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Interactions Between Closely-Held Firms and Their Owners -Evidence from administrative data and a randomized field experiment

Alternative title: Interactions Between Closely-Held Firms and Their Owners -Evidence from administrative data

Awarded: NOK 3.3 mill.

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2014 - 2018

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Most tax research on firms is conducted on large corporations with separation between ownership and management. However, the majority of firms are small and medium sized and often owner-managed. For such firms, the owner decides on firm behavior to maximize his private level utility. The main goal of this project is to investigate how ties between individuals and firms can affect behavioral responses to taxes. We find that changes in the dividend tax can affect tax avoidance, tax evasion, investments, and also, the measured level of inequality. The integration between corporation and owner affects which share of the owner?s true income is observable on individual level, and thus also measured income inequality. Pass-through income is taxed when earned; capital-gains income is taxed when realized; and dividends when distributed. Business owners often have control over the timing and character of their income. And laws change, changing the incentive and ability to shift income between the individual and corporate sectors. The introduction of a dividend tax in Norway in 2006 lead to lock-in of retained profits in the corporate sector and reduced income inequality post-reform, based on observable realized income statistics from administrative tax data. We propose a new integrated approach for measuring income from the firm and distribute change in retained profits as income to owners. Then the income share of the top 1% increases post-reform, from 7% (when measured as realized income from tax data) to 12% (when distributing earned, but retained, profits to owners). What is seen as an increase in income inequality in the US following the 1986 tax reform may in fact mainly be a reporting issue, as there is a shift from incorporated to pass-through firms, rendering firm level income visible at the personal income tax return and thus being included in individual level at the time of accrual instead of realization. Related, we discuss available evidence about the evolution of top wealth shares in the United States over the last one hundred years. Various methods of measuring the top wealth shares generate consistent findings until mid-1980s but diverge since then, due to the changing nature of top incomes and the increased importance of self-made wealth. There is heterogeneity in the participation in tax planning activities. We show that few Swedish individuals utilize legal and observable tax avoidance opportunities by establishing a shell corporation. We show that in addition to monetary benefits from tax avoidance (incentives), the opportunity to participate in tax avoidance (access), as well as information and knowledge about these opportunities (awareness), are important factors for the individual?s tax avoidance decision. We further show that tax avoidance appear to spread within municipalities. We also find that changes in the dividend tax rate can have real effects through corporate investments. A Swedish dividend tax cut in 2006 lead to reduced cost of capital for previously cash-constrained firms. These firms increased their investments post-reform, compared to cash-rich firms. Tax compliance is by nature challenging to observe and analyze. In rich Swedish micro data, we observe over-reporting of a self-reported dividend allowance that can reduce the total tax liability of Swedish business owners. We find that tax noncompliance increases as individuals face higher tax rates and that incentives appear to play an economically important role in tax noncompliance. Another way to study tax evasion is through audits, where we primarily look closer into the employer-employee relationship. Third-party reporting and employers? tax withholding only work as self-enforcing compliance mechanisms as long as the employer and employee do not cooperate to evade taxes. We have cooperated with the Norwegian tax administration on randomized firm level audits to uncover the extent of unreported workers. By merging the audit data to administrative data, we provide evidence of collaborative tax evasion by employers and employees. We also show that audits work; employers increase reported wage payment after an audit by the tax administration.

Much of the economic literature draws a sharp distinction between firms and individuals. However, for firms with one or few owners, there is usually no separation of management and control, and specific individual owner's circumstances can shape the behav ior of the firm. The interactions of closely-held firms and individual behavior is central for a number of important topics such as the effects of tax policy on firm behavior, effects of audits on firm and personal tax compliance, estimates of taxable inc ome elasticity, tax evasion, and income and wealth inequality. We analyze the following questions: 1. How do changes in tax incentives and monitoring activities affect closely held firms' and their owners' reporting of tax liabilities? In particular, ca n we detect effects on the propensity of owner-managers of closely-held corporations to distribute corporate earnings through other channels, so-called masked dividends, such as through shareholder loans and private consumption within the firm? 2. How d o tax authorities' monitoring of firms affect the reported tax liabilities of closely held firms and their owners? Again, we pay particular attention to possible effects on masked dividends as well as studying possible spill-over effects of audits at the firm level on the behavior of the owner as well as on the behavior of other firms of the owner. 3. How does the possibility of owner-managers in closely held firms to use the firm as a tax shelter affect measures of income inequality? How do income equali ty measures evolve if we combine firm and shareholder level information? To analyze these questions, we utilize unique individual-owner linked data from Norwegian administrative registers and a natural field experiment under conduction by the Norwegian t ax authorities. Variation in incentives for reporting tax liabilities are obtained from both the natural field experiment and two recent reforms (a 2006 dividend tax reform and a 2011 removal of accountant duty).

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