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

Abstract

We develop a model of entrepreneurial choice in which some individuals have a comparative advantage in starting new businesses. 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 e¤ect 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.

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