Abstract
This paper analyzes optimal linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heterogenous individuals. A dual income tax with a positive marginal tax rate on not only labor income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labor tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labor income if savings are elastic compared to investment in human capital; substitution between inputs in human capital formation is difficult; and most investments in human capital are verifiable. Numerical calculations suggest that the optimal marginal tax rate on capital income is close to the tax rate on labor income.
Highlights
Should capital income be taxed? This has always been an important question in public finance
Reminiscent of Pigou (1928), models with infinitely lived individuals without endogenous human capital formation typically find that a zero tax on capital income is optimal in the long run (Chamley 1986; Judd 1985)
This paper investigated the interactions between labor markets, capital markets, and human capital investments in a second-best world in which the government engages in redistribution without being able to verify work and learning efforts
Summary
Should capital income be taxed? This has always been an important question in public finance. Erosa and Gervais (2002), Golosov et al (2006), and Diamond (2006) analyze optimal capital income taxes in life-cycle models rather than models with infinitely lived individuals, but they allow for non-separable preferences in consumption and leisure They demonstrate that optimal capital taxes are positive if leisure and consumption are more complementary later in life than they are earlier in life.5 Saez (2002) and Diamond (2006) incorporate heterogenous preferences and find that capital income should optimally be taxed for redistributive reasons if high-ability individuals feature a lower discount rate than low-ability individuals do.
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