Income Shifting and Responses to Tax: Evidence from Company Owner-Managers

There has been substantial growth in the number of people who work for themselves, rather than as employees in others' businesses. These individuals are particularly responsive to changes in tax rates; for example, they are known to bunch at kinks in non-linear tax schedules. However, less is known about the relative importance of the various mechanisms used in order to bunch in taxable income. We use a new link between the personal and corporate tax records of UK company owner-managers to investigate how much of their responsiveness to tax is due to real reductions in activity versus avoidance mechanisms. We show that a substantial proportion of their responsiveness is due to short-term income shifting across tax years. We provide evidence that the remainder may be due to longer-term income shifting i.e. withdrawing income as capital gains on company sale or dissolution. Our findings have important implications for tax design.