for sole proprietors--all net profits are subject to SECA taxes (and individual income taxes). Net losses are allowed to offset other self-employment income, but cannot result in negative income subject to SECA tax. In practice, however, hardly any losses are actually used to reduce SECA taxes, whether because there is no other self-employment income to offset or because the taxpayer is unaware that the offset is allowed.
Partnerships are required to report to their partners the amount of income subject to SECA tax separately from the amount passed through for income tax purposes. How that amount is determined, however, depends on the type of partner.
* General partners. The distributive share of all operating business income received by general partners who are individuals is subject to SECA tax. This includes losses, which, like sole proprietorship losses, can be used (but generally are not) by individual partners to reduce their SECA tax liability.
* Limited partners. The distributive share of operating business income allocated to limited partners is not subject to the SECA tax--limited partners who are individuals must pay SECA tax only on amounts they receive as "guaranteed payments" for services rendered.
* LLC members. Because LLC members are not classified as "general" or "limited," there is ambiguity in the law concerning how they should be treated for SECA tax purposes. (6) Actual practice does not seem at all uniform, with some following general partnership rules and others following limited partnership rules.
C corporations and S corporations are required to estimate a "reasonable compensation" for the services provided by their owners and deduct that from ordinary business income as "compensation of officers." Amounts reported as officers' compensation are subject to FICA taxes, just like employee wages. In the case of C corporations, ordinary business income is subject to the corporate income tax. In the case of S corporations, it is passed through to the owners to be included in their individual income tax calculations. Thus, they generally face opposite incentives to mischaracterize capital and labor income. These incentives are discussed in the next section.
INCENTIVES AND OPPORTUNITIES TO RECHARACTERIZE INCOME
Sole proprietors and general partners have no incentive to recharacterize labor income as capital income or vice versa, because it will be taxed identically in either case. The incentive to minimize labor income facing S corporation owners and limited partners, however, is unambiguous. The incentives facing C corporation owners are more complicated.
S Corporation Owners and Limited Partners
Instead of being taxed at the business-entity level, S corporation and partnership income characterized as capital is passed through and taxed at the individual level. Income characterized as labor (whether as compensation of officers or guaranteed payments) is taxed at the individual level at the same rate as income from capital, so the individual income tax provides no incentive to recharacterize. But unlike capital income, labor income is also subject to the FICA tax (for compensation of S corporation officers) or SECA tax (for guaranteed payments to limited partners). To avoid those employment taxes, S corporation owners and limited partners have a strong incentive to characterize as much labor income as possible as capital income.
Despite the relatively uniform incentives they face, S corporation shareholders and limited partners face different legal constraints on their abilities to recharacterize income. Limited partnerships have more flexibility to recharacterize income than do S corporations because they are allowed to (1) disconnect the distribution of capital income from the ownership of the capital assets, and (2) make guaranteed payments that do not reflect reasonable compensation. S corporations, in contrast, must distribute capital income in proportion to share ownership and comply with the reasonable compensation standard. Only the ambiguity surrounding the definition...
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