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.