Optimal Capital-Income Taxation in a Model with Credit Frictions

Abstract

The optimality of the long-run capital-income tax rate is revisited in a simple neoclassical growth model with credit frictions. Firms pay their factors of production in advance, which requires borrowing at the beginning of the period. Borrowing, in turn, is constrained by the value of collateral they own at the beginning of the period. This constraint leads to inefficiently low amounts of capital and labor. In this environment, the optimal capital-income tax in the steady state is non zero. Specifically, with no capital deprecation allowance, the capital-income tax is unambiguously negative so that the distortions stemming from the credit friction are offset by subsidizing capital. When depreciation allowance is introduced, capital-income tax can be either positive or negative depending on the degree of allowance. Quantitative analyses show that for plausible degrees of depreciation allowance the capital-income tax is indeed negative. However, when the government cannot distinguish between capital-income and profits, the capital-income tax is positive as the government levies the same tax rate on both sources of income. These results stand in contrast to the celebrated result of zero capital-income tax of Judd (1985) and Chamley (1986).