Financial Frictions, Corporate‐to‐Consumption Tax Shifting, R&D‐Driven Growth, and Welfare

ABSTRACT Does shifting the tax base from corporate income to consumption under a balanced‐budget constraint improve welfare? From a purely efficiency perspective, we study this question in a Rivera‐Batiz and Romer‐type variety‐expanding growth model with heterogeneous R&D productivity and financial frictions that limit external finance for innovation. Taking the labor income tax rate as fixed, we characterize the welfare‐maximizing corporate income and consumption tax rates and examine how they vary with financial development, modeled as a relaxation of borrowing constraints on R&D and interpreted as an improvement in legal institutions. Our main contribution is to show how financial development affects the welfare implications of corporate‐to‐consumption tax shifting through entrepreneurial selection in R&D. When financial frictions are severe, lower corporate taxation is less attractive because R&D investment is inefficiently allocated. As frictions are relaxed, more productive entrepreneurs gain access to finance, improving the productivity composition of R&D investment. Beyond a threshold level of financial development, lower corporate taxation—and, in some cases, a corporate‐profit subsidy—becomes welfare enhancing, implying a greater reliance on consumption taxation. We also examine the robustness of these results under alternative assumptions regarding patent protection, productivity dispersion, intertemporal preferences, returns to specialization, government size, and the labor income tax rate.