Entrepreneurship, taxation and capital investment

Augmenting a standard Bewley model with an entrepreneurial sector and occupational heterogeneity allows us to study important channels through which fiscal policies affect aggregate variables, factor prices, wealth distribution and welfare. To disentangle the forces involved, we consider flexible forms of taxation that distinguish between sources of income. Our quantitative analysis shows that reducing the tax burden on capital formation stimulates investment, but the effects vary depending on whether we target entrepreneurial capital or non-entrepreneurial capital. A low tax on capital income from savings increases the aggregate capital stock and production, but it also raises the opportunity cost of business investment. General equilibrium effects further discourage entrepreneurial investment due to a higher wage cost and a compensating tax increase on other sources of income. The reform is most effective when we reduce the tax on business income. A flat business tax of 10% will raise entrepreneurial investment by 20% in the long run. Workers also benefit as the wage increases by 5%. However, the adjustment costs associated with the transition make political support for such reforms difficult. (C) 2007 Elsevier Inc. All rights reserved.