How to Tax Capitalists in the Twenty-First Century?

We study the optimal tax system design in an economy featuring active business owners running closely-held, highly profitable businesses–a.k.a. capitalists in the twenty-first century. In line with the current U.S. law, they choose a legal form of a firm’s organization between a pass-through entity and a C corporation, which determines how their business income is taxed. The model captures a critical trade-off between these forms. C corporations face double taxation of profits but have easier access to external equity and can insure themselves better against investment risk relative to pass-through entities. Through endogenous selection, our model generates the predominant position of the pass-through business owners in line with the U.S. data. We compute the optimal fiscal policy under two revenue-neutral scenarios. Under the current U.S. legal restrictions scenario, we find that the reform maximizing the social welfare of the population eliminates corporate income tax and increases mildly the progressivity of the personal income tax code. This implies a sizeable switch of economic activity towards C corporations, which improves capital allocation in the economy, insurance provision and resource redistribution toward workers. Under the uniform business profit tax scenario, we find that the progressivity of the labor income tax-transfer code should more than double, and business income tax should be set to 31 percent. This optimal policy strictly dominates in terms of welfare, the optimal policy computed under the current legal framework. Separation of labor income taxation from business profit taxation allows the Ramsey planner to separate distortions of the labor supply margin from distortions on the accumulation of the productive capital and the choice of the legal form of business organization margins.