Optimal Corporate Taxation under Financial Frictions

We study the optimal design of corporate taxation when firms are subject to financial constraints. We find that corporate taxes should be levied on unconstrained firms, since those firms value resources inside the firm less than financially constrained firms. When the government has complete information about which firms are and are not constrained, this principle is sufficient to characterize optimal corporate tax policy. When the government (and other outsiders) do not know which firms are and are not constrained, the government can use the payout policies of firms to elicit whether or not the firm is constrained, and assess taxes accordingly. Using this insight, we discuss conditions under which a tax on dividends paid is the optimal corporate tax. We then extend this result to a dynamic setting, showing that, if the government lacks commitment, the optimal sequence of tax mechanisms can be implemented with a dividend tax. With commitment, we reach a very different conclusion--a lump sum tax on firm entry is optimal. We argue that these two models demonstrate an underlying principle, that optimal corporate taxes should avoid exacerbating financial frictions, and demonstrate that the structure of the financial frictions can drastically change the optimal policy.