Overcoming wealth inequality by capital taxes that finance public investment

Abstract

Wealth inequality is rising in high-income countries. Can increased public investment financed by higher capital taxes counteract this trend? We examine how such a policy affects the distribution of wealth in a setting with distinct wealth groups: dynastic savers and life-cycle savers. Our main finding is that this policy always decreases wealth inequality when the elasticity of substitution between capital and labor is moderately high. At high capital tax rates, dynastic savers disappear. Below these rates, life-cycle savers gain from the higher public expenditures financed by the higher capital tax rates. We calibrate our model to OECD economies and find a threshold elasticity of 0.82.