The Rise of Pass-Throughs: A Quantitative Exploration

From 1980 to 2012, the share of U.S. businesses organized as pass-through entities (for example, LLCs and S-corporations) rather than C-corporations more than doubled. We show the shift in business organization has significant implications for real economic activity. First, using firm-level administrative data on flows between legal forms, we demonstrate that reorganizations surge during tax reforms that reduce the effective tax rate on pass-through business income. Next, using a decomposition of changes in the income distribution, we show that the rise of pass-through entities explains up to 40 percent of the increase in the share of pre-tax income for top 1 percent households. Finally, to understand the economic mechanism linking tax reform and changes in real activity, we provide an equilibrium model with heterogeneous households and entrepreneurs with an endogenous choice of legal form. We use the model to quantify the contribution of TRA86 tax reform through the business reorganization channel to the evolution of household income, wealth and consumption inequality. Looking forward, we use the model to investigate the macroeconomic consequences of pass-through rise and its impact on income inequality.