Capital income taxation with housing

Abstract

This paper quantitatively investigates capital income taxation in the general-equilibrium overlapping generations model with household heterogeneity and housing. Housing tax policy is found to affect how capital income should be taxed, due to substitution between housing and non-housing capital. Given the existing U.S. preferential tax treatment for owner-occupied housing, the optimal capital income tax rate is close to zero (1%), contrary to the high optimal capital income tax rate found with overlapping generations models without housing (31%). A low capital income tax rate improves welfare by narrowing a tax wedge between housing and non-housing capital; the narrowed tax wedge indirectly nullifies the subsidies (taxes) for homeowners (renters) and corrects over-investment to housing. Naturally, when the preferential tax treatment for owner-occupied housing is eliminated, a high capital income tax rate improves welfare as in the model without housing.