Tax wedges, financial frictions and misallocation

Arpad J Abraham, Piero Gottardi, Joachim Hubmer, Lukas Mayr*

*Corresponding author for this work

Research output: Contribution to journalArticle (Academic Journal)peer-review

1 Citation (Scopus)

Abstract

We revisit the classical result that in a closed economy the incidence of corporate taxes on labor is approximately zero. We consider a rich general equilibrium framework, where agents differ in the level of their wealth as well as in their managerial and working ability. Potential entrepreneurs go through all the key decisions affected by corporate tax changes: the choice of (i) occupation, (ii) organizational form, (iii) investment, and (iv) financing structure. We allow both for the presence of financial frictions and the traditional tax advantage of debt over corporate equity, which jointly generate misallocation of capital and talent. In this environment we characterize the effects of increasing corporate taxes both analytically and for a calibrated version of the model. We show that this tax increase reallocates production from C corporations to pass-through businesses. Since, due to distorted prices, the latter have higher capital-labor ratios, this reallocation generates a reduction in labor productivity and wages. Furthermore, the corporate tax increase induces some C corporations to reorganize as pass-throughs, which implies more restricted access to external funds and thus a socially inefficient downsizing of production in these firms. Finally, the tax increase causes further misallocation of talent by inducing agents with low wealth relative to their managerial talent to switch from entrepreneurship to being workers, while the reverse happens for agents with higher wealth and lower managerial skills. Overall, we find that both labor and capital bear a large share of the corporate tax incidence, while entrepreneurs are net beneficiaries of the tax change.
Original languageEnglish
Article number105000
Number of pages18
JournalJournal of Public Economics
Volume227
Early online date29 Sept 2023
DOIs
Publication statusPublished - 1 Nov 2023

Bibliographical note

Publisher Copyright:
© 2023 The Author(s)

Keywords

  • Corporate taxation
  • General equilibrium
  • Heterogeneous agents
  • Tax incidence

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