Payroll Taxes and the Decision to be Self-Employed

Payroll Taxes and the Decision to be Self-Employed Mark Stabile* Department of Economics University of Toronto 150 St. George St., Toronto, ON, M5S 3G7 Phone: 416-978-4329, fax: 416-978-6713 mark.stabile@utoronto.ca

Abstract This paper investigates and quantifies the role of payroll taxes in the decision to be selfemployed. It examines the effects of introducing into the labour market a payroll tax which taxes employers, but which exempts the self-employed. It exploits two changes in the tax legislation to confirm that it is changes in legislation and not other sector specific trends that are driving the results. Our findings suggest that payroll taxes do indeed influence the decision to be self-employed, with the probability of self-employment increasing as taxes on employees increase and vice versa. Furthermore, there appear to be declines in the return to self-employement caused by the tax, possibly due to inefficient allocation of labour towards self-employment. JEL Codes: H2, J2 Key Words: payroll taxes, self-employed

1 1. Introduction As expenses for targeted social programs, such as health insurance and retirement programs, continue to increase, governments are often faced with the task of finding ways to finance these benefits. In many cases programs are financed through several methods, including both income and paryoll taxes. For example, the U.S. Medicare program, which primarily serves the population ages 65 and over, is financed partly through a payroll tax levied both on employees and employers as well as by general income tax revenues. As pressure mounts in many countries to decrease income taxes, the role of the payroll tax in financing universal benefit programs may become increasingly important. Economists have extensively studied how payroll taxes affect both labour supply and wages. Recently, (see Bruce (2000) for example) research has also examined how individuals may alter their labour supply to avoid paying taxes altogether. In particular, in many cases individuals who are self-employed are exempt from part or all of payroll taxes. Individuals may choose to become self-employed, in part, to avoid paying these payroll taxes. To the extent that taxes affect occupational choice, it is essential that policy makers understand how taxes may promote or discourage entrepreneurship, and to determine for whom such incentives will have the largest effects. This paper investigates and quantifies the role of payroll taxes in the decision to be self-employed. It examines the effects of introducing a payroll tax into the labour market which taxes employers, but which exempts the self-employed. In particular, it examines the introduction of the Employer Health Tax introduced by the province of Ontario in 1990. This is a

2 particularly useful payroll tax to examine for two reasons. Firstly, the tax was introduced only in one province, Ontario, providing a natural test and control group with which to examine the impact of the tax. Secondly, the government changed the way the tax affected the self-employed a few years after the tax was first introduced, providing a second opportunity to study the response of the self-employed to the payroll tax. Since we essentially observe the reform twice, the effects of interest are overidentified, allowing us to be more sure that we do not mistake sector specific trends for the effects of the reform (Baker and Benjamin, 1999). Our findings suggest that payroll taxes do indeed influence the decision to be self-employed, with the probability of self-employment increasing as taxes on employees increase and vice versa. This paper also investigates the magnitude of any distortionary effects these taxes may have. There appear to be real distortions caused by the tax due to changes in the allocation of labour. We show evidence that wages among the self-employed declined after the introduction of the payroll tax and that upon extending the payroll tax to the selfemployed, the wages in this sector increased. The paper is organized as follows: section 2 reviews previous literature on both payroll tax incidence and the decision to be self-employed. Section 3 outlines the tax legislation under study. Section 4 introduces the empirical methodology. Section 5 describes the data used in the anlaysis. Section 6 presents the empirical results. Section 7 concludes. 2. Payroll Taxes and the Self-Employed

3 Several papers which examine the incidence of payroll taxes particularly their effects on wages and employment. Most of the findings suggest that payroll taxes are generally passed on to the worker in the form of lower wages (see for example Gruber (1997) and Gruber and Krueger (1990). Anderson and Meyer (1997) examine the incidence of a firm-varying payroll tax earmarked to finance a particular benefit the U.S. unemployment insurance premium. Their results suggest substantial wage effects although they do not rule out potential employment effects. Studies in Canada are summarized nicely in Kesselman (1997). Here the evidence is mixed with findings ranging from no wage effects (Wilton and Prescott, 1996) to full shifting of the tax onto labour (Beach et al, 1995 ). Previous work has also examined the effects of tax rates on the decision to be self-employed. Blau (1987) uses aggregate U.S. time-series data to examine the changes in self-employment between 1948 and 1982. He finds evidence that higher marginal tax rates in the upper income brackets of the personal income tax have a positive effect on self-employment and that the opposite is true in lower income brackets. Gentry and Hubbard (2000) examine the effects of marginal tax rates and income progressivity on entrepreneurial entry and find significant increases in entrepreneurial entry when tax rates are less progressive. Using pooled US and Canadian data between 1983 and 1994 Schuetze (2000) finds that increases in average income tax rates have large and positive effects on the rate of male self-employment. Each of these studies has examined the impact of personal income taxes on the decision to be self-employed. Moore (1983) examines the incidence of the payroll tax on the decision to be self-employed using cross sectional data from the 1978 Current Population Survey and finds that increases in

4 payroll taxes lead to increases in the probability of self-employment. One potential limitation of this study is that all the variation is from a single cross section. Therefore, an individual s income in one state is used to calculate tax rates in both the self-employed and wage and salary state. More recent work by Bruce (2000) examines the effect of marginal tax rates from wage employment versus self-employment on the decision to become self-employed using data from the Panel Study of Income Dynamics and exploiting changes in payroll taxes over time. Bruce finds that increasing marginal tax rates on self-employment income increases the probability of becoming self-employed. 3. The Ontario Employer Health Tax The Ontario Employer Health Tax was introduced as a means to abolish Medicare premiums in Ontario (Kesselman, 1997). The tax was announced on May 17, 1989 and came into effect on January 1, 1990. Prior to the introduction of the tax workers were required to pay lump-sum OHIP premiums based on either an individual or family rate. Part of these premiums were paid by employers on behalf of these employees. All individuals were required to pay OHIP premiums although there were assistance plans for individuals and families with low incomes. When the payroll tax was introduced, the premiums were abolished, although the payroll tax was not earmarked specifically for health care 1. The budget literature available made no suggestion that the new tax would be a temporary measure. The payroll tax covers all major forms of employee

5 compensation and fringe benefits (excluding employer pension contributions). The statutory incidence of the tax is exclusively on the employer. The tax rate varies by the size of the payroll, ranging from 0.98% of employer payroll to a maximum value of 1.95% of payroll. While the self-employed were required to pay OHIP premiums prior to the payroll tax, the original payroll tax exempted all selfemployed individuals. Beginning in 1993, the Ontario government also included selfemployed individuals in the payroll tax. Self-employed individuals were exempt from the payroll tax for up to $40,000 of total net self-employment income 2 and were subjected to a graduated payroll tax after that (Ontario Budget, 1989). Table 1a and 1b show the range and magnitude of the payroll tax for both employers and the self-employed. 3 To give some idea of the burden of the payroll tax, a firm with ten or more employees, and a yearly payroll of $400,000 (CND) or more faced a payroll tax of 1.95%. This amounts to roughly $800 per employee on average, although one might expect that the burden of the tax would increase proportionately with income. 4. Empirical Strategy This paper attempts to measure the impact of tax policy on the decision to be selfemployed. In particular, we examine whether the introduction of a payroll tax encouraged individuals to become self-employed in order to avoid payroll taxes. Although the payroll tax is relatively small at a maximum of 1.95% of payroll, when combined with existing payroll taxes, the resulting effect of such a tax on the decision to be self-employed may be significant on the margin. Individuals will consider the total tax differential between

6 salary and self-employment earnings, which may be considerably larger than the payroll tax alone, when making employment decisions. This paper uses the exogenous changes in this differential, the changing payroll tax legislation, to examine the marginal effect of the different tax treatment of the self-employed. In order to identify this effect we examine the decision to be self-employed both before and after the introduction of the payroll tax. Since there are many other factors that might affect the decision to be self-employed, we contrast individuals in Ontario, where the payroll tax came into effect, with two plausible control groups. First, we use other provinces in Canada that had a stable payroll tax environment over the period in question. The control provinces include British Columbia, Alberta, Saskatchewan, and the Maritime provinces excluding Newfoundland. Newfoundland, Manitoba and Quebec are excluded because they have their own payroll taxes and experienced rate changes during the period in question that might affect the decision to be self-employed in those provinces. The remaining control provinces did not have any payroll taxes in effect over this period, with the exception of premiums for workers compensation program, the rates of which changed very little from year to year. At the federal level, payroll taxes are used to finance Employment Insurance and the Canada Pension Plan. While these rates varied slightly over this time, they affected all workers in our sample equally (only Quebec sets its own rate rates for its pension program (Baker and Benjamin, 1999)). As a second control group we use American states that immediately border Ontario (Ohio, Michigan and New York). While there may be more regulatory differences between US states and Canadian provinces, the economies of neighboring states are quite similar to that of Ontario. The empirical specification outlined below assumes Canadian provinces

7 as the relevant control group, but the analysis is identical for the control group of American states. We use a simple difference-in-differences estimator to examine the impact of being self-employed in Ontario before and after the introduction of the 1990 payroll tax as compared to other provinces in Canada which do not include a payroll tax: ˆ δ = ( self self ) ( self self ) (1) dd Ont, before Ont, after Other, before Other, after where self is the propensity to be self-employed in either Ontario or the other control provinces in either before or after the legislative change. The difference-in-differences estimator, δˆ dd, is the difference in the propensity to be self-employed in Ontario after the introduction of the payroll tax, relative to changes in the propensity to be self-employed in the control provinces. We attribute the difference-in-differences to be due to the introduction of the payroll tax, and as such we expect that δˆ dd will be positive, reflecting the fact that by exempting the self-employed from the payroll tax, more individuals will choose to be self-employed. We can expand the difference-in-differences framework into a multivariate framework which controls for other factors which one might expect to affect the propensity to be self-employed such as income, occupation, sex, and marital status, by modeling the decision to be self-employed as a probit equation of the following form: self it = β 1 Yeart * Ontarioi + β 2Yeart + β 3Provincei + δx ti + ε it (2)

8 The coefficient on the interaction between Year*Ontario is the multivariate version of the difference-in-differences estimator. Year represent year fixed effects and Province are province fixed effects. The interaction term between Year and Ontario is the interaction between residing in Ontario and a dummy for the post-reform years. X is a vector of other observed demographic characteristics including income, sex, marital status, age, industry and occupation. X includes the provincial or state unemployment rate to account for more global factors that might affect self-employment. We also experiment with specifications that include a linear time trend to account for the increase in self-employment across all regions over this time period. Our results are robust to the inclusion of these trends. Standard errors are cluster-corrected at the province level, using the cluster command in Stata, since the variation is not at the individual level, but across provinces over time. If the introduction of the payroll tax in Ontario affected the propensity to be selfemployed, we would then expect that with the 1993 change in tax legislation, which no longer excluded the self-employed with incomes over $40,000 from the payroll tax, part of the effect of the 1990 payroll tax would be reversed. Since only those self-employed with total self-employment income greater than $40,000 were affected by the tax, we would not expect an effect of the same magnitude, but we should see some decline in the propensity to be self-employed since the payroll tax advantages of being self-employed have been removed. To model this we repeat the univariate and multivariate differencesin-differences exercise for the period pre and post 1993 to see whether, in fact, the propensity to be self-employed is again responsive to the change in payroll tax exempt status. We first perform a similar difference-in-differences analysis to the one outlined above, with the a priori expectation that the propensity to be self-employed will move in

9 the opposite direction. However, only individuals earning $40,000 or less were exempt from the tax, all other self-employed individuals were subject to the payroll tax as of 1993. If we were to examine only those individuals with more than $40,000 we might be concerned that earnings are endogenously determined, in part, based on cutoff levels for tax exemptions. To account for this we predict whether individuals will have earnings greater than $40,000 using educational attainment. This procedure is in keeping with previous literature (see, for example, Baker 2002) and the correlation between education and income in our sample is very high. We examine only those individuals with some college education or higher. The consistency of our results across the two tax changes allows us to ensure that we are measuring the effects of the payroll tax and not provincial-specific trends. During the period 1990-1995 relatively few other changes that affected the selfemployed in Ontario. There were various changes in the income tax schedule that differed in Ontario from the control groups. To control for the potential effects of income taxes on the decision to be self-employed, we calculate individual marginal tax rates on employment income and include this variable in our analysis. To control for endogeneity in the marginal tax rate, potentially caused by individuals changing their marginal tax rate by becoming self-employed, we instrument for the individual s marginal tax rate using changes in provincial income tax rates over time. This methodology, also used by Bruce (2000), amounts to using the difference in the marginal tax rates faced by the same individual, with the same income, but under different income tax structures as the instrument for the tax rate. The variation in marginal tax rates that we impose on individuals comes from changes in provincial income tax rates that occurred in various

10 provinces over this time period. Since we are using only changes in tax rates and not changes in individual behavior to generate the instrument, the instrument is free from the endogeneity problem noted above. There were other small legislative changes that we believe do not complicate our analysis. In 1992 and 1993 Ontario changed the tax rate on the taxable income of small businesses, but these taxes affected both the self-employed and non-self-employed alike (Ontario Budget, various years). In 1994 the government exempted employers from the Employer Health Tax for any new employees for a period of one year. While this may have provided a limited term incentive to hire more employees, the exemption was only for one year, was stated as such, and did not apply to any existing employees (Ontario Budget, various years). The stated short and temporary nature of this one-year change makes it unlikely that there would be large changes in worker behavior. We use three years of post-1993 data to help control for any effects of this one-year exemption. The control provinces look similar to Ontario in other observable respects. Mean ages, education levels, percent male, percent married, and hours worked are all practically identical between Ontario and the control provinces in 1988, the base year for our analysis. Average income levels are higher in Ontario than in the control provinces and this remains true in all our sample years. The percent of workers in various occupations is also quite similar between Ontario and the control provinces. The two exceptions to this are that the control provinces have a larger share of workers in agricultural occupations and Ontario has a slightly larger share in product fabricating occupations. Since many workers in the agricultural sector are self-employed, we repeat all of our analyses with and without workers in the agricultural sector to be sure that this

11 difference is not driving our results. Our results are robust to this exclusion and we report results both with and without agriculture workers below. We include province-specific dummy variables to capture any permanent structural differences between Ontario and the control provinces. Means for Ontario and the control provinces are reported in Appendix A. 5. Data We use data from the annual Canadian Survey of Consumer Finances. We pool cross-sections from the 1989 (1988 income year), through 1997 (1996 income year) surveys, excluding the income years 1990 and 1993 as those were the years that the legislation in question changed. The Canadian Survey of Consumer Finances contains income information, labour force characteristics and demographic characteristics for individuals aged 15 and over. In each year we have data on earnings from various sources and on which of these sources was the individual s primary source of earnings. We eliminate individuals in Newfoundland, Quebec and Manitoba from the sample because these three provinces had their own payroll taxes in place during the time of our analysis. We use data from the 1988 and 1989 income years as the pre-payroll-tax period, from the 1991 and 1992 income years as the post-payroll-tax and pre-self-employed-tax period, and the 1994, 1995, and 1996 income years as the post-self-employed-tax period. 4 We estimate the effects of the two reforms separately to allow for flexibility in all the coefficients over time and to facilitate sample restrictions for the second tax change. We examine only those individuals who reported themselves as working in the previous year. Our sample consists of approximately 25,000 workers per year from the seven remaining

12 provinces, aged fifteen through eighty, of which approximately 3,000 are categorized as self-employed each year. We define individuals as self-employed during the previous year if they are working and claim self-employment income as their major source of income in that year. We choose this definition of self-employment because the questions refer to the same job as the income questions refer to. There is an alternate question in the Survey of Consumer Finances that refers to the current year; however, we cannot link this question to the job for which we have income information in the survey. 5 The self-employment rate rose between 1988 and 1995 the period during which the tax changes took place in Ontario. In 1988, 6.6 percent of working Canadians in our sample claimed self-employment income as their primary income source. By 1995, that number had increased to 8.8 percent. If we exclude the self-employed who work in agriculture, the self-employment rate went from 5.3 to 7.6. Figure 1 shows the change in the self-employment rate over time, excluding workers in the agriculture sector. 6 Both Ontario and the control provinces show an upward trend in rates of self-employment, consistent with the findings in Schuetze (2000) 7. The alternate measure of self-employment (not shown in the figure) results in a slightly higher self-employment rate in each year (between 1 and 1.5 percentage points) that is, at least in part, due to the upward trend in self-employment rates. The time trends in the self-employment rates are similar between the two measures. We also use data on individual marginal tax rates by province and year. These rates account for federal and provincial taxes and surtaxes as well as for standard deductions available to all tax filers. The rates do not take into account potential

13 deductions for children and a spouse. To account for changes in the self-employment rate due to changes in income taxes, we include these marginal tax rates in our analyses. For the U.S. states we use data from the March samples of the Current Population Survey (CPS) for the same years as the Survey of Consumer Finances listed above. The CPS contains demographic and labour force information for approximately 150,000 individuals. Like the SCF, the income questions in the Current Population survey refer to the previous year. To try to ensure consistency across the two samples, we use the CPS questions on self-employment that refer to the same year as the income questions. For our sample of three states, Michigan, Ohio and New York, we have approximately 10,000 observations per year of which approximately 6% on average are self-employed. Data on the unemployment rate are from CANSIM for Canada and from the Bureau of Labor Statistics for the United States 8. 6. Empirical Results 6.1 The Propensity to be Self-Employed The empirical strategy involves two tests. The first test examines whether the propensity to be self-employed in the test province (Ontario) differed after the introduction of the payroll tax relative to the control provinces. The second test examines whether the movement towards self-employment altered, in part, after the exemption status for self-employed workers was partially revoked. We perform these analyses by examining a simple difference-in-differences between the test and control provinces before and after the payroll tax changes and then expanding this difference-in-difference

14 into a regression framework to control for a variety of other potential factors which might influence the decision to be self-employed. We first examine the effects of the introduction of the payroll tax in 1990 on the probability of being self-employed as we define it above (reported in Table 2). Prior to the introduction of the legislation approximately 6% of workers in Ontario were selfemployed versus 8.6% in the control provinces. After the introduction of the legislation, 7% of workers in Ontario were self-employed versus 8.6% in the control provinces, a statistically significant difference-in-differences of approximately 1 percentage point. This suggests that the introduction of the payroll tax coincided with an increase in selfemployment in Ontario versus the control provinces. There are several other factors that might influence the decision to be selfemployed. For example, the probability of being self-employed differs considerably across occupations, industry, and by income and education level. Further, macroeconomic cycles resulting in changes in unemployment rates may lead individuals into or out of self-employment. To be sure that these differences are not driving the change reported above, we expand the analysis into a multivariate framework. We report these results in Table 3. After controlling for the individual s total income, education, marital status, age, occupation, industry, and the provincial level unemployment rate, the difference-in-differences result remains with a 0.8 percentage point increase in the probability of being self-employed in Ontario after the introduction of the payroll tax versus the change in the control provinces over the same time period. The occupation controls are jointly significant. Income is positively correlated with being self-employed. Individuals with a university degree are more likely to be self-employed than individuals

15 with other levels of education. The unemployment rate does not significantly affect selfemployment rates with the inclusion of the other control variables. To test the robustness of the results, we try several other specifications. We repeat the analysis for men and women separately (not shown here). For men the effect of the payroll tax is practically identical. For women the results are slightly smaller but remain positive and significant. We also re-run the analysis excluding the occupational and industry level dummy variables and both including and excluding linear time trends. Again the main results are almost identical. We also include marginal tax rates for individuals in the sample. These tax rates differ by income and province and reflect an individual s combined federal and provincial marginal tax rate, including surtaxes and standard deductions 9. Our results suggest that an individual s marginal tax rate is negatively correlated with the probability of being self-employed 10. Including the marginal tax rates has almost no effect on our difference-in-differences estimate of the impact of the payroll tax. The third column of Table 3 excludes agricultural workers from our sample. We exclude these workers since self-employed farmers may be less able to enter or exit selfemployment following changes in the payroll tax. We find that the probability of being self-employed in Ontario after the introduction of the tax, relative to the control group, increases by 0.9 percentage points, quite similar to the full sample results. The fourth column reports the two-stage results for the effect of the payroll tax using changes in income tax laws as an instrument for the marginal tax rate. The coefficient on the difference-in-differences is slightly larger than the single stage probit results, and identical to results obtained from linear probability models (not shown here) at 1.4 percentage points, and remains statistically significant. The t-statistic on the excluded

16 instrument in the first stage is 40.4 and the R-squared for the first stage is 0.66. The complete first stage results are reported in Appendix B. Overall, both the standard difference-in-differences and the multivariate regressions show an increase in the propensity to become self-employed after the introduction of the payroll tax in Ontario versus the same time period in other provinces. The magnitude of the effects is not inconsistent with Abbott and Beach (1997), who find that a one percentage point rise in the employer tax rate reduces employment by 0.9 percent to 3.3 percent. As noted above, the self-employed exemption from the payroll tax was altered in 1993. The legislation was changed so that self-employed individuals who were earning less than $40,000 were exempt from the payroll tax, but those self-employed earning more than $40,00 were subject to a graduated tax rate. Since the introduction of the payroll tax in Ontario affected the propensity to be self-employed we should see some reversal of this effect after the tax exemptions were altered a few years later. To test this we predict whether there is a decline in the propensity to be self-employed after the change in legislation. Table 4a presents the results. Relative to the control provinces, after the change in the tax rate, self-employment levels were lower in Ontario. Rates of self-employment increased for both the control provinces and Ontario over the test period. In the control provinces the rate of self-employed rose from 8.6 percent to 10.0 percent. In Ontario the self-employment rate rose from 6.8 to 7.7 percent a statistically significant difference-in-differences of 0.5 percentage points. If we limit the sample to those individuals who we predict to have earnings of greater than $40,000, the results are quite similar. We use only those individuals with

17 education levels of some college or greater as a predictor of whether an individual earns more than $40,000 11. The results are presented in Table 4b. The propensity to be selfemployed fell in Ontario relative to the control provinces by 0.5 percentage points, although this estimate is not quite significant at the 10 percent level (t=1.25). We expand the analysis of the 1993 tax change to a multivariate framework, controlling for province, occupation, industry, income, and other demographic characteristics as well as the provincial unemployment rate. Once we control for these other influences on self-employment, we see a negative and significant coefficient estimate for the difference-in-differences between Ontario and the control provinces over the tax change. The probability of being self-employed in Ontario after the tax change is 0.4 percentage points lower than the difference in the control provinces over this same period. This result is significant at the 5% level. Once again, the occupational and industry controls are jointly significant, and higher levels of education are strongly correlated with being self-employed. The results are reported in the second column of Table 5. 12 We repeat the analysis selecting only those individuals with some college education or more. The results are quite similar for this group. The probability of being self-employed in Ontario after the tax change is 0.6 percentage points lower than the difference in the control provinces over this same period. Again, this result is significant at the 5% level. Comparing the coefficient estimates of the 1990 tax change with those of the 1993 tax change, the two marginal effects on the treated populations are of similar absolute magnitude (well within each others confidence intervals), suggesting that the effects of the payroll tax were offset for the respective treatment group (in this case only

18 those with college education or more) by the inclusion of self-employment earnings three years later. The fourth column of Table 5 reports results excluding agricultural workers from the sample to compare to our earlier results from the 1990 tax change. Again we select only the sample with some college education or more. The coefficient on the marginal tax rate is negative and strongly significant, and the other coefficient estimates are quite stable in both magnitude and significance. The two-stage estimates are reported in the fifth column. When we instrument for the marginal tax rate, the effect of the payroll tax remains negative and significant and is slightly larger than the single-stage results. However, the instrumented coefficient on the marginal tax rate is no longer significant for this sample. The t-statistic on the excluded instrument in the first stage is 19.4 and the R- squared for the first stage is 0.61. As an alternative control group we consider a set of U.S. states surrounding Ontario. Using data from the Current Population Survey we construct a control group from New York, Ohio and Michigan. While the regulatory structure of these states may differ from Canada s, these states have similar economies to that of Ontario. GDP growth over the period in question was quite similar between the great lake states and Ontario (Statistics Canada, various years and Bureau of Labor Statistics, various years). Table 6 presents results of the multivariate difference-in-differences estimates. Univariate difference-in-differences results are not presented but are quite similar to the multivariate results. Columns two and three present results for the 1990 tax change with and without agricultural workers. The difference in the propensity to be self-employed increased by 1.1 percentage points in Ontario relative to the U.S. control group states. This result is in

19 the same direction as with the Canadian control group, although the magnitude is somewhat larger. Other controls also have similar effects on the probability of being selfemployed. Married males are more likely to be self-employed, and individuals with a college degree are more likely to be self-employed than the base category of a high school education. Income is not a significant predictor of self-employment in this specification. In contrast to the Canadian control group, the unemployment rate is positively correlated with self-employment. The fourth and fifth columns of Table 6 present results for the 1993 tax change. Again we see a positive and significant increase in the propensity to be self-employed in Ontario versus the U.S. control states, in this case contrary to our expectations. One possible explanation for this is that self-employment rates were falling in the US over this period (Schuetze, 2000) and this decline dominates any effect of the Ontario payroll tax. 6.2 Distortions Resulting from the Payroll Tax Given the evidence suggesting that payroll taxes that differentiate between types of income affect the decision to be self-employed, we might be concerned that there are distortionary effects from this differential taxation. One possible consequence of such differential taxation is that individuals may be shifting into an employment status in which they have lower productivity. If with a payroll tax that exempts self-employment income individuals choose to be self-employed, whereas in the absence of the tax they choose to not to be self-employed, we might expect that some of the movement into selfemployment is an inefficient allocation of labour (see Watson (1985) for a theoretical

20 discussion of this possibility). Individuals may sort themselves efficiently in the absence of differential taxation and make inefficient allocation decisions in the presence of differential taxation. If this is the case, then the average returns to self-employment will decrease as more individuals turn to self-employment. If the above hypothesis is true then we should see a decline in the average returns to self-employment after the introduction of the payroll tax in 1990 and an increase in the returns to self-employment after the self-employed exemption is removed in 1993. To test this we use a multivariate difference-in-differences estimator similar to those specified above. Here we compare the wages of the self-employed in Ontario and the control provinces, before and after the legislative change. We transform income using an inverse hyperbolic sine transformation as proposed in Burbidge et al (1988) 13. The results are presented in Table 7. The second column presents results for the period surrounding the introduction of the payroll tax in 1990. There appears to be little change in the return to self-employment in Ontario relative to the control provinces after the introduction of the payroll tax. However, after the self-employment exemption is dropped in 1993, we see that the returns to self-employment rise in Ontario relative to the control provinces (column 3). As an alternate test for changes in the returns to self-employment we examine the difference in wages between self-employed and non-self-employed workers in Ontario before and after the introduction of the payroll tax. This specification addresses concerns that there may be structural differences across provinces that affect the returns to selfemployment and that our analysis is picking up these differences and not the effects of the tax. Here we compare only individuals in one province. Again, we would expect that

21 the returns to self-employment would decline relative to the non-self-employed after the introduction of the payroll tax, and they would increase again as inefficient labour moves out of self-employment three years later. Our results are consistent with this hypothesis and are presented in Table 8. While the coefficient on the initial payroll tax change is larger in absolute value than the coefficient on the 1993 change (about 50 percent larger) it would appear that much of the initial decline was offset after the 1993 payroll tax change. The magnitude of the wage distortions suggested by these coefficients is quite large (evaluated at the mean the change is wages is approximately $16,000 CDN). As a result we conduct some further analyses to attempt to rule out other possible explanations for our results. One potential concern is that the returns to self-employment are driven primarily by past returns in the sector instead of changes in the payroll tax. To attempt to control for this possibility we include a variable equal to the average wage in the selfemployment sector in each province for the previous year (not shown here). This coefficient is insignificant in almost every specification and does not alter the coefficient on the effects of changes in the payroll tax. Both specifications suggest that selfemployment income fell in Ontario relative to the control provinces after the introduction of the tax. Again, our estimates suggest that the wage distortions were reversed upon the inclusion of self-employed workers under the payroll tax. A second possible explanation for the large changes in the return to selfemployment is that individuals on the margin between choosing self-employment and salary earnings are individuals with lower average earnings. While it is not possible to determine exactly which individuals altered their behaviour as a result of the tax, we can

22 again use education as a proxy for earnings potential and examine whether the average educational attainment among the self-employed changed in Ontario relative to the control provinces as a result of the payroll tax. If we were to observe that individuals with the lowest education are also those individuals most likely to move in and out of selfemployment, this would be consistent with the marginal worker also having lower average earnings. We perform the same empirical test as we used above with wages to examine the difference in differences in educational attainment for self-employed workers in Ontario relative to the control provinces before and after the change in legislation. While we do not present the results here, we do not find a significant coefficient on the difference in differences in educational attainment (although the coefficient is negative), suggesting that there was no statistically significant difference in the average educational attainment between groups as a result of the tax change. We exploit the second change in tax legislation three years later to confirm this finding and again find no significant difference in educational achievement between the selfemployed in Ontario relative to the control provinces. Hence, the evidence, at least when using education as a proxy for earnings, is not consistent with the hypothesis that it is simply individuals with lower average earnings who are moving between jobs and causing returns to self employment to fluctuate. As a final check on what is driving these large changes in the returns to selfemployment, we examine only those individuals with positive income. Individuals who are self-employed are more likely to report zero or even negative income in a year than salaried workers, and the relative decline may be disproportionately due to these individuals. It would appear that this is indeed the case. When we restrict the sample in

23 this way and take differences over the legislative changes, the significant coefficients on the interaction between living in Ontario post-1990 disappear, as do the significant coefficients of the opposite sign three years later. That the result disappears once we restrict the sample to positive income earners suggests that it is the bottom of the distribution that is lowering the overall returns in the self-employment sector. 7. Conclusions This paper presents evidence that payroll taxes that differentiate between types of earnings can distort labour market decisions. Ontario s Employer Health Tax, which began by exempting self-employed income, is an example of such as payroll tax. Our evidence comparing Ontario to other Canadian provinces suggests that individuals avoided the tax by moving towards self-employment. Moreover, these movements resulted in real wage effects with returns to self-employment falling in response to the influx of self-employed workers. The introduction of a payroll tax ranging from one to two percent of total payroll resulted in between a 0.6 and 1 percentage point increase in the probability of being self-employed. Including self-employment income in the payroll tax base offset the movement towards self-employment for the affected group almost exactly. To give an idea of the magnitude of this change, there were approximately 308,000 self-employed workers in the year prior to the implementation of the payroll tax (calculated using weighted SCF data). An increase of 0.6 percentage points would represent about 30,000 workers. Using the average value of the tax per worker calculated above of $800, this represents a tax revenue loss of $24 million (CDN). Of course, this

24 estimate only represents the average loss in payroll tax revenue and is not an estimate of the total change in revenue due to the payroll tax. These results are robust to several specifications and the magnitudes are consistent with previous evidence on the effects of taxes on employment (Kesselman, 1997). Using an alternate control group of US states we continue to find a movement into self-employment post 1990 but no movement out of self-employment three years later. The policy implications of these findings extend beyond the specific case examined here. Many countries, including Canada, exempt most self-employment from payroll taxes used to fund unemployment insurance, as well as exempting the self employed from many general payroll taxes (Kesselman, 1997). In an attempt to measure the potential distortions which result from the tax we examine the returns to self-employment and find a decline in the returns to selfemployment as individuals move into self-employment and a corresponding increase in the returns to self-employment as individuals move out of self-employment. Again, the loss in income is offset almost exactly for the affected population with the inclusion of self-employed income in the payroll tax. The results are consistent with a model where workers, along with their employers, adjust their labour market behavior to avoid paying tax, which then results in workers making sub-optimal choices about becoming selfemployed.

25 * I thank Michael Baker, Dwayen Benjamin, Sherry Glied, Glenn Hubbard, Jonathan Kesselman, Michael Smart and the editor and referees for helpful comments. All errors are my own. 1 Not only was the payroll tax not earmarked for health insurance, the tax has no bearing on an individual s eligibility for any health care services in Ontario. Hence we would not expect any shift outwards in labour supply as a result of individuals valuing a benefit associated with the tax. 2 Total net self-employment income includes most business and self-employment income, and is applied to all income whether earned in Ontario or elsewhere. 3 In 1997 the tax structure and rates were adjusted again; however, the focus on this paper is on the changes in the tax structure between 1990 and 1996. 4 Individuals with missing information are excluded from the estimation sample. 5 Our main results are robust to the measure used for self-employment. 83% of individuals claiming selfemployment as their major source of income also claim to be self-employed. 6 If we include agricultural workers in Figure 1, the trends are similar but the gap between the test and control provinces is larger. 7 Schuetze concludes that nation-wide increases in unemployment and average income tax rates contributed to the rise in male self-employment over this period. 8 For the combined US-Canadian sample we use occupation and industry categories which are the lowest common denominator across the two data sets. We do not alter the top coding of income across the samples, but have re-estimated our regressions with and without income as a control and our results are quite similar. 9 The unit of taxation in Canada is the individual and not the family. All taxpayers file separately although there are deductions available for dependents with income under $5380. 10 This finding is consistent with previous research. Alternate specifications (not reported here) find that when an interaction is included for higher income individuals marginal tax rates have a positive effect on the probability of being self-employed for upper-income individuals and a negative effect for lower-income individuals, in keeping with Blau (1987).

26 11 Alternatively we predict income using age, sex, education, marital status, and year dummies and then compare individuals across provinces and over time using only those individuals whose predicted incomes are greater than $40,000. The results do not change significantly from those presented above. 12 We repeat the analysis for men and women separately, including and excluding occupational and industry dummies, and including and excluding linear time trends. All results are qualitatively identical with the exception of women separately for whom the effects of the payroll tax are smaller. 13 The inverse hyperbolic sine (IHS) transformation, equal to log(y + (y 2 +1) 1/2 ) is very similar to the log transformation of income for positive income values. However, since self-employed earnings can and do take on negative values, the IHS transformation is applied. To check the fit of the transformation we compare coefficients using both IHS and a standard log transformation for the sample greater than zero. The two specifications are almost identical over this range.

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