Taxes, Private Equity, and Evolution of Income Inequality in the US*
From 1980 to 2012 the share of U.S. business receipts from businesses organized as pass through entities (for example LLCs and S corporations) rather than traditional C corporations nearly triples following a sequence of tax reforms that reduced the effective tax rate on pass through business income. We show this shift in the pattern of business organization has significant economic implications for firm dynamics and income inequality. First, using firm level administrative data we find that the tax reform dampened the employment growth of the US firms. Next, using a reduced form decomposition of data from the Survey of Consumer Finances, we find the increase in pass through entities explains over 50 percent of the increase in the share of pre tax income for the top 1 percent of households. Finally, to illustrate the mechanism and quantify the effects of policy shifts we develop a heterogeneous agent equilibrium model with workers, entrepreneurs and endogenous choice of legal forms, which captures a key trade off between tax benefits and diversification of investment risk. In the calibrated model, we quantify the contribution of tax reforms through the business reorganization channel to the evolution of income, wealth and consumption inequality of workers and entrepreneurs. Our initial estimates indicate that 1 percentage point reduction in the marginal personal income tax translates into the 0.3 percentage point increase in the top 1 percent pre tax income share and significant increase in the number of the pass through businesses.