Human Capital External Effect and Taxation of Physical Capital Income

Abstract

It is commonly believed that taxation of physical capital is a bad idea. Whereas in reality many countries do levy heavy taxes on capital income. In this paper we show that taxation of physical capital can be justified when there is non-convexity of technology due to human capital external effect. We demonstrate that taxation of capital income should be implemented via residence-based taxation, that is, to increase the welfare of the residents of the country, the government has to levy the entire tax burden only on them. We also show that source-based taxation reduces welfare.