Incorporation and Taxation: Theory and Firm-Level Evidence

Abstract

This paper provides theory and firm-level evidence on the incorporation decision of entrepreneurs in a model of corporate governance and taxation. The theory explains how the incorporation decision of entrepreneurs is driven by taxation (corporate and personal income taxes), corporate transparency, access to external capital and limited liability. We estimate features of this model using a large cross-section of more than 540,000 firms in European manufacturing. The impact of taxation on the incorporation decision is at the heart of this analysis. We find that higher personal income tax rates and their progression are associated with an increase in the probability of incorporation, while higher corporate tax rates entail an impediment to incorporate. This finding is robust to the inclusion of other economic and institutional determinants and to a variety of functional form assumptions about the latent variable in the estimated discrete choice model.