Sweat equity is essential to any enterprise, especially a new business whose owner is trying to build it from the ground up. It’s the value of capital that owners accumulate through the hours they put into building client lists, customer bases, good will and other business intangibles.
And while owners are paid immediately (or soon) for the time spent producing actual goods and services, they’re compensated for their sweat equity only through future profits or capital gains. Therefore, sweat equity has an unpredictable payoff. And economists have found it remarkably hard to measure. It is, after all, intangible.
In “Sweat Equity in U.S. Private Businesses” (SR560), Minneapolis Fed visiting scholar Anmol Bhandari and Fed consultant Ellen McGrattan, both of the University of Minnesota, focus on the measurement problem and then analyze tax implications for businesses, small and large. To be specific, they reveal flaws in current estimates of business income and valuation from widely used surveys, develop a model to find more accurate values for net incomes and sweat equity of U.S. private businesses, and then evaluate the impact of lowering tax rates on private and public firms.
Sweat equity is essential to any enterprise, [but] has an unpredictable payoff. And economists have found it remarkably hard to measure.
Their bottom lines: U.S. sweat equity is large—about the same value as fixed assets—and lower taxes on both private “pass-through” firms and public corporations would have a significant economic impact, generating higher consumption, output and GDP. Sweat equity itself would also rise significantly.
Bhandari and McGrattan first show the weaknesses of some existing estimates of business incomes and values that are dependent on flawed survey results. The Federal Reserve’s Survey of Consumer Finance, for example, has unreliable responses on business incomes. Comparison with IRS data reveals that survey responses from other standard sources are also undependable. (For details, see Minneapolis Fed staff report 568, “What Do Survey Data Tell Us about U.S. Businesses?”)
To develop a better estimate, the economists build a model economy in which households can either work for large public firms or own a private firm, a decision made on the basis of a household’s relative productivity in either sector. Corporations pay corporate income tax, but most private firms are organized as “pass-through” entities. Pass-throughs are sole proprietorships, partnerships and S corporations that do not pay the corporate income tax; instead, the income they generate is passed along to the owners, where it shows up as Form 1040 income. (Schedule C for sole proprietors and Schedule E for partners and S corporations.) Pass-throughs have existed for quite a while, but when the Tax Reform Act of 1986 significantly lowered individual tax rates, being a pass-through business became much more attractive.
Another key distinction: The value of a small business lies largely in accumulated sweat equity, and income generated by sweat capital “can be thought of as dividends,” they write “whose present value is the sweat equity we are interested in measuring.”
The model’s parameters are set at values taken from IRS data, U.S. Census of Business figures and U.S. national accounts. With this model economy at equilibrium, Bhandari and McGrattan derive the value of U.S. sweat equity. They estimate it at roughly 0.65 times GDP, similar to the value of private business fixed assets. This figure varies little among small businesses, but because small business income does vary widely, that suggests a large range in rates of return.
The impact of taxes
The economists’ last step is gauging the impact of changes in taxation. In theory, lower taxes on private business income can induce an individual to start a business, causing a rise in overall sweat capital. The impact ultimately depends on how the tax harms or benefits returns to sweat investment.
The research reveals not only how large private business sweat equity is—roughly as valuable as fixed assets—but the importance of tax policy in encouraging or stifling it.
“If we lower both business rates by 10 percentage points,” they write, “we find wages and GDP higher by 5 percent, C-corporate output higher by 6.5 percent, private business output higher by 9 percent and sweat equity by 6 percent.” (The exact numbers are likely to change somewhat, pending refinement of model parameters and pinning down 2017 tax policy details.)
Bhandari and McGrattan’s research thus reveals not only how large private business sweat equity is—roughly as valuable as fixed assets—but the importance of tax policy in encouraging or stifling private firms dependent on it. “Tax policy changes of the magnitude being discussed by U.S. policymakers would have a significant effect on key economic aggregates and the allocation of hours and capital to production in privately held versus publicly traded businesses.”
Moreover, their research provides a new framework for estimating the impact of tax policy on an essential but largely neglected sector: privately held businesses that grow through sweat equity.