Job market paper
Taxing Top Incomes in the World of Entrepreneurs
This paper shows that high top marginal income tax rates generate large losses of aggregate output and productivity. These losses arise because taxes distort the investment decisions of entrepreneurs who constitute a large share of high earners. I identify two novel distortions. The first is the "productivity investment effect". Top income tax rates distort the productivity investment decisions not only of entrepreneurs who are already in the top income bracket but also of those who will become top earners in the future by building up their firms. The second force is the "incorporation timing effect". Successful entrepreneurs grow their firms and then sell their businesses to the corporate sector through incorporation. High top tax rates push these entrepreneurs to sell before the firms reach their full productivity potential. This force is driven by a feature of the tax code that treats the sale of a firm to the corporate sector as capital gains, which are taxed at a lower rate than personal income. Both effects imply that even though it targets only a small fraction of households, increasing the top marginal income tax rate generates large output costs by decreasing productivity. Since lower productivity erodes the tax base, in a calibrated model, the revenue-maximizing top income tax rate that takes both effects into account is 45%.