nep-bec New Economics Papers
on Business Economics
Issue of 2010‒08‒21
24 papers chosen by
Christian Calmes
Universite du Quebec en Outaouais

  1. The Vanishing Procyclicality of Labor Productivity By Jordi Galí; Thijs van Rens
  2. Competition, Efficiency, and Soundness in Banking: An Industrial Organization Perspective By Schaeck, K.; Cihák, M.
  3. Globalization, the Business Cycle, and Macroeconomic Monitoring By S. Boragan Aruoba; Francis X. Diebold; M. Ayhan Kose; Marco E. Terrones
  4. Financial Intermediation, Competition, and Risk: A General Equilibrium Exposition By Di Nicolo, G.; Lucchetta, M.
  5. Deposit Market Competition, Wholesale Funding, and Bank Risk By Craig, B.R.; Dinger, V.
  6. Robustness to Strategic Uncertainty By Andersson, O.; Argenton, C.; Weibull, J.
  7. The Establishment-Level Behavior of Vacancies and Hiring By Steven J. Davis; R. Jason Faberman; John C. Haltiwanger
  8. Explaining union growth and decline with flows in and out of membership. An analysis of Swiss union locals By Oesch, Daniel
  9. The Dynamics in Requested and Granted Loan Terms when Bank and Borrower Interact Repeatedly By Kirschenmann, K.
  10. Risk-return Efficiency, Financial Distress Risk, and Bank Financial Strength Ratings By Hua, Changchun; Liu, Li-Gang
  11. Executive Compensation Based on Asset Values By Byström, Hans
  12. Internal Promotion and the Effect of Board Monitoring: A Comparison of Japan and the United States By Meg Sato
  13. Firm Growth, European Industry Dynamics and Domestic Business Cycles By Harald Oberhofer
  14. The Rise in Executive Compensation - Consequence of a 'War for Talents'? By Katja Rost
  15. Modelling the Determinants of Job Creation: Microeconometric Models Accounting for Latent Entrepreneurial Ability By Abdelfatah Ichou
  16. Competitive, but too small - productivity and entry-exit determinants in European business services By Kox, Henk L.M.; Leeuwen, George van; Wiel, Henry van der
  17. Competition and Innovation: Pushing Productivity Up or Down? By Brouwer, E.; Wiel, H.P. van der
  18. The Determinants of Corporate Growth By Rosique, Francisco
  19. Who Starts with Open Source? Institutional Choice of Start-Ups in the German ICT Sector By Michael Fritsch; Sebastian von Engelhardt
  20. The Importance of Trust for Investment: Evidence From Venture Capital (Revision of DP 2009-43) By Bottazzi, L.; Da Rin, M.; Hellmann, T.
  21. Motives of Socially Responsible Business Conduct By Graafland, J.J.; Kaptein, M.; Mazereeuw v/d Duijn Schouten, C.
  22. The relationship between oil prices and long-term interest rates By Christopher Reicher; Johannes Utlaut
  23. The effects of Entry in thin markets By Alex Dickson
  24. A Theory of Taxation and Incorporation By Christian Keuschnigg; Peter Egger; Hannes Winner

  1. By: Jordi Galí; Thijs van Rens
    Abstract: We document three changes in postwar US macroeconomic dynamics: (i) the procyclicality of labor productivity has vanished, (ii) the relative volatility of employment has risen, and (iii) the relative (and absolute) volatility of the real wage has risen. We propose an explanation for all three changes that is based on a common source: a decline in labor market frictions. We develop a simple model with labor market frictions, variable effort, and endogenous wage rigidities to illustrate the mechanisms underlying our explanation. We show that the reduction in frictions may also have contributed to the observed decline in output volatility
    Keywords: labor hoarding, labor market frictions, wage rigidities, effort choice
    JEL: E24 E32
    Date: 2010–08
  2. By: Schaeck, K.; Cihák, M. (Tilburg University, Center for Economic Research)
    Abstract: How can competition enhance bank soundness? Does competition improve soundness via the efficiency channel? Do banks heterogeneously respond to competition? To answer these questions, we exploit an innovative measure of competition [Boone, J., A new way to measure competition, EconJnl, Vol. 118, pp. 1245-1261] that captures the reallocation of profits from inefficient banks to their efficient counterparts. Based on two complementary datasets for Europe and the U.S., we first establish that the new competition indicator captures a broad variety of other characteristics of competition in a consistent manner. Second, we verify that competition increases efficiency. Third, we present novel evidence that efficiency is the conduit through which competition contributes to bank soundness. In a final examination of banks’ heterogeneous responses to competition, we find that smaller banks’ soundness measures respond more strongly to competition than larger banks’ soundness measures, and two-stage quantile regressions indicate that the soundness-enhancing effect of competition is larger in magnitude for sound banks than for fragile banks.
    Keywords: bank competition;efficiency;soundness;Boone indicator;quantile regression
    JEL: G21 G28
    Date: 2010
  3. By: S. Boragan Aruoba; Francis X. Diebold; M. Ayhan Kose; Marco E. Terrones
    Abstract: We propose and implement a framework for characterizing and monitoring the global business cycle. Our framework utilizes high-frequency data, allows us to account for a potentially large amount of missing observations, and is designed to facilitate the updating of global activity estimates as data are released and revisions become available. We apply the framework to the G-7 countries and study various aspects of national and global business cycles, obtaining three main results. First, our measure of the global business cycle, the common G-7 real activity factor, explains a significant amount of cross-country variation and tracks the major global cyclical events of the past forty years. Second, the common G-7 factor and the idiosyncratic country factors play different roles at different times in shaping national economic activity. Finally, the degree of G-7 business cycle synchronization among country factors has changed over time.
    JEL: E3 E6 F4
    Date: 2010–08
  4. By: Di Nicolo, G.; Lucchetta, M. (Tilburg University, Center for Economic Research)
    Abstract: We study a simple general equilibrium model in which investment in a risky technology is subject to moral hazard and banks can extract market power rents. We show that more bank competition results in lower economy-wide risk, lower bank capital ratios, more efficient production plans and Pareto-ranked real allocations. Perfect competition supports a second best allocation and optimal levels of bank risk and capitalization. These results are at variance with those obtained by a large literature that has studied a similar environment in partial equilibrium. Importantly, they are empirically relevant, and demonstrate the need of general equilibrium modeling to design financial policies aimed at attaining socially optimal levels of systemic risk in the economy.
    Keywords: General Equilibrium;Bank Competition;Market Power Rents;Risk
    JEL: D5 G21
    Date: 2010
  5. By: Craig, B.R.; Dinger, V. (Tilburg University, Center for Economic Research)
    Abstract: In this paper we revisit the long debate on the risk effects of bank competition and propose a new approach to the empirical estimation of the relation between deposit market competition and bank risk. Our approach accounts for the opportunity of banks to shift to wholesale funding when deposit market competition is intense. The analysis is based on a unique comprehensive dataset which combines retail deposit rates data with data on bank characteristics and with data on local deposit market features for a sample of 589 U.S. banks. Our results support the notion of a risk-enhancing effect of deposit market competition.
    Keywords: bank competition;wholesale funding;bank risk;deposit rates
    JEL: G21
    Date: 2010
  6. By: Andersson, O.; Argenton, C.; Weibull, J. (Tilburg University, Center for Economic Research)
    Abstract: We model a player’s uncertainty about other players’ strategy choices as smooth probability distributions over their strategy sets. We call a strategy profile (strictly) robust to strategic uncertainty if it is the limit, as uncertainty vanishes, of some sequence (all sequences) of strategy profiles, in each of which every player’s strategy is optimal under under his or her uncertainty about the others. We derive general properties of such robustness, and apply the definition to Bertrand competition games and the Nash demand game, games that admit infinitely many Nash equilibria. We show that our robustness criterion selects a unique Nash equilibrium in the Bertrand games, and that this agrees with recent experimental findings. For the Nash demand game, we show that the less uncertain party obtains the bigger share.
    Keywords: Nash equilibrium;refinement;strategic uncertainty;price competition;Bertrand competition;bargaining;Nash demand game
    JEL: C72 D43 L13
    Date: 2010
  7. By: Steven J. Davis; R. Jason Faberman; John C. Haltiwanger
    Abstract: This paper is the first to study vacancies, hires, and vacancy yields at the establishment level in the Job Openings and Labor Turnover Survey, a large sample of U.S. employers. To interpret the data, we develop a simple model that identifies the flow of new vacancies and the job-filling rate for vacant positions. The job-filling rate moves counter to aggregate employment but rises steeply with employer growth rates in the cross section. It falls with employer size, rises with worker turnover rates, and varies by a factor of four across major industry groups. We show that (a) employers rely heavily on other instruments, in addition to vacancy numbers, as they vary hires, (b) the hiring technology exhibits strong increasing returns to vacancies at the establishment level, or both. We also develop evidence that effective recruiting intensity per vacancy varies over time, accounting for about 35% of movements in aggregate hires. Our evidence and analysis provide useful inputs for assessing, developing and calibrating theoretical models of search, matching and hiring in the labor market.
    JEL: D21 E24 J63
    Date: 2010–08
  8. By: Oesch, Daniel
    Abstract: This paper enquires into the causes of union growth and decline by analysing flows in and out of membership. It does so at the level of 70 Swiss union locals over the period 2006-08. Gross flows in union membership are found to be much larger than the resulting net changes: turnover of annually 10 per cent thus is a surprisingly constant feature across unions. Net changes in membership are primarily determined by inflows: successful union locals differ from languishing ones with respect to their entry rates, whereas exit rates are similar. There is large variance in union locals’ entry rates that is not accounted for by the labour market context. Rather, it seems attributable to differences in union organization and strategy.
    Keywords: trade unions; membership; strategic choice; turnover; recruitment
    JEL: J51 J63 J5
    Date: 2010
  9. By: Kirschenmann, K. (Tilburg University, Center for Economic Research)
    Abstract: This paper studies how credit constraints develop over bank relationships. I analyze a unique dataset of matched loan application and loan contract information and measure credit constraints as the ratio of requested to granted loan amounts. I find that the most important determinants of receiving smaller than requested loan amounts are firm age and size at the time of the first interaction between borrower and bank. Over loan sequences, credit constraints decease most pronouncedly in the beginning of relationships and for the initially young and small firms. Moreover, the structure of the dataset allows me to disentangle the demand and supply effects behind these observed credit constraints. I find that the gap between requested and granted loan amounts decreases because both sides converge. If previous credit constraints were large, requested amounts increase more moderately, while granted amounts increase more strongly than in the case of small previous constraints. The findings are a sign of the use of dynamic incentives at the bank side to overcome information problems when contracting repeatedly with opaque borrowers. The results further suggest that, particularly in the beginning of a bank relationship, borrowers learn from their previous experience with credit constraints and adjust their demand accordingly.
    Keywords: Credit constraints;relationship lending;small business lending;asymmetric information;learning
    JEL: D82 G20 G21 G30
    Date: 2010
  10. By: Hua, Changchun (Asian Development Bank Institute); Liu, Li-Gang (Asian Development Bank Institute)
    Abstract: This paper investigates whether there is any consistency between banks' financial strength ratings (bank rating) and their risk-return profiles. It is expected that banks with high ratings tend to earn high expected returns for the risks they assume and thereby have a low probability of experiencing financial distress. Bank ratings, a measure of a bank's intrinsic safety and soundness, should therefore be able to capture the bank's ability to manage financial distress while achieving risk-return efficiency. We first estimate the expected returns, risks, and financial distress risk proxy (the inverse z-score), then apply the stochastic frontier analysis (SFA) to obtain the risk-return efficiency score for each bank, and finally conduct ordered logit regressions of bank ratings on estimated risks, risk-return efficiency, and the inverse z-score by controlling for other variables related to each bank's operating environment. We find that banks with a higher efficiency score on average tend to obtain favorable ratings. It appears that rating agencies generally encourage banks to trade expected returns for reduced risks, suggesting that these ratings are generally consistent with banks' risk-return profiles.
    Keywords: bank ratings; risk-return efficiency; stochastic frontier analysis
    JEL: D21 D24 G21 G24 G28 G32
    Date: 2010–08–12
  11. By: Byström, Hans (Department of Economics, Lund University)
    Abstract: This paper describes how credit default swaps could be employed to create performance based executive compensation portfolios that reflect the value of a firm’s debt as well as equity; i.e. the total value of all a firm’s assets. So-called Asset Value Unit (AVU) compensation portfolios are defined and compared to ordinary (long-term incentive) stock compensation portfolios for a range of banks from the recent EU-wide stress testing exercise conducted by the Committee of European Banking Supervisors (CEBS). While our study is limited to bank executives, the suggested method of paying executives using credit default swaps in addition to stocks also works for non-financial firms as well as for non-executives. The empirical results suggest that executive/CEO compensation plans based on asset values behave more reasonably than traditional equity based plans.
    Keywords: executive pay; executive compensation; stock; credit default swap; bank; stress test
    JEL: G10 G21 G34 G38
    Date: 2010–08–14
  12. By: Meg Sato
    Abstract: This paper analyses two pronounced features of Japanese corporate governance--large corporate boards almost entirely composed of insiders and the tendency to appoint CEOs through internal promotions. It is often argued that Japanese boards are less effective in monitoring CEOs than U.S. boards which tends to be composed of a small number of directors, majority of which are outsiders. I show that Japanese corporate governance exhibits less inefficiencies than U.S. corporate governance. I further discuss the recent changes in Japanese corporate governance and provide theoretical explanation that they do not necessarily enhance board monitoring.
    JEL: G30 K22 P51
    Date: 2010
  13. By: Harald Oberhofer (University of Salzburg)
    Abstract: Based on the empirical firm growth literature and on heterogeneous (microeconomic) adjustment models, this paper empirically investigates the impact of European industry fluctuations and domestic business cycles on the growth performance of European firms. Since the implementation of the Single Market program the EU 27 member countries share a common market. Accordingly, the European industry business cycle is expected to become a more influential predictor of European firms' behaviour at the expense of domestic fluctuations. Empirically, the results of a two-part model for a sample of European manufacturing firms reject this hypothesis. Additionally, subsidiaries of multinational enterprises constitute the most stable firm cohort throughout the observed business cycle.
    Keywords: Firm growth, industry dynamics, domestic business cycle, European integration, multinational enterprises, two-part model
    Date: 2010–07–19
  14. By: Katja Rost
    Abstract: The rise in executive compensation has triggered a great amount of public controversy and academic research. Critics have referred to the salaries paid to managers as 'pay without performance', while defenders have countered that the large salaries can be explained by a 'war for talents'. This research tests whether a war for talent provides an explanation. The rise in executive compensation in recent years is explained by the assumption that, over the past decades, general managerial skills have become more important relative to firm-specific knowledge for the production of managers. A shift toward transferable managerial skills requires higher compensation, particularly in large firms, to attract and retain managerial talents. Relying on an internationalized and deregulated managerial labor market, i.e. the Swiss banking sector, the empirical findings confirm that a shift toward transferable managerial skills in large firms is indeed an explanation for the rise in executive compensation. However, the shift towards transferable managerial skills in large firms does not improve firm performance, giving no supporting evidence for a war for talent. It is discussed how transferable managerial skills may used to legitimize higher compensation at the top, e.g. by promulgating definitions of talent in elite labour markets.
    Keywords: Executive compensation, efficient labor market view, transferable skills, outside options
    Date: 2010–08
  15. By: Abdelfatah Ichou
    Abstract: During the last decades, most developed countries have shown a remarcable increase in entrepreneurship rates. Recent research suggests that this increase is, for a considerable part, caused by an increase in the share of solo self-employed. Nowadays, for example, more than half of all Dutch business owners are solo self-employed. This raises the question which factors determine whether an entrepreneur becomes an employer or remains solo self-employed. A recent study by EIM investigates the decision of entrepreneurs whether or not to become an employer and the decision of employers to hire a certain number of employees. The first decision is examined by estimating duration models that model the duration of the time spent as solo entrepreneur before the transition to employer is made. The estimations are performed on a panel of Dutch start-ups in 1998, 1999 and 2000. We find that entrepreneurs who founded a firm to improve their work-life balance are less likely to make the transition to employership. The remaining factors that we found to influence the employer decision do this all in a positive way. These factors include whether or not the entrepreneur has the objective to maximize revenue, experience within the industry in which he operates, his entrepreneurial experience, selfefficacy, risk attitude and the time that is spent in the company. We also find that the likelihood of becoming a job creator is positively related to the business cycle. The second decision is examined by estimating count models that model the number of employees that are hired in the first year of employership. We find that higher levels of educational, entrepreneurial experience and self-efficacy of the entrepreneur lead to a greater firm size. Another factor that increases firm size is innovativeness. The moment in time at which the transition from soloentrepreneur to employer is made, also plays are role. For the first few years we find a negative relationship with firm age, indicating that the faster the switch is made, the more personnel will be employed. Also, for the employee decision we find a positive relation with the business cycle.  
    Date: 2010–08–09
  16. By: Kox, Henk L.M.; Leeuwen, George van; Wiel, Henry van der
    Abstract: The paper investigates whether scale effects, market structure, and regulation determine the poor productivity performance of the European business services industry. We apply parametric and nonparametric methods to estimate the productivity frontier and subsequently explain the distance of firms to the productivity frontier by market characteristics, entry- and exit dynamics and national regulation. The frontier is assessed using detailed industry data panel for 13 EU countries. Our estimates suggest that most scale advantages are exhausted after reaching a size of 20 employees. This scale inefficiency is persistent over time and points to weak competitive selection. Market and regulation characteristics explain the persistence of X-inefficiency (sub-optimal productivity relative to the industry frontier). More entry and exit are favourable for productivity performance, while higher market concentration works out negatively. Regulatory differences also appear to explain part of the business services' productivity performance. In particular regulation-caused exit and labour reallocation costs have significant and large negative impacts on the process of competitive selection and hence on productivity performance. Overall we find that the most efficient scale in business services is close to 20 employees and that scale inefficiencies show a hump-shape pattern with strong potential scale economies for the smallest firms and diseconomies of scale for the largest firms. The smallest firms operate under competitive conditions, but they are too small to be efficient. And since this conclusion holds for about 95 out of every 100 European business services firms, this factor weighs heavily for the overall productivity performance of this industry.
    Keywords: productivity; frontier models; scale; industry dynamics; regulation; European Union; business services
    JEL: L8 C34 L1 R38
    Date: 2010–07–01
  17. By: Brouwer, E.; Wiel, H.P. van der (Tilburg University, Center for Economic Research)
    Abstract: This paper examines the relationship between competition, innovation and productivity for the Netherlands. We use industry level data aggregated from micro data as well as moments from firm level data for the period 1996-2006. We match innovation data from Community Innovation Survey with accounting data to link innovative activities with performance at the industry level. We find strong evidence for a positive impact of competition on Total Factor Productivity (TFP) at the industry level. Competition directly increases TFP by reducing X-ineficiencies and removing inefficient forms from markets, but also through more innovation. Nonetheless, there exists an inverted U- curve between competition and innovation for the Netherlands, at least for manufacturing industries. Yet, our results indicate that a negative effect of competition on productivity through lower innovation expenditures arises only at very high levels of competition.
    Keywords: competition;innovation;profit elasticity;productivity
    JEL: D40 L16 O31
    Date: 2010
  18. By: Rosique, Francisco
    Abstract: Corporate Growth is a concept that has been widely treated in a specific way or as part of strategy theories, in definition and in econometric models and has also been studied in many different aspects and approaches. The author describes in depth the main variables affecting corporate growth and the underlying business processes. This empirical research has focused on Sales, Profit-Cash Flow, Risk, Created Shareholder Value, Market Value and Overall Performance econometric models. These panel data models are based on the 500 Companies of the Standard & Poor’s 500. The methodology used has been very strict in identifying exogenous variables, walking through the different alternative econometric models, discussing results, and, in the end, describing the practical implications in today’s business corporate management. We basically assume that the Functions/Departments act independently in the same company, many times with different objectives, and in this situation clear processes are key to clarify the situations, roles and responsibilities. We also assume that growth implies interactions among the different functions in a company and the CEO acts to lead and coach his immediate Directors as a referee of the key conflicts through his Operating Mechanism. The objective of this PhD Dissertation is to clarify the business priorities and identify the most relevant variables in every process leading to the highest efficiency in reaching a sustainable and profitable growth. It covers the lack of academic studies on the nature and specific driving factors of corporate growth and provides a working framework for Entrepreneurs and Management leading to the Company’s success.
    Keywords: Models with Panel Data; Capital; Produtivity; Firm choice; Growth; Investment; Corporate Finance; Firm objectives; Firm performance; Industry studies; Manufacturing; Primary products and construction; Services; Transportation and utilities; Business economics; Research and development
    JEL: L25 L90 O32 C33 G30 L80 L60 L21 D92 D24 M21 L70
    Date: 2010–06–23
  19. By: Michael Fritsch (School of Economics and Business Administration, Friedrich-Schiller-University Jena); Sebastian von Engelhardt (School of Economics and Business Administration, Friedrich-Schiller-University Jena)
    Abstract: We analyze the characteristics of new businesses in the German ICT industry, distinguishing them based on their choice between two IPR regimes: open source software (OSS) or closed source software (CSS). The share of new firms with an OSS-based business model has increased considerably over the last several years. OSS-based firms tend to be smaller (in terms of staff and capital) and experience less shortages of capital. Only older cohorts of OSS-intensive start-ups had more difficulty than their CSS counterparts in convincing potential financiers of their viability, indicating that OSS business models are now well established. We find no evidence that the lower entry barriers for OSS firms are particularly attractive to start-ups with low human capital endowment or to necessity-motivated entrepreneurs.
    Keywords: New business formation, institutions, open source, intellectual property rights, software industry
    JEL: D02 L17 L26 L86
    Date: 2010–08–04
  20. By: Bottazzi, L.; Da Rin, M.; Hellmann, T. (Tilburg University, Center for Economic Research)
    Abstract: We examine the effect of trust on financial investment and contracting decisions in a micro-economic environment where trust is exogenous. Using hand-collected data on European venture capital, we show that the Eurobarometer measure of trust among nations significantly affects investment decisions. This holds even after controlling for investor and company fixed effects, geographic distance, information and transaction costs. The national identity of venture capital firms’ individual partners further contributes to the effect of trust. Education and work experience reduce the effect of trust but do not eliminate it. We also examine the relationship between trust and sophisticated contracts involving contingent control rights and find that, even after controlling for endogeneity, they are complements, not substitutes.
    Keywords: Venture Capital;Social Capital;Trust;Financial Contracts;Corporate Governance.
    JEL: G24 G34 K22 M13
    Date: 2010
  21. By: Graafland, J.J.; Kaptein, M.; Mazereeuw v/d Duijn Schouten, C. (Tilburg University, Center for Economic Research)
    Abstract: The social and ecological challenges that governments face have raised their interest in socially responsible business conduct (SRBC). In this article we analyze the motives of executives to perform SRBC. We distinguish three types of motives: financial, ethical and altruistic motives. We test the hypotheses on a sample of 473 executives. The estimation results show that SRBC is driven by a combination of intrinsic and extrinsic motives, but that the intrinsic motives are stronger than the extrinsic motive.
    Keywords: intrinsic motivation;extrinsic motivation;corporate social responsibility;socially responsible business conduct
    JEL: M14 Z12
    Date: 2010
  22. By: Christopher Reicher; Johannes Utlaut
    Abstract: We estimate a seven-variable-VAR for the U.S. economy on postwar data using long-run restrictions, taking changes in long-run interest rates and inflation expectations into account. We find a strong connection between oil prices and long-run nominal interest rates which has lasted throughout the entire postwar period. We find that a simple off-the-shelf theoretical model of oil prices and monetary policy, where oil prices are flexible and other prices are sticky, in fact predicts a strong relationship if inflation and oil prices were driven by monetary policy. The observed magnitude of this relationship is still a bit of a puzzle, but this finding does call into question the identification techniques commonly used to identify oil shocks
    Keywords: Oil shocks, interest rates, inflation
    JEL: E31 E58 N50
    Date: 2010–07
  23. By: Alex Dickson (Department of Economics, Strathclyde University)
    Abstract: We consider entry of additional firms into the market for a single commodity in which both sellers and buyers are permitted to interact strategically. We show that the market is quasi-competitive, in that the inclusion of an additional sellerlowers the price and increases the volume of trade, as expected. However, whilst buyers benefit from this change under reasonable conditions on preferences, we cannot conclude that sellers are always made worse off in the face of more intense competition, contrary to the conventional wisdom. We characterize the conditions under which entry by new sellers may raise the equilibrium profit of existing sellers, which will depend in an intuitive way on the elasticity of a strategic analog of demand and the market share of existing sellers, and encompass completely standard economic environments.
    Keywords: bilateral oligopoly; entry; comparative statics.
    JEL: C72 D21 D43 L13
    Date: 2010–07
  24. By: Christian Keuschnigg; Peter Egger; Hannes Winner
    Abstract: This paper provides a theory of incorporation and taxation that emphasizes the role of the corporate legal form in facilitating access to external capital and the potential advantages of limited liability. Incorporation relaxes financing constraints and makes corporations larger than comparable non-corporate firms. For the same reason, a tax on corporations imposes a smaller first order welfare loss than a tax on non-corporate firms. Shifting the tax burden from non-corporate to corporate firms raises welfare, justifying some double taxation of corporate profits under a classical system. We compare the role of taxes with other institutional reforms and discuss how the theoretical results of the paper can be tested empirically.
    Keywords: Incorporation, corporate tax, external capital, limited liability
    JEL: H25 H73 F23 C21
    Date: 2010–08

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