Optimal tax reform in the presence of adjustment costs

Abstract

The optimal implementation of an efficiency-enhancing capital taxation reform is examined when the government is concerned about arbitrary reform-induced redistributions and investment causes firms to incur adjustment costs. Theoretical results indicate that immediate partial enactment of reform is optimal with concave adjustment costs, while with convex adjustment costs, the optimal reform implementation policy is either (i) immediate partial enactment with sufficiently low adjustment costs, (ii) phased-in partial enactment with intermediate adjustment costs, or (iii) postponed partial enactment with sufficiently high adjustment costs. Numerical results suggest that, relative to the optimal one-step implementation policy, little is gained by phasing-in reform.