Optimal taxation of entrepreneurial capital with private information
This paper studies optimal taxation of entrepreneurial capital with private information and multiple assets. Entrepreneurial activity is subject to a dynamic moral hazard problem and entrepreneurs face idiosyncratic capital risk. We first characterize the optimal allocation subject to the incentive compatibility constraints resulting from the private information. The optimal tax system implements such an allocation as a competitive equilibrium for a given market structure. We consider several market structures that differ in the assets or contracts traded and obtain three novel results. First, differential asset taxation is optimal. Marginal taxes on bonds depend on the correlation of their returns with idiosyncratic capital risk, which determines their hedging value. Entrepreneurial capital always receives a subsidy relative to other assets in the bad states. Second, if entrepreneurs are allowed to sell equity, the optimal tax system embeds a prescription for double taxation of capital income Ã¢â‚¬â€œ at the firm level and at the investor level. Finally, we show that taxation of assets is essential even with competitive insurance contracts, when entrepreneurial portfolios are also unobserved.
This paper studies optimal taxation of entrepreneurial capital and financial assets in economies with private information. Returns to entrepreneurial capital are risky and depend on entrepreneurs' effort, which is not observed. The presence of idiosyncratic risk in capital returns implies that the intertemporal wedge on capital that characterizes constrained-efficient allocations can be positive or negative. The properties of optimal marginal taxes on entrepreneurial capital depend on the sign of the intertemporal wedge. If the wedge is positive, the marginal capital tax should be decreasing in capital returns, while the opposite is true when the wedge is negative. Optimal taxes on other assets should be set according to their correlation with risky productive capital. The intertemporal wedge associated with an asset is greater than the one associated with entrepreneurial capital as long as their correlation is less than one. The optimal tax system tends to reduce the variance of capital returns after tax relative to before tax, while the opposite is true for other assets. If entrepreneurs are allowed to sell shares of their capital to outside investors, returns to externally owned capital are subject to double taxation- at the level of the entrepreneur and at the level of the outside investors.
capital taxation, private information, entrepreneurs, moral hazard
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