Output distortions and the choice of legal form of organization

We study distortions to aggregate output created by the differential tax treatment of corporations and pass -through entities. We develop a firm dynamic model in which the legal form of organization is an endogenous choice for firms facing trade-offs between the tax treatment of business income, access to external capital, and the evolution of productivity over time. We match this model to features of the US economy and find that equalizing tax treatments across legal forms while keeping tax revenue constant leads to a 6.8% increase in aggregate output. The reallocation of capital between firms accounts for about 40% of this increase. Our findings suggest that unifying the tax treatment of different legal forms creates output gains while maintaining the existing structure of the tax system. It may be politically easier to implement this type of reform than removing corporate tax entirely.