Estimating the scale of type I avoidance

To estimate the scale of type I avoidance, we separately consider how a family reduce

tax liability conditional on income by shifting income from ordinary income to the lower

taxed dividends and capital gains.

Scale of type I avoidance due to shifting income to dividends

First, we examine whether dividends income increases conditional on total income after

a family becomes self-employed. Focusing on post-1992 sample when dividends information

is separable from other property incomes, table 2.6 shows that dividends increase by 7.2%.

Though the estimate is imprecise for the whole self-employed, we see the corporate self-

Table 2.6. Change of dividends (since 1992)

Notes: The sample focuses on the first employee-self-employed cycle of families ever turning from employees to self-employed within sample period. Other controls include dummies for age, education, marital status, race, state, head’s hours worked, homeownership, disability, current family scale, and year dummies. Standard errors clustered at family level are in parentheses. Estimates are weighted using the sampling weights of respective surveys. *** p<0.01, ** p<0.05, * p<0.1.

Then we estimate the scale of tax avoidance due to shifting income to dividends. In

table 2.7, the first two columns simply replicates columns 3-4 in table 2.4, based on which we

have obtained the tax saving levels from type III avoidance. The last two columns show the

tax saving due to both type III avoidance and type I avoidance considering dividends. From

column 3, we can calculate the average tax saving of the self-employed due to both type III

avoidance and type I avoidance considering dividends as [1-exp(-0.066)]*exp(8.012)=$192.69.

Comparing it with the tax saving due to type III avoidance, $184.39, then we obtain the

average tax saving due to transferring ordinary income to dividends for the self-employed as

$8.3. Similarly, we can obtain the tax saving due to dividends for the corporate self-employed

and non-corporate self-employed as $13.57 and $5.55. Given the result obtained above that

the income shifted to dividends is not too much, such a small avoidance scale is not surprising.

so if we focus only on the several years since 2003, the estimate of avoidance scale due to

shifting income to dividends might be larger. But a limitation is that the sample would be

too small to render a reliable estimate. Given the relative small amount of dividends, we

believe the small avoidance scale estimated here is close to truth.

Table 2.7. Avoidance scale due to shifting income to dividends and capital gains (since 1992)

Notes: The sample focuses on the first employee-self-employed cycle of families ever turning from employees to self-employed within sample period. Other controls include dummies for age, education, marital status, race, state, head’s hours worked, homeownership, disability, current family scale, and year dummies. Standard errors clustered at family level are in parentheses. Estimates are weighted using the sampling weights of respective surveys. *** p<0.01, ** p<0.05, * p<0.1. Columns (5)-(6) focus on those with non-negative capital gains.

Scale of type I avoidance due to shifting income to capital gains

First, we examine whether capital gains increase when families become self-employed,

capital gains. But transferring ordinary income to capital gains income may mostly be

adopted by the self-employed families, who have their own businesses. Such income shifting

may be mainly reflected in the capital gains from business/farms rather than from stocks or

real estate. So we expect to see most increases in capital gains come from business/farms

when a family turns from an employee to self-employed.

To test the hypothesis that conditional on reported total income, families would have

higher capital gains when they become self-employed, we use the following regression:

CGit/Yi0=β0+β1Yit/Yi0+β2Ait/Yi0+β3Selfit+γ·Xit+λt+µi+εit,

whereCGit is annualized capital gains/losses,Ait is net wealth excluding home equity, Yit is total family income. As a form of heteroskedasticity correction, these monetary terms

are divided by Yi0, the family income of household i in the last year prior to becoming

self-employed. In addition to total reported income, we further control for net wealth because

capital gains from investments may well be correlated with the net wealth of a family. For

the dependent variable, in addition to total capital gains, we look at capital gains in three

assets separately. To focus on the representative household, in this regression we exclude the

top 1% and bottom 1% extreme values of total capital gains/losses.

Table 2.8 shows the regression results. Column 1 shows that, on average, a family would

have higher capital gains after becoming self-employed, though not statistically significantly.

Column 2 shows that, as expected, a family would have significantly more business/farm

capital gains when it becomes self-employed. The capital gains from real estate and stocks

are less than before becoming self-employed, though not statistically significantly. It seems

Table 2.8. Change of capital gains (since 1984)

Notes: The sample in columns 1-8 focuses on the first employee-self-employed cycle of families ever turning from employees to self-employed within sample period, and excludes the top 1% and bottom 1% extreme values of total capital gains. Other controls include dummies for age, education, marital status, race, state, head’s hours worked, homeownership, disability, and current family scale. Standard errors clustered at family level are in parentheses. Estimates are weighted using the sampling weights of respective surveys. *** p<0.01, ** p<0.05, * p<0.1.

(business/farm capital gains in particular) income after becoming self-employed. Columns

6 shows that business/farm capital gains increase more for the corporate self-employed, as

expected.

Then we estimate the scale of tax avoidance due to shifting income to capital gains.

Here we make several assumptions. First, we assume that the imputed accrued capital

gains is a good proxy for realized capital gains. Since we focus on the families turning from

employees to self-employed and end their business in the end, all accrued capital gains should

be realized within the sample period. Second, we choose to focus only on the capital gains

from business/farm and assume they are long term capital gains, so subject to a lower tax

rate than the ordinary income. Third, we focus on the cases when non-negative net capital

gains. Any capital losses that help deduct income at ordinary income account has been

considered when we calculate tax liability using TAXSIM. When we calculate corporate

income, we average business life time capital gains and losses to calculate the net capital

gains per business year. Such approach would help deal with the carryover of capital losses

for corporations.

Columns 5 of table 2.7 show that the scale of type III avoidance plus type I avoidance

considering both dividends and capital gains is on average [1-exp(-0.129)]*exp(7.955)=$344.9

for the self-employed, which implies a $152.21 tax saving due to shifting income to capital

gains. Similarly, we obtain that the tax saving is $275.51 and $129.69 for corporate and

non-corporate self-employed, respectively.

Testing a relevant assumption

Our identifying assumption is that the self-employed should have the same tax liability

as the employees, conditional on reported total income, if there were no behavioral changes

(e.g. shifting income and manipulating exemptions and deductions) after a family becomes

self-employed. Then we can interpret the lower tax liability of the self-employed conditional

examine a relevant assumption: conditional on reported total income, the ever self-employed

families should have the same tax liability, before they became self-employed, as the always-

employee families. If this is untrue, then the families choosing to become self-employed

would have different income structure from the always-employee families when they were

both employees, which would make our conceptual framework to estimate tax avoidance scale

invalid.

To test this hypothesis, we focus on the sample of employee observations (using

always-employee families and ever self-employed families) and run the following regression

lnT axit=β0+β1lnYit+β2Selfi+γ·Xit+λt+εit,

where T axit can be tax liability ignoring dividends and capital gains, tax liability

considering only dividends, or that considering both dividends and capital gains. From

column 2-4 of table 2.16 we see that β2 is close to zero in all three cases, which renders

support for our identifying assumption.