Tax Wedges, Financial Frictions and Misallocation
This seminar is hosted by Paulo Santos Monteiro.
We revisit the classical result that in a closed economy the incidence of corporate taxes on labour is approximately zero. We consider a rich general equilibrium framework, where agents differ in the level of their wealth as well as in their managerial and working ability. Potential entrepreneurs go through all the key decisions affected by corporate tax changes: the choice of (i) occupation, (ii) organisational form, (iii) investment, and (iv) financing structure.
We allow both for the presence of financial frictions and the traditional tax advantage of debt over corporate equity, which jointly generate misallocation of capital and talent. In this environment we characterize the effects of increasing corporate taxes both analytically and for a calibrated version of the model. We show that this tax increase reallocates production from C corporations to pass through businesses. Since, due to distorted prices, the latter have higher capital-labour ratios, this reallocation generates a reduction in labour productivity and wages. Furthermore, the corporate tax increase induces some C corporations to reorganize as pass throughs, which implies more restricted access to external funds and thus a socially inefficient downsizing of production in these firms. Finally, the tax increase causes further misallocation of talent by inducing agents with low wealth relative to their managerial talent to switch from entrepreneurship to being workers, while the reverse happens for agents with higher wealth and lower managerial skills. Overall, we find that both labour and capital bear a large share of the corporate tax incidence, while entrepreneurs are net beneficiaries of the tax change.
The speaker is joined by Piero Gottardi, Joachim Hubmer and Lukas Mayr.