Does Taxing Business Owners Affect Their Employees? Evidence from a Change in the Top Marginal Tax Rate

Debates about the taxation of business owners often center around the distributional impacts of these taxes and the degree to which they affect workers. The majority of business income in the U.S. is earned by pass-through businesses and taxed subject to the personal income tax system, yet the existence and magnitude of spillovers from personal income taxation to firm behavior has been difficult to estimate. This paper uses a new linked owner-firm-employee dataset created from administrative tax records to analyze how a recent increase in the top marginal tax rate faced by pass-through business owners affected the compensation of their employees. I use panel difference-in-differences methods to compare the earnings of employees in similar firms but whose owners were differentially exposed to a recent tax increase and estimate that approximately 15 to 18 cents per dollar of new tax liability was passed through to employee earnings. This resulted from lower earnings growth among employees attached to their firms, not compositional changes in employment. These results show behavioral responses to the business income taxation embedded in the personal income tax system and imply that the incidence of the personal income tax was not fully borne by those directly subject to the tax change.