Tax Neutrality: Illusion or Reality? The Case of Entrepreneurship

The theoretical work on capital income taxation has focused on conditions under which a tax system preserves investment neutrality. The trouble with such a neutrality view is that it is focused on one margin among others. The economics of start-up firms is, however, fundamentally different from the economics of established corporations. In particular, the opportunity cost of an entrepreneur should be stated in terms of forgone earnings in the labor market, adjusted for the option value of abandoning the firm throughout the lifetime. Moreover, the future-exit option interferes with the early start-up decision when a nascent entrepreneur is forward-looking. The paper shows that the requirement of start-up neutrality is not satisfied by any of the well-known investment-neutral tax systems, including the comprehensive income tax, the dividend tax, the Johansson-Samuelson tax, the cash-flow tax, and the ACE tax.