Taxation theory rarely takes entrepreneurship into consideration. We discuss how this omission affects conclusions derived from standard models of capital taxation when applied to entrepreneurial income.
Some of the defining features of entrepreneurship often omitted by standard capital taxation theory are incorporated into the analysis. This includes the lack of a well-functioning external market for entrepreneurial effort, limited access to external capital and the complementarities between entrepreneurial effort, entrepre-neurial innovation and capital investment. Because of these constraints, the entrepreneurial project is tied to the individual owner-manager. Unlike the typical passive portfolio investor assumed in cost of capital models the entrepreneur is unable to decouple savings decisions from investment decisions, and due to the comple-mentarities in production makes a joint decision on the supply of effort and capital. The returns from success-ful entrepreneurial ventures thus cannot be readily divided into labor and capital income, in stark contrast to what is assumed in standard taxation theory.
When unique attributes of entrepreneurship are taken into account, some major conclusions of capital taxation models no longer hold, including the neutrality of capital taxation in owner-managed firms. These results are particularly important for the Nordic system of dual taxation, the theoretical foundation of which relies on the ability to neatly separate capital income from the labor income of the self-employed.
Henrekson, Magnus and Tino Sanandaji (2008), "Entrepreneurship and the Theory of Taxation", IFN Working Paper No. 732. Stockholm: Research Institute of Industrial Economics.