Entrepreneurial Taxation with Endogenous Entry

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 low 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.