Business Start-ups, The Lock-in Effect, and Capital Gains Taxation

We develop a model of entrepreneurial choice in which some individuals have a comparative advantage in starting new business enterprises. Two frictions play key roles in our model: markets are incomplete and entrepreneurs can own equity in only one business enterprise at a time. In the model entrepreneurs optimally smooth consumption over time while accumulating adequate assets to self insure against the possibility that their start ups or ongoing business enterprises are unsuccessful. Efficiency dictates that entrepreneurs should specialize in start ups and sell successful start ups to professional managers. We consider the role of capital gains taxation. Capital gains taxes create an incentive for entrepreneurs to manage their own enterprises and avoid paying such taxes rather than sell them to professional managers. With taxation of capital gains, some of the entrepreneurs get inefficiently locked into running their own enterprises. We quantify the role of this effect and argue that it is large. Our model is consistent with a number of key features of the data, including evidence on transitions of entrepreneurs from self employment to other labor market activities. ∗Chari: University of Minnesota, Federal Reserve Bank of Minneapolis, and NBER; Golosov: MIT; Tsyvinski: UCLA, Harvard, and NBER. We thank Mariacristina De Nardi, and Patrick Kehoe for their comments. We are particularly indebted to Gueorgui Kambourov and Iourii Manovskii for providing invaluable assistance with PSID data set. Chari thanks the National Scienece Foundation for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.