Incorporation, Selection and Firm Dynamics: A Quantitative Exploration

Abstract

This paper studies how incorporation, which provides limited liability to firm owners, affects firm dynamics and macroeconomy. I propose an endogenous growth model of firm dynamics with endogenous entry and exit, where firms spend resources to improve their productivity and choose whether to incorporate or not. Incorporation provides li- ability protection which ensures that firm value is bounded from below, at the expense of high set-up and maintaining cost. An important model feature is that firms have het- erogeneous (high and low) types which differ in their capacity to improve productivity. This heterogeneity allows for the possibility of selection as high-type firms, who have higher growth potential, benefit more from incorporation. I calibrate the model by us- ing Danish firm-level data, specifically exploiting the heterogeneity in exit rates by age conditional on size to identify firm types in growth potential and therefore selection. The quantitative results suggest that both treatment and selection effects of incorpora- tion are important and accounting for firm heterogeneity is quantitatively relevant in explaining the observed better performance of incorporated firms. Conditional on the firm type, incorporated firms choose an expansion rate, the rate at which firms improve their productivity, 50% higher than unincorporated firms do on average. Upon entry, 90% (15%) of the incorporated (unincorporated) firms are high-types, which are esti- mated twice as efficient as low-types in improving their productivity. This underlines a significant selection effect which is more pronounced among incumbents as the exit rate of high-type firms is lower. In a counterfactual economy where the incorporation decision is randomized within firm types, the productivity growth decreases from 3% to 2.7% and the difference in the average size of incorporated and unincorporated firms decreases by 32%. I find significant welfare gains from subsidizing incorporated firms and large welfare losses from removing incorporation choice. These welfare results are largely driven by the change in the degree of selection, i.e. the change in the composition of firm types.