Capital income taxation, wealth distribution and borrowing constraints

Abstract

The theorem of zero taxation of capital income is reexamined and is shown to hinge critically on the assumptions of a long horizon and perfect markets for the inter-temporal allocation of resources. The theorem does not hold when borrowing constraints prevent individuals from insuring against idiosyncratic shocks and have a precautionary motive for savings. Structural assumptions are made such that with no taxation, aggregate savings are socially ‘excessive’ in the long-run, i.e. the rate of return is smaller than the discount rate. Sufficient conditions for a Pareto efficient taxation or subsidization of capital in the long-run depend on the correlation between individuals’ consumption and savings. A subsidy may be efficient when individuals’ incomes follow a predictable pattern of life-cycles with no negative bequest.