Income Taxes and Entrepreneurs' Use of Labor


This paper investigates the effect of entrepreneurs’ personal income tax situations on their
use of labor. We analyze the income tax returns of a large number of sole proprietors before and
after the Tax Reform Act of 1986 and determine how the substantial reductions in marginal tax
rates associated with that law affected their decisions to hire labor and the size of their wage
bills. We find that individual income taxes exert a statistically and quantitatively significant
influence on the probability that an entrepreneur hires workers. A 6 percentage point reduction
in the marginal tax rate of an entrepreneur in the 39.6 percent bracket induces an approximately
1 1.8 percent increase in the probability that he hires labor. Further, conditional on hiring
employees, taxes also influence the total wage payments to those workers. The elasticity of the
median wage bill with respect to the marginal tax rate is about 0.397.

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Journal of Labor Economics, Vol. 18, No. 2 ,April, 2000
Working Papers