Entrepreneurial Taxation, Occupational Choice, and Credit Market Frictions

This paper analyzes Pareto optimal non-linear taxation of profits and labor income in a private information economywith endogenous firm formation. Individuals differ in both their skill and their cost of setting up a firm, and choose between becoming workers and entrepreneurs. I show that a tax system in which entrepreneurial profits and labor income must be subject to the same non-linear tax schedule makes use of general equilibrium effects through wages to indirectly achieve redistribution between entrepreneurs andworkers. As a result, constrained Pareto optimal policies can involve negative marginal tax rates at the top and, if available, input taxes that distort the firms’ input choices. However, these properties disappear when a differential tax treatment of profits and labor income is possible, as for instance implemented by a corporate income tax. In this case, redistribution is achieved directly through the tax system rather than “trickle down” effects, and production efficiency is always optimal. When I extend the model to incorporate entrepreneurial borrowing in credit markets, I find that endogenous cross-subsidization in the credit market equilibrium results in excessive (insufficient) entry of low-skilled (high-skilled) agents into entrepreneurship. Even without redistributive objectives, this gives rise to an additional, corrective role for differential taxation of entrepreneurial profits and labor income. In particular, a regressive profit tax may restore the efficient occupational choice. ∗Email address: [email protected]. I am grateful to Daron Acemoglu and Iván Werning for invaluable guidance and ongoing support. I also thank Richard Blundell, Eddie Dekel, Peter Diamond, Amy Finkelstein, Jonathan Gruber, Caroline Hoxby, Alessandro Pavan, James Poterba, Emmanuel Saez, Karl Scholz, Robert Shimer, Carmen Taveras, Robert Townsend and seminar participants at Chicago, MIT, Northwestern, Stanford, St. Gallen, UCL and Wisconsin Madison for helpful comments and suggestions. All errors are my own.