Taxing Firms Facing Financial Frictions∗

In the U.S. business income is taxed several times at different sources, including corporate income, dividends, capital gains, and interest payments. We investigate how the different rates above affect firm investment and the allocation of capital in the economy. To do so, we construct and calibrate a model with heterogeneous firms, borrowing constraints, costly equity issuance and endogenous entry and exit. Because of the financial frictions, the taxes mentioned are not perfect substitutes and distort different margins. In our model firms enter small and grow over time to reach an optimal size. Firms are borrowing constrained and rely on retained earnings to grow. The corporate income tax reduces net worth and with retained earnings available for investment, delaying capital accumulation. Taxes on dividends, capital gains and interest income do not reduce net worth. We use the model to quantitatively analyze the steady state consequences of a reform that replaces the corporate income tax by a common tax on shareholders. We find that such reform improves the allocation of capital in the economy, increasing total factor productivity by 1.7%. JEL: E44, G11, H21, H25, O16