Taxes, Debt, Investments and the Choice of Business Form with Overconfident and Pessimistic Entrepreneurs

Abstract

This article is the first to analyze the simultaneous choice of investment and organizational form using the behavioral finance approach. When entrepreneurs are rational, the choice of investment and organizational form is irrelevant in most cases. However, when entrepreneurs are overconfident/pessimistic, it leads to overinvestment/underinvestment. We show that a combination of corporate tax for limited liability businesses along with a universal personal income tax can improve the efficiency of decision-making and increase social surplus.

Keywords: corporate tax, overconfidence, overinvestment, unlimited liability, limited liability, imperfect loss-offset, debt

JEL Classification: D82, D89, D90, G32, H21, H32, L26, L29