Taxing capital along the transition—Not a bad idea after all?

Abstract

This paper quantitatively characterizes optimal tax systems in a model of overlapping generations, when transitional cohorts are explicitly taken into account. We use the recent study of Conesa et al. (2009) as an example, but extend it by transitional dynamics. We furthermore develop a general and coherent way of aggregating welfare effects of different individuals and cohorts in the short- and the long-run. Our welfare measure includes the case of a utilitarian social welfare function, yet is not limited to this perspective.We show that the optimality of a high capital income tax rate along the transition crucially depends on the assumption of a utilitarian social welfare function. This objective of the policy maker comprises implicit redistributive objectives across and within cohorts. Based on pure economic efficiency and insurance effects, however, we find a zero capital income tax rate and a less progressive labor income tax schedule to be optimal. Such a tax system receives political support from initial cohorts. A high capital income tax regime on the other hand does not.