This paper confirms the conjecture that the evaluation of tax policy leads to very different conclusions once the role of entrepreneurs is considered. Contrary to previous literature, the author finds that switching from a progressive to a proportional income tax system has a negligible effect on wealth inequality in the United States. This surprising result arises because entrepreneurial activities moderate the effects of the policy change on the wealth distribution. The author shows that proportional income tax reform increases entrepreneurial investment and savings by reducing the marginal income tax rates paid by entrepreneurs. Within the model, an increase in business investment implies a higher demand for labour, which raises the wage rate of workers and drives down the average return to entrepreneurial activities. This general-equilibrium feedback narrows the income and savings gap between workers and entrepreneurs, and, in turn, leads to a reduction in income and wealth inequality. While the elimination of progressive income taxation increases entrepreneurial investments, it has almost no effect on the number of entrepreneurs, as the costs of entrepreneurial activities rise with increasing wages. The model is also able to account for the substantial share of income and wealth held by entrepreneurs, the high savings rate of entrepreneurs relative to workers, and the high concentration of wealth observed in the data.

Also published as:

Entrepreneurship, wealth inequality, and taxation
Review of Economic Dynamics (1094-2025)
July 2005. Vol. 8, Iss. 3, pp. 688-719