How Do Business Owners Respond to a Tax Cut? Examining the 199A Deduction for Pass-through Firms

We measure the short-run responses of businesses and their owners to Section 199A, a deduction that reduced the effective tax rate on most U.S. pass-through business income beginning in 2018. We study taxpayer behavior using de-identified tax records of individuals and businesses. With some notable exceptions, we find neither strong evidence of tax avoidance behavior nor evidence of positive real economic effects. We do not find an increase in 2018 or 2019 business income eligible for the deduction, either in the time series or from comparisons of taxpayers with exogenously differing levels of exposure to the deduction. We examine specific hypothesized margins of adjustment. Partnerships reduce compensation paid to owners, in line with the incentives created by 199A, but S corporations do not. In contrast to fears expressed about the legislation, we do not find that workers – whether new hires or current employees – switch from employee to contractor status to claim the new deduction. Finally, we find no evidence of changes in real economic activity as measured by physical investment, wages to non-owners, or employment of non-owners, though this analysis is underpowered in the short-run.