INCOME TAXATION AND BUSINESS INCORPORATION: EVIDENCE FROM THE EARLY TWENTIETH CENTURY

A differential between the corporate income tax rate and the personal income tax rates applied to non-corporate income can play an important role in a firm's choice of organizational form. The impact and interdependency of income tax incentives are crucial factors in the design of efficient tax policies. In this paper I exploit the variation in income taxes across U.S. states in the early 20th century to estimate these sensitivities. The potential endogeneity of state taxes is addressed using an instrumental variables approach. The results demonstrate that the relative taxation of corporate to personal income has a significant impact on the corporate share of economic activities. On average, a ten percentage point increase in the corporate tax rate is associated with a 0.2 to 0.3 percent decrease in the corporate share of economic activities, while a ten percentage point increase in the personal income tax rates applied to non-corporate income raises the corporate share of economic activities by 0.5 to 0.6 percent.