Optimal taxation of entrepreneurial capital with private information

This paper studies optimal taxation of entrepreneurial capital with private information and multiple assets. Entrepreneurial activity is subject to a dynamic moral hazard problem and entrepreneurs face idiosyncratic capital risk. The optimal tax system implements the constrained-e ¢ cient allocation as a competitive equilibrium for a given market structure. We consider several market structures that di¤er in the assets or contracts traded and obtain three novel results. First, di¤erential asset taxation is optimal. Marginal taxes on bonds depend on their hedging value, and entrepreneurial capital is subsidized relative to other assets in bad states. Second, if entrepreneurs are allowed to sell equity, double taxation of capital income is optimal. Capital returns must be taxed before and after distribution. Finally, we show that taxation of assets is essential even with competitive insurance contracts, when entrepreneurial portfolios are unobserved