Entrepreneurship, Agency Frictions and Redistributive Capital Taxation

We study optimal capital taxation in a model with financial frictions, where the distribution of wealth across heterogeneous entrepreneurs affects how efficiently capital is used in the economy. The government sets linear taxes on wealth, consumption, capital and labor income to maximize the steady state welfare of workers, who own no wealth. In our setting, capital income taxes are particularly costly, because these taxes lead to a more inefficient allocation of capital and, ultimately, lower aggregate total factor productivity. We model financial frictions as arising endogenously as a result of an asymmetric information problem and find that the tightness of financial frictions is affected by tax rates. In our setting, optimal tax rates can be written as simple closed-form functions of pre-tax prices and parameters. We find that the optimal total tax burden on entrepreneurs should be zero, even though the government cares only about workers’ welfare.