The Rise of Pass-Throughs and the Decline of the Labor Share

Updated research from Matthew Smith, Danny Yagan, Owen Zidar and Eric Zwick finds that reallocating activity to the form it would have taken prior to the Tax Reform Act of 1986 accounts for one third of the decline in the corporate sector labor share between 1978 and 2017. Bottomline“… Our key finding is that adjusting for pass-through growth raises the 2017 corporate-sector labor share by 1.6 percentage points and implies the 1978-2017 decline is overstated by 31.9%.While our emphasis on pass-throughs does not preclude the importance of other mechanisms, it does provide new evidence that can help guide future investigation….”

They note/speculate this phenomenon has current implications given the 2017 tax reform, “…Following the 2017 tax reform, firms face new incentives to select the tax-minimizing corporate form and owner-manager compensation due to, for example, the lower C-corporation tax rate and the qualified business income deduction for pass-through firms. As these incentives are understood, investigating future trends in the labor share will require grappling with the nuances of the tax code….”

“.. .In the past forty years in the United States, the share of corporate-sector value added accruing to labor in national accounts fell from 62.9% to 57.9% (Figure 1A). This period coincided with a striking rise in the share of business activity organized in “pass-through” form (Figure 1B).This paper shows that these trends are related. Why would growth of the pass-through sector, which now accounts for the majority of business income, matter for the corporate-sector labor share?The simple answer is taxes. First, entrepreneurs have flexibility to characterize their income as labor payments or as profits. They typically choose the label that minimizes taxes subject to the law. In recent years, that label has been pro t for a growing number of firms. Second, the composition of corporate-sector rms has changed: many labor-intensive rms are now organized outside the corporate sector as tax-preferred partnerships. The joint quantitative importance of these factors for falling labor shares and rising capital shares is an open question with implications for the analysis of technological change, inequality, and tax policy. The historical turning point for the rise of pass-throughs is the Tax Reform Act of 1986 (TRA86). TRA86 lowered personal income tax rates substantially and raised the tax burden on (non-pass-through) C-corporations. As a result, by organizing in pass-through form, entrepreneurs avoid C-corporation taxes and bene t from lower effective tax rates. Subsequent changes in payroll taxation and in the legal treatment of pass-throughs raised the benefits and feasibility of adopting pass-through form, accelerating the pace of this sector’s growth

Effect by firm size, “…More than half of the adjustment comes from skilled service firms in capital-light industries. Firms in these industries include law firms, consultancies, doctors’ and dentists’ offices, and financial service rms such as hedge funds and private equity funds. Such medium-sized firms account for a disproportionate share of pass-through value added, while large, capital intensive manufacturers are more prominent as C-corporations (Figure 1D). By correcting for downward bias among mid-market service firms, our adjusted series implies a larger role for superstar firms and the manufacturing sector to drive the remaining decline in the labor share…….To map micro estimates to aggregate quantities, we depart from Smith et al. (2019) and estimate heterogeneous impacts by firms size. Figure 2A estimates the effects on labor payments for firms divided into groups based on mean firm sales. We partition firms based on mean sales with boundaries at $100K, $500K, $1M, $10M, and $100M in 2014 dollars. Scope for relabeled labor income is greater among smaller firms, as effect sizes monotonically decrease with firms size. Effect sizes exceed 2% of sales even among firms with $1M to $10M in sales and are meaningful (1.1% of sales) for rms in the $10M to $100M size group. Only the largest firms show no relabeling response upon switching. Other variables do not experience major declines following switching events (Appendix B). Among S-corporations, mid-market rms account for a substantial share of aggregate activity. Firms with less than $10M and rms with $10M to $100M in average sales respectively account for 51% and 30% of total S-corporation value added, 38% and 34% of total sales, and 65% and 25% of total owner pay in the most recent available years (Figure 2B)….”

Matthew Smith, Danny Yagan, Owen Zidar and Eric Zwick, “The Rise of Pass-Throughs and the Decline of the Labor Share,” National Bureau Of Economic Research, October 2021, https://www.nber.org/papers/w29400