Taxing Firms Facing Financial Frictions

What is the effect of replacing the corporate income tax by a tax on business owners? To answer this question we construct a model with heterogeneous firms, borrowing constraints, costly equity issuance and endogenous entry... [ view full abstract ]

What is the effect of replacing the corporate income tax by a tax on business owners? To answer this question we construct a model with heterogeneous firms, borrowing constraints, costly equity issuance and endogenous entry and exit. Calibrating the model to the U.S. economy, we find that replacing the corporate income tax with a revenue-neutral common tax on shareholders, steady-state output would increase by 6.8% and total factor productivity (TFP) by 1.7%. Due to financial frictions, taxes levied at the corporate income level and at the shareholder level are not perfect substitutes because they distort different margins. In our model, firms are hit by productivity shocks and aim to adjust their capital stock in pursuit of optimal size. Optimal firm behavior often dictates reliance on retained earnings for growth. The corporate income tax reduces retained earnings available for investment, thereby delaying capital accumulation. As the retained earning are not paid back to shareholders, the friction just described does not occur when taxes are levied at the dividend level. The mechanism is amplified by endogenous entry and exit and by general equilibrium feedback.