Difficulties in attracting external financing is a main constraint on investment of existing firms and the creation of new firms. However, finance constraints do not affect all firms equally. New innovative firms often have little own funds but large, profitable investment opportunities. These firms are most likely to be finance constrained. Large and mature com-panies, in contrast, tend to have lots of existing assets for collateral and may have already exhausted their investment needs. They are unlikely to be finance constrained but may suffer from other governance problems, such as empire building and misuse of corporate funds. As documented in a large body of empirical literature, different segments of the business sector are thus affected by financial frictions in different ways. Business taxation will therefore have different consequences for the financing and investment of different types of firms.
With few exceptions, existing literature in public economics has incorporated neither the theory of heterogeneous firms nor the modern theory of corporate finance. It is a unique re-search opportunity to merge heterogeneous firm theory and corporate finance to study public policy in market equilibrium. The project pursues five research questions which all make use of corporate finance theory. (i) What are the determinants of the firms' choices of legal form (corporate vs. non-corporate status)? Should the tax system discriminate among corporate and non-corporate firms? (ii) What are the differential effects of taxes on investment of financially constrained and unconstrained firms? Since these two types of firms systematically differ in their factor productivity and investment prospects, the effect of taxes on the composition of firms becomes important. (iii) What is the role of dividend taxation in the presence of firm heterogeneity? Constrained firms use all available own funds to finance investment, do not pay dividends and earn an excess return. In contrast, large mature firms with free cash-flow often prefer internal investments even if the return is below average, instead of paying out funds that could be more profitably invested elsewhere. In determining pay-out behavior, div-idend taxation should affect the efficiency of capital allocation and aggregate investment. (iv) What is the effect of labor taxation and job protection on investment of constrained firms, and how does this affect aggregate unemployment? (v) How do institutional quality and financial market development affect a country's comparative advantage in innovative sectors?