Taxing Top Earners: The Role of Entrepreneurs

Abstract

This paper studies the optimal top marginal income tax rate in a quantitative framework with entrepreneurial choice, financing constraints, and realistic earnings and wealth distributions. I find that the revenue-maximizing top tax rate is approximately 41 percent — close to the recent levels in the US. In contrast, when calibrated with only workers to match realistic earnings and wealth distributions, the model predicts a revenue-maximizing top tax rate of 81 percent — close to the established view. There are two channels through which the baseline model has a lower revenue-maximizing top tax rate. First, the wealth distribution channel: increasing the top tax rate decreases wealth accumulation and leads to a less skewed wealth distribution in the long run (there are more top entrepreneurs with low wealth and less top entrepreneurs with high wealth). With financing constraints, there is a similar change in the business earnings distribution, implying a fall in the average business earnings at the top. Second, the general equilibrium effect on labor earnings of workers: in the model with entrepreneurs, increasing the top tax rate reduces the capital stock much more than labor supply, which decreases the capital-labor ratio and thus the equilibrium wage rate in the model economy. Finally, I find that the welfare-maximizing top marginal income tax rate is close to the revenue-maximizing one.