Progressive Taxation, Moral Hazard, and Entrepreneurship

This paper considers the general equilibrium and welfare effects of a linear progressive income tax with entrepreneurship and moral hazard. A competitive intermediation sector diversifies risk associated with entrepreneurial activity, but full risk consolidation is prevented by moral hazard. Since effort is not observable, risk bearing of entrepreneurs is required for incentive reasons. The extent of risk consolidation is endogenously explained. We find that a nonredistributive tax is neutral. A progressive tax always impairs entrepreneurship while the effect on welfare can be positive or zero, depending on the specification of moral hazard. Some results may also depend on the concrete formulation of preferences.