The Optimal Taxation of Business Owners

Abstract

Business owners in the United States are disproportionately represented among the wealthy and are exposed to substantial idiosyncratic risk. Further, recent evidence indicates that business income primarily reflects returns to the human capital of the owner. Motivated by these facts, this paper characterizes stationary efficient allocations and signaling equilibria with linear taxes when business income depends on innate ability, luck, and the past effort of the owner. I first show that in stationary efficient allocations, more productive entrepreneurs typically bear more risk and the distributions of consumption and firm size are approximately Pareto, with the tail of the latter typically thicker than that of the former. I then consider allocations in which entrepreneurs may save in a risk-free bond and signal a willingness to exert continued effort by retaining a fraction of their wealth in their firm. The optimal linear taxation policy calls for separate treatment of firm profits, interest, and wealth. The tax on profits plays a redistributive role, the tax on interest affects the incentives to retain equity and exert effort, and the tax on wealth affects the degree of consumption smoothing over time.

Keywords: optimal taxation, moral hazard, optimal contracting, human capital

JEL Classification: D61, D63, E62