Essays On Taxation And Competition Under Firm Heterogeneity And Financial Frictions

In this dissertation, I study the implications of taxation -and other regulations- in environments with financial frictions and firm entry. The first chapter asks if there is a role for the regulation of the market of funds for firms that lack collateral and have a large uncertainty about their ability to generate profits. To answer the question, it characterizes optimal financial contracts in a competitive environment with risk, adverse selection, and limited liability. In this environment, competition among financial intermediaries always forces them to fund projects with negative expected returns both from a private and from a social perspective. Intermediaries use steep payoff schedules to screen entrepreneurs, but limited liability implies this can only be done by giving more to all entrepreneurs. In equilibrium, competition for the profitable entrepreneurs forces intermediaries to offer better terms to all customers. There is cross-subsidization among entrepreneurs and intermediation profits are zero. The three main features of the framework (competition, adverse selection, and limited liability) are necessary in order to get the inefficient laissez-faire outcome and a role for financial regulation. The result remains robust when firms can collateralize some portion of the credit as long as there is an unsecured fraction. These results provide a motive for regulating the market for unsecured financing to business start-ups. The second chapter quantifies the effect of replacing the corporate income tax by a tax on business owners. This is done by constructing a model with heterogeneous firms, borrowing constraints, costly equity issuance and endogenous entry and exit. Calibrating the model to the U.S. economy, the chapter documents that replacing the corporate income tax with a revenue-neutral common tax on shareholders, the steady-state output would increase by 6.8% and total factor productivity (TFP) by 1.7%. Due to financial frictions, taxes levied at the corporate income level and at the shareholder level are not perfect substitutes because they distort different margins. In the model, firms are hit by productivity shocks and aim to adjust their capital stock in pursuit of optimal size. Optimal firm behavior often dictates reliance on retained earnings for growth. The corporate income tax reduces retained earnings available for investment, thereby delaying capital accumulation. As the retained earnings are not paid back to shareholders, the friction described does not occur when taxes are levied at the dividend level. The mechanism is amplified by endogenous entry and exit and by general equilibrium feedback