The Optimal Taxation of Business Owners

Business owners in the United States are disproportionately represented among the very wealthy and are exposed to substantial idiosyncratic risk. Further, recent evidence indicates business income primarily reflects returns to the human (rather than financial) capital of the owner. Motivated by these facts, this paper characterizes the optimal taxation of income and wealth in an environment where business income depends jointly on innate ability, luck, and the accumulated past effort exerted by the owner. I show that in (constrained) efficient allocations, more productive entrepreneurs typically bear more risk and that the associated stationary distributions of income, wealth, and firm size exhibit the thick right (Pareto) tails observed in the data. Finally, when owners may save in a risk-free bond and trade shares of their business, I show that the optimal linear taxes in this environment call for double taxation of firm profits, at both the firm and the personal income level, and for a tax/subsidy on wealth that may assume either sign.