Entrepreneurial Taxation and Occupational Choice
This paper analyzes Pareto optimal non-linear taxation of profits and labor income in a private information economy with 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 (or “trickle down”) effects through wages to indirectly achieve redistribution between entrepreneurs and workers. 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. In this case, redistribution is achieved directly through the tax system rather than “trickle down” effects, and production efficiency is always optimal. ∗Email address: scheuer@stanford.edu. I am grateful to Daron Acemoglu and Ivan 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, Wisconsin Madison and the Review of Economic Studies European Tour at Toulouse, EUI Florence and Warwick for helpful comments and suggestions. All errors are my own.