Transitions between Employment and Self-Employment in Response to Differential Taxation

How does the differential tax treatment of employees versus self-employed affect the decision to switch to self-employment? Using administrative data on the universe of taxpayers, we study the impact of a large tax cut for business owners in Poland on high-income individuals’ decisions to transition from employment to self-employment. In 2004, the marginal tax rate for business owners in the top income bracket decreased from 40% to a flat rate of 19%, while employees remained subject to a progressive tax schedule with a top rate of 40%. We find a 17% increase in the probability of high-income employees switching to self-employment five years after the reform. The increase in entries to self-employment was driven by increased transitions to long-term solo self-employment (self-employment without dependent workers), especially in high-skilled service industries. In 2009, another reform reduced the tax differential. The entries from employment to self-employment temporarily decreased, but those who had previously switched to self-employment did not return to employment. These findings suggest that large tax differentials increased the attractiveness of self-employment as an alternative to employment but also increased the share of entrants to self-employment who do not hire workers.