This paper describes the positive effect that corporate income tax has on capital formation in the presence of liquidity constraints and uninsurable risk. The author uses a dynamic general-equilibrium model in which individuals choose whether to become entrepreneurs or workers. Workers save by holding corporate equity and therefore are subject to double taxation, as the return on their savings is taxed at both the corporate and personal level. Entrepreneurs, on the other hand, save by investing in their businesses and are taxed only at the personal level. This differential tax treatment results in an increase in capital accumulation because entrepreneurs must save in response to liquidity constraints and uninsurable risk. A calibrated version of the model is used to quantify the consequences of eliminating the corporate income tax. Interestingly, the removal of the corporate income tax decreases capital formation: by eliminating double taxation, the return on workers' savings increases, which in turn reduces the number of entrepreneurs. Consequently, the stock of capital decreases, since entrepreneurs have a higher marginal rate of saving than workers, as they save not only for life-cycle motives but to self-insure against business risk and to start and finance their businesses.

Also published as:

Business risk, credit constraints, and corporate taxation
Journal of Economic Dynamics and Control (0165-1889)
September 2008. Vol. 32, Iss. 9, pp. 2971-3008