Entrepreneurship and the Theory of Taxation

Abstract:     
A review of the literature on firm taxation reveals that the economics of entrepreneurship has only recently and gradually been taken into consideration, and not yet sufficiently so. We discuss how this affects conclusions derived from standard models of capital taxation when applied to entrepreneurial income, identifying some defining features of entrepreneurship important for analyzing the effects of taxation of ownermanaged firms in the process. These include the lack of a well-functioning external market for entrepreneurial effort, limited access to external capital and complementarities between entrepreneurial innovation, effort and capital. Due to these constraints, the entrepreneurial project is tied to the individual owner-manager. The entrepreneur is unable to decouple savings decisions from investment decisions, and makes joint decisions on the supply of effort and capital. The return from successful entrepreneurial ventures can therefore not be readily divided into labor and capital income, falling in deep contrast to what is typically assumed in taxation theory.

When distinct attributes of entrepreneurship are taken into account, certain conclusions of capital taxation models no longer hold, including the neutrality of capital taxation in owner-managed firms. Cost of capital formulas derived from the behavior of public firms underestimate distortions when applied to the investment behavior of entrepreneurial firms.

For tax purposes and otherwise, it becomes useful to analyze return to entrepreneurial activity as income of a distinct factor of production. In this context, conceptual issues and the difficulties of measuring entrepreneurial income are discussed.

Number of Pages in PDF File: 33

Keywords: Capital income taxation, Dual income taxation, Entrepreneurship, Innovation, Institutions, Labor supply, New firm creation, Optimal factor taxes, Taxation, Tax policy

JEL Classification: H21, H25, L5, L26, M13, O31, E25, G32

working papers series