Since 1980, labor’s share of corporate income has declined in countries around the world, a finding documented in 2013 by Chicago Booth’s Loukas Karabarbounis (now at the University of Minnesota) and Brent Neiman. In the United States, for instance, employee compensation as a percentage of corporate gross value added—or businesses’ total contribution to GDP—steadily fell from 63 percent in 1978 to 58 percent in 2017, according to research by the US Treasury’s Matthew Smith, University of California at Berkeley’s Danny Yagan, Princeton’s Owen Zidar, and Chicago Booth’s Eric Zwick.

Economists have blamed automation, the decline of manufacturing, and the increase in outsourced offshore production for the contracting US labor share. But the tax code could also be a significant contributor.

Zwick and his coauthors find that incentives in Congress’s 1986 rewrite of the tax code spurred a migration by businesses away from C corporations—the traditional corporate form, so-called after subchapter C of the Internal Revenue Code—and toward alternatives such as partnerships and S corporations. The result is that income in the billions of dollars is treated as profits instead of wages, and this has accounted for about a third of the decline in the corporate-sector labor share, according to the research.

Entrepreneurs have long had the ability to characterize their income as direct wages or as a share of profits, and they’ve typically selected the label that legally minimizes taxes.

Wages paid by C corporations are generally subject to personal income taxes plus payroll and social-insurance taxes. By contrast, owner-managers of S corporations do not pay payroll or social-insurance taxes when they report their share of profits as business income. Similarly, owner-managers of partnerships receive little pay as wages. Instead, their compensation consists of pass-through profits and guaranteed payments, both of which can also avoid payroll and social-insurance taxes.

Such pass-through structures always had some appeal but became more attractive under the Tax Reform Act of 1986, which reduced personal income tax rates substantially while raising the tax burden on non-pass-through C corporations.

And they became yet more attractive, and feasible, thanks to subsequent changes in payroll taxation and the legal treatment of pass-throughs. In 2017, the lowest tax rate for a C corporation owner-manager was about 4 percentage points higher than for an S corporation owner-manager.

Giant companies such as Exxon Mobil and General Motors have retained their traditional corporate structure, as the pass-through primarily appeals to private companies that are neither seeking to raise a lot of external capital nor to list their shares for public trading. But many family firms, doctors, and other operations with few owners have become S corporations. And those with many owners—such as large law firms, venture-capital funds, and private-equity funds—have become partnerships. The money flowing through these structures is significant. In the case of S corporations, $99 billion in aggregate income was passed through to owner-managers as profits instead of as wages in 2017, the researchers find.

Profits or wages?

Smith et al., 2021

By reallocating activity to the form it would have taken before the 1986 revisions to the rules, the researchers find that tax-driven choices of business structuring accounted for one-third of the decline in the corporate-sector labor share between 1978 and 2017. In analyzing deidentified tax data associated with 183,000 enterprises that switched from a C corporation to an S corporation between 2000 and 2012, they find that reported labor payments fell sharply in the switching year but were offset by a corresponding increase in reported profits. This suggests that S corporation owner-managers compensated themselves in a tax-preferred manner.

The researchers also considered partnerships. In the 1990s, growth in the pass-through sector shifted from S corporations to partnerships as the latter became more flexible and legally substitutable for other corporate structures. Partnership activity grew from 13 percent in 1980 to 35 percent of total business profits in 2017. That same year, $187 billion that was paid to partners would have been classified as wages had the businesses been traditional C corporations, the researchers estimate.

They used linked owner-company data for partnerships to construct estimates of owner pay shares from the partnership sector for each year from 2001 to 2014, assuming the share to be about the same as for similarly sized S corporations. They conclude that a significant share of C corporation labor in the US has shifted to the likes of law firms, consultancies, doctors’ and dentists’ offices, hedge funds, and PE funds—enterprises that are capital light, as opposed to capital-heavy manufacturing industries.

This in part reinforces the narrative that the decline in US-based manufacturing contributed to the decline in labor compensation. However, the timing of the decrease that Smith and his colleagues identify may help researchers evaluate other causes of labor-share shrinkage. And it could be that similar tax-code developments affect such measurements globally, which has implications for policy discussions.

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