Optimal Capital Income Taxation with Housing

Abstract

I quantitatively study the optimal capital income taxation in the general equilibrium overlapping generations model with uninsurable idiosyncratic income shocks and with housing and flnancial assets. Following key characteristics of housing are explicitly modeled: (i) housing is held for the dual purpose of consumption and savings, (ii) housing can be either owned or rented, (iii) if owned, housing can be used as a collateral for mortgage loans, and (iv) there is a preferential tax treatment for owner-occupied housing through tax-exemption of imputed rents and mortgage interest payment deduction. Using calibrated models, I investigate whether and how the optimal capital income tax rate difiers between the model with both housing and flnancial assets and the standard model without housing. I flnd that the optimal capital income tax changes signiflcantly depending on the housing tax policy. This is mainly because capital income tax afiects both portfolio choice between housing and flnancial assets, and tenure decision. In particular, I flnd that, when preferential tax treatment for owner-occupied housing like the current U.S. economy is maintained, there is a large welfare gain by lowering the capital income tax rate and thus narrowing the tax wedge between housing and flnancial assets, and owning and renting. The optimal capital income tax rate in the baseline model with housing is 13%, which is substantially lower than the optimal capital income tax rate in the model without housing, which is 37%. On the other hand, if the preferential tax treatment for owner-occupied housing is eliminated, it becomes optimal to tax both assets heavily, like in the one-asset life-cycle model. Indeed, the optimal tax rate for capital income and housing is 43%, which is higher than in the model without housing. Finally, welfare gain form implementing the optimal capital income tax rate is large in the model with housing; in both cases above, the welfare gain is larger than 2% of ∞ow consumption.