Tax policy and the financing of innovation *

• We study tax policy in a Schumpeterian model with asymmetric information in financial markets.
• Taxing profits to subsidise labor income may increase innovation.
• Substituting labor and profit taxes for consumption taxes more decidedly boosts innovation.
• If the government cannot tax consumption, the second best equilibrium exhibits adverse selection.
• The model predicts an inverted-U relationship between competition and growth.

We study tax policy in a Schumpeterian growth model with asymmetric information in the financing of innovation. Investors cannot a priori distinguish between more or less talented entrepreneurs. Net-worth allows talented entrepreneurs to self-invest and avoid being pooled with less talented entrepreneurs in the credit market. Increasing net-worth boosts innovation even when financed through higher profit taxes. Taxing consumption effectively raises net-worth and subsidizes profits simultaneously. Sufficiently taxing consumption implements the social optimum free of adverse selection. If forced to tax consumption less, the government implements a second best allocation with adverse selection when boosting net-worth enough to avoid adverse selection requires taxing profits excessively.