The Effect of Capital Taxation on Capital Accumulation and Welfare

Abstract

This paper analyzes the effects of time-consistent capital taxation on the level of capital and welfare. We find that a commitment to a zero capital tax shifts the time inconsistency problem towards labor taxes and the provision of public consumption. By comparing the worst time-consistent policies with and without a commitment to zero capital taxes, we find that the mere existence of a capital tax might lead to capital tax rates that are as high as 90% at steady state and capital stocks that are 84% lower. There the welfare gains of a commitment to zero capital taxes are about 7.4% of initial steady state consumption. At the other end, comparing the best time-consistent policies, we find that the welfare losses of a commitment to zero capital taxes are about 0.9% of consumption.