Monday, October 15, 2012

Why should entrepreneurial income be taxed less progressively than labor income?

Capital income is typically less taxed, and there are good theoretical reasons to do so. It has mostly to do with the fact that you do not want to discourage the accumulation of capital, which increases wages. You also want to encourage entrepreneurship, which has lead to various tax credits fro entrepreneurs (plus the fact they have an easier time under-reporting income if they are self-employed). But should entrepreneurial income be taxed as progressively as other income?

Florian Scheuer says no, and it should be less progressive, which is actually how it is in the data. Indeed, business taxation is less progressive than taxation of individuals. This makes sense according to Scheuer because of adverse selection on credit markets. The argument is as follows. Individuals choose whether to become regular workers or entrepreneurs. The latter are not all equally suited for the job, and they need credit. There is adverse selection on the credit markets which leads to cross-subsidization from good risks to bad risks. Thus, too many bad risks enter entrepreneurship. Having a flatter tax schedule reverses some of this cross-subsidization.


Anonymous said...

There is one thing that really puzzles me. How do you manage to regularly discuss NBER working papers weeks before they even appear on the NBER website?

DavidG said...

I think it's a mistake to conflate entrepreneurship with capital gains. They are not the same thing -- not always.

Economic Logician said...

Anonymous: NEP has them before anybody else, apparently.