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The Optimal Taxation of Business Owners


Business owners in the United States are disproportionately represented among the wealthy and are exposed to substantial idiosyncratic risk. Further, recent evidence indicates that business income primarily reflects returns to the human capital of the owner. Motivated by these facts, this paper characterizes stationary efficient allocations and optimal linear taxes on income and wealth when business income depends on innate ability, luck, and the past effort of the owner. I first show that in stationary efficient allocations, more productive entrepreneurs typically bear more risk and the distributions of consumption and firm size are approximately Pareto, with the tail of the latter typically thicker than that of the former. I then characterize optimal linear taxes when owners may save in a risk-free bond and trade shares in their businesses. The optimal utilitarian policy calls for separate taxes on firm profits, capital income, and wealth, serving distinct purposes. The tax on profits plays a redistributive role, the tax on capital income affects the incentives to retain equity and exert effort, and the tax on wealth affects the degree of consumption smoothing over time.

Keywords: Optimal taxation, moral hazard, optimal contracting, human capital.
JEL Codes: D61, D63, E62.


Suggested citation: Phelan, Thomas. 2021. “The Optimal Taxation of Business Owners.” Federal Reserve Bank of Cleveland, Working Paper no. 19-26r. https://doi.org/10.26509/frbc-wp-201926r.

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