A Model of the Optimal Tax Mix Including Capital Taxation

Abstract

This paper uses a three-tax linear model to study the optimal tax mix numerically. The three aggregate taxes relate to labour, capital and commodities. The most striking result is that with a linear expenditure system based on econometric estimates, indirect (i.e. commodity) taxation dominates the optimal tax mix, with over 80% of tax revenue coming from indirect taxes. The main reason for this outcome appears to be that commodity taxation has a less harmful effect on labour supply than labour income taxation and a less harmful effect on capital supply than capital income taxation. Comprehensive computational modelling of the optimal tax mix has been absent from the literature. In light of the results presented here, there appears to be considerable scope for further research in this area. From a theoretical perspective, a major innovation in this paper is the introduction of capital taxation into a static tax mix model. The analytical part of the paper provides approximate predictions for optimal linear tax rates, called the modified inverse elasticity rule. Using these formulas, explanations are provided for the dominance of indirect taxation in the optimal tax mix.