Wealth Tax, Entrepreneurship, and the Legal Form of Business Organization

This paper studies the effects of wealth taxation on efficiency, equity, and welfare in a heterogeneous-agent model with incomplete markets and endogenous occupational and legal-form choice. Entrepreneurs choose between operating as pass-through businesses and C-corporations. While C-corporations face less favorable tax treatment and higher operating costs, they benefit from easier access to external finance. The choice of legal form therefore shapes both the after-tax return to entrepreneurial investment and the severity of financial constraints. Calibrating the model to the U.S. economy, we show that the effects of wealth taxation depend crucially on the endogenous reallocation of entrepreneurs across legal forms. Revenue-neutral reforms that encourage entrepreneurs to switch toward pass-through businesses tighten financial constraints, exacerbate capital misallocation within the entrepreneurial sector, and amplify the efficiency costs of wealth taxation. By contrast, reforms that encourage entrepreneurs to organize as C-corporations relax financial constraints, improve capital allocation, and can more than offset the aggregate distortions induced by the wealth tax. We further show that the distributional and welfare effects crucially depend on the design of the wealth tax itself. While a flat wealth tax does not lower wealth inequality, it generates aggregate welfare gains under all revenue-recycling schemes we consider. By contrast, a progressive wealth tax reduces inequality but may generate aggregate welfare losses because it more strongly discourages entrepreneurial investment.