Why the Optimal Long-Run Tax Rate on Capital is Zero…or Very High: The Missing Explanation

Abstract

Judd’s (1985) finding that the optimal long-run rate of tax on capital is zero—even if equity is an important social objective—has exerted substantial influence in academic and policy circles over the last quarter century. Only very recently has it become clear that Judd’s zero-tax result rests on an implicitly adopted assumption about how savings responds to taxation. Working within the very same model structure, Straub and Werning (2020) demonstrate that the optimal long-term tax rate is positive and potentially large under an alternative equally plausible assumption. This paper attempts to fill a remaining gap in the literature by providing a clear explanation of what is driving results in both variants of Judd’s original model. Furthermore, it suggests that the real logical engine in both cases is an oddity in the mathematical conception of infinity that is of little consequence for actual tax policy. A mathematical appendix is available here: https://ssrn.com/abstract=3589726