Optimal Taxation of Entrepreneurial Capital with Private Information

Abstract

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 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 di! er in the assets or contracts traded, and obtain three novel results. First, the intertemporal wedge on entrepreneurial capital can be negative, as more capital relaxes the entrepreneur’s incentive compatibility constraints. Second, di! erential asset taxation is optimal. Marginal taxes on financial assets 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 bad states. Third, if entrepreneurs are allowed to sell equity, the optimal tax system embeds a prescription for double taxation of capital income- at the firm level and at the investor level.