Business entities are ordinarily subject to one of two alternative tax regimes. Under a partnership regime, partners pay tax on their respective shares of the partnership’s income. Under a corporate regime, the corporation itself pays tax on the income as it accrues. When the corporation eventually distributes the income in the form of a dividend, shareholders pay a second level of tax. While in some instances, the law dictates which of these two regimes applies, several countries, including the United States, permit noncorporate entities to choose the tax regime to which they will be subject (the so-called “check-the-box” regulations).

Which regime is preferable from the perspective of the taxpayers depends on a variety of factors, including the entity’s expected profits and losses, the types of income it is expected to generate and the expenses it is expected to incur, and the marginal tax rates of the parties involved. Numerous articles have been written about the relative burdens of the different regimes, and “choice of entity” is a staple in law school courses on business entity taxation. Business entities (or their tax advisors) take into consideration these and other factors and choose the optimal tax regime with the lowest effective expected tax burden.

At least, that is how things are supposed to operate. Commentators, teachers, and policymakers tend to assume that businesspeople are rational actors who seek to maximize after-tax profit, and that their decision whether to “check the box” results in their being subject to the least burdensome tax regime. If business entities habitually choose one regime over the other, it is reasonable to assume that in most cases the former is indeed preferable from their perspective. Such a phenomenon could induce an investigation as to whether that tax regime contained unwarranted benefits or whether the alternative regime was unduly burdensome.

In this week’s feature article, four German professors examine the response of partnerships in Germany to that country’s check-the-box rules. They surprisingly discover a considerable underuse of the opportunity to check-the-box and choose a corporate tax regime. Since the rule’s introduction in 2008, only about 5.6% of those entrepreneurs who benefit from the corporate tax regime chose it. This, they argue, raises a critical question of why so many entrepreneurs forgo potentially substantial tax savings by choosing the partnership tax regime.

To investigate the issue, they undertook an incentivized online experiment which allowed them to examine preferences for partnership versus corporate taxation under controlled conditions. They analyzed a number of frictions that could impede optimal behavior and discovered that two of them significantly affect the choice of tax regime. The first is the perception that corporate taxation is too complex, and as individuals tend to be complexity averse, this perception increases the attractiveness of the partnership tax regime. I must admit that this argument struck me as somewhat counterintuitive, as in the United States, partnership tax has a (well-deserved) reputation for being considerably more complicated than corporate taxation, and while I have little knowledge of German entity taxation, from what I have been able to gather, there too partnership taxation is in fact more complicated than corporate taxation (although the gap may not be as wide as in the United States). However, as we are here dealing with behavioral frictions, it is not the actual complexity but rather the perceived complexity that is important. If corporate tax is perceived as more complex, the complexity averse are likely to shy away from it. Under the heading of complexity, the authors also include a misperception of the overall burden of the corporate tax regime, with individuals often simply adding the corporate-level tax to the shareholder-level tax (without taking into account that, when all earnings are distributed, the shareholder-level tax base is, in fact, the corporation’s after-tax earnings).

The second is status quo bias. Entrepreneurs who have experience with the partnership tax system are more likely to stick with the system with which they are familiar, even when the alternative offers tangible benefits.

To complete the picture, the two frictions that the authors surmised might affect choice of entity, but which do not appear to do so were (a) the corporate tax regime’s separate tax payments that entrepreneurs might view as more painful than a single tax under the partnership model, and (b) the liquidity shock that could occur when entrepreneurs who rely on business liquidity to finance personal consumption fail to take into account the fact that retained corporate earnings are subject to shareholder-level tax when they are distributed.

Given the complexity of both the partnership and the corporate tax regimes, it is not surprising that entrepreneurs would err when selecting the tax regime that is to apply to them. What is surprising is the second experiment in which the authors surveyed 292 certified German tax advisors. They presented them with a scenario in which the corporate tax regime was clearly preferable. Nevertheless, fewer than half of those surveyed recommended adopting the corporate tax regime. One of the reasons given was the anticipated reaction of clients: the desire of tax advisors to preserve client relations could predispose them to confirm client biases.

It would be interesting if a similar study were made of U.S. entrepreneurs and tax advisors. I, for one, would be curious as to whether the findings of the survey would also hold in the United States. In any case the article sheds light on an important phenomenon to which we in the world of academia often give too little credence: the disconnect between theory and practice. Whatever theoretical analysis might dictate, facts on the ground often have a life of their own.