Capital Income Tax Research Articles

The Taxation of Capital Income in Canada: Analysis and Directions for Reform

This paper describes and analyzes the taxation of capital income in Canada, including the corporate income tax and the taxation of dividends and capital gains at the personal level. The paper then turns to a discussion of directions for policy reform. The perspective is that of a small open economy with highly mobile capital. I argue that a rent-based tax at the corporate level coupled with increases in the taxation of dividends and capital gains at the personal level is attractive in terms of the equity-efficiency trade-off.

Optimal taxation in an endogenous growth model with variable population and public expenditure

AbstractIn this paper we analyze second‐best optimal taxation in an endogenous‐growth model driven by public expenditure, in presence of endogenous fertility and labor supply. Normative analysis shows positive taxes on the number of children, which are necessary to correct for congestion in the publicly provided input (such as education and healthcare), negative public debt. Results on capital and labor income taxation depend on whether the public input is optimally provided.

The effects of financing rules in pay-as-you-go pension systems on the life and the business cycle

Abstract Empirically, revenues of public pension systems are more volatile than expenditures. Therefore, the question arises how the social security authority should buffer its revenues and adjust its contributions over the business cycle. This paper studies the corresponding effects on the life cycle of households and the business cycle in a large-scale overlapping generations model. In particular, the labor supply is endogenous and takes the intertemporal links between contributions and pension benefits into account. Sluggish adjustments of contribution rates that are implemented by adjusting a financial buffer stock both stabilize an economy and decrease the volatility of lifetime utilities of most workers and retirees, in contrast to sole adjustments of contribution rates. However, changes of consumption, capital income, or lump sum taxes, which aim to balance public pension budgets, improve the allocation of aggregate risk across cohorts for people up to an age of at least 71 years.

Supply-side optimal capital taxation with endogenous wage inequality

In a model with a continuum of imperfectly substitutable laborers and endogenous skill premiums, this paper derives optimal tax formulas as functions of social welfare weights and a small set of estimable statistics. It first demonstrates that differential capital tax, based on capital’s effect on skill premiums, is desirable even in the steady state, while nonlinear capital tax is not desirable under an additively separable utility function. It then explores both uniform and sector-specific capital income tax (UCIT and SCIT), with a sector corresponding to a type of laborer. Numerical application to U.S. taxation delivers an inverted U-shaped relationship between the SCIT rate and sectoral wage. The optimal SCIT rate on the top-income sectors increases with the elasticity of substitution between the sectoral products and amounts to a net return tax of 45.9%. Reform from UCIT to SCIT compresses wage gaps between the top ten percent and others considerably. It especially favors the median-income individuals whose wages are increased as high as 3.8%. Due to production inefficiency, switching from UCIT to SCIT implies small welfare gains (0.07%~0.22% in consumption-equivalent terms).

A Tale of Two Bases: Progressive Taxation of Capital and Labor Income

Macroeconomic models routinely abstract simultaneously from two features of the US federal tax code: the joint taxation of ordinary capital and labor income and the special taxation of preferential capital income. In this article, we argue that this abstraction omits a “portfolio-effect” mechanism where endogenous changes to the ordinary-preferential composition of households’ capital income influence individuals’ optimal labor and saving decisions through its impact on their effective marginal tax rates. We demonstrate the quantitative importance of this tax detail by simulating provisions from the recently enacted “Tax Cuts and Jobs Act” using a heterogeneous-agent overlapping generations framework calibrated to the US economy. Our findings imply that accounting for the detailed taxation of labor and capital income should be considered an important modeling feature for tax policy analysis.

Capital Income Taxation in the Netherlands

Capital Income Taxation in the Netherlands

Supply-side Optimal Capital Taxation with Endogenous Wage Inequality

In a model with a continuum of imperfectly substitutable laborers and endogenous skill premiums, this paper derives optimal tax formulas as functions of social welfare weights and a small set of estimable statistics. It first demonstrates that differential capital tax, based on capital's effect on skill premiums, is desirable even in the steady state, while nonlinear capital tax is not desirable under an additively separable utility function. It then explores both uniform and sector-specific capital income tax (UCIT and SCIT), with a sector corresponding to a type of laborer. Numerical application to U.S. taxation delivers an inverted U-shaped relationship between the SCIT rate and sectoral wage. The optimal SCIT rate on the top-income sectors increases with the elasticity of substitution between the sectoral products and amounts to a net return tax of 45.9%. Reform from UCIT to SCIT compresses wage gaps between the top ten percent and others considerably. It especially favors the median-income individuals whose wages are increased as high as 3.8%. Due to production inefficiency, switching from UCIT to SCIT implies small welfare gains (0.07%∼0.22% in consumption-equivalent terms).

Inequality, Growth, and Congestion Externalities

Abstract We describe and numerically simulate the aggregate and distributional properties of an endogenous growth model with an infrastructure externality which is subject to relative congestion. We show that the congested externality induces higher growth, greater inequality, labor/leisure trade-off ambiguities and an ineffective capital income tax for the government to achieve long-term redistribution goals. We demonstrate the economic implications of congestions in production and consumption externalities on the public to private capital ratio, growth and income distribution. Finally, we discuss alternative tax options for promoting inclusive growth.

Capital Income Taxation under Full loss offset Provisions of a Prospect Theory Investor

In this paper we examine capital income taxation of a reference dependent sufficiently loss averse investor in a two period portfolio choice model under full loss offset provisions. Capital income taxation with loss offset provisions has been found to stimulate risk taking in expected utility models under certain assumptions about attitudes towards risk but would such effect be found under prospect theory type of preferences? We observe that the impact of capital income taxation depends on investors’ reference levels relative to their endowment income and thus we explore capital income taxation for different types of loss averse investors in terms of their ambition. We consider the less ambitious investors to be the ones with relatively low reference levels (they avoid relative losses in both periods) and more ambitious investors to be those with relatively high reference levels. We analyze two types of more ambitious investors: investors with higher time preference (who experience relative losses only in the second period under the bad state of nature) and investors with lower time preference (who experience relative losses only in the first period). We observe that capital income taxation stimulates current consumption in most cases which encourages risk taking, although the final outcome would depend on the investors’ degree of risk aversion, the rate of time preference and the tax rate in relation to certain thresholds. Current consumption could be discouraged for some ambitious type of investors that have relatively high second period reference levels but not necessary first period reference levels. in summary, to determine the impact of capital income taxation on the decision variables the reference levels in relation to endowment income play the most significant role. Ignoring reference depended preferences can lead to different conclusions for investors reaction to capital income taxation. We also find certain type of investors whose happiness level increases with capital income taxation under full loss offset provisions.

Social environment and corporate payouts

We investigate if macro-level social capital, which captures the notions of trust and honesty, has any effects on corporate payout policy. We find that firms situated in U.S. states (or counties) with higher levels of social capital (SC) have higher dividend payouts (DP). These results survive a battery of robustness tests dealing with inference and various forms of endogeneity. We find that the positive SC-DP association is more prominent when monitoring is weak. We also find that the positive SC-DP association remains when we account for internal social capital, political corruption, federal and state income taxes, and other possible dividend clienteles such as in-state pension funds and pension-age populations. Our study contributes to the literatures that regional locations and social considerations constitute clienteles who affect important corporate strategic decisions such as corporate payouts.

Fiscal shocks and spillovers in a dynamic two-country model

This paper examines the cross-border effects of domestic fiscal shocks on foreign economic activities by constructing a two-country general equilibrium model. The model yields two main results by comparing four alternative fiscal shocks: government spending, the capital income tax rate, the labor income tax rate, and the consumption tax rate. First, domestic fiscal shocks can generate sizable spillovers abroad. Second, once the size of each fiscal shock is normalized to achieve an equal change in government revenue, the spillover effects of different fiscal shocks on the foreign economic variables are qualitatively similar.

Fiscal devaluation and labor market frictions in a monetary union

We evaluate the macroeconomic and labor market impact of a fiscal devaluation in one region of a monetary union. We simulate a monetary-union model of the euro area (EA) and the world economy featuring search-and-matching labor markets. We obtain the following results. First, a region-specific devaluation improves trade-competitiveness, macroeconomic conditions, and employment. Second, a permanent regional fiscal devaluation has more expansionary labor-intensive effects than lowering the capital income tax rate and increasing the consumption tax rate. Third, simultaneous EA-wide and world-wide fiscal devaluations have expansionary effects on macroeconomic and labor market conditions. Fourth, a EA accommodative monetary policy enhances the expansionary effects of the EA-wide fiscal devaluation on the generic Member State; to the opposite, the Member State faces lower economic activity and employment if the world-wide fiscal devaluation is accompanied by an accommodative monetary stance outside the EA.

Gender Equality and Taxation - International Perspectives

Several strands in the international development of taxation during the last decades have contributed to structural problems that act as a hinder and even counteract the basis for gender equality. A general problem is that tax equity has become equivalent to what is good for economic growth. When social justice no longer plays a part in tax policy concern, the welfare state erodes. The income gap becomes extremely large, poverty increases, and the rich don’t pay their fair share of the tax burden. As women relative to men in most intersections of society have a subordinated socio-economic position, the outcome of this tax policy is not beneficial for women. This outcome stands out as deeply contradictory to the layers of legal obligations and policies, on both a national and international level, aiming to promote gender equality. The aim of this paper is to expose how tax laws can consolidate and even strengthen economic inequalities between men and women. I will discuss the deeply rooted culture of supporting the bread-winner family model by extensive tax expenditures, and why these type of regulations serves as disincentives to women’s labour market supply and the gendered inequality in the distribution of paid and unpaid work. Another topic is to explain why the world-wide loss of redistributive power in national tax systems is fuelling gender inequalities. The relation between gender equality and the taxation of capital income will be given some extra attention, with the purpose to make an argument that sustainable tax bases is very much a women’s issue.

Ageing and Welfare-State Policy Making: Macroeconomic Perspective

It has been well recognized that population ageing could generate structural changes centered around the dwindling labor force, on one hand, and the expanding dependency on the generosity of the welfare state, on the other hand. Ageing-related welfare state policy entails both fiscal issues and migration issues. The paper employs a general-equilibrium model with a policy-making focus, to help understand the mechanism governing the provision of social benefits, labor income taxation, capital income taxation, migration curbs on low skilled and high skilled, driven by the ageing of the population. Greater generosity of the welfare state comes together with policy of a more liberal migration policy — incentive compatible with the interests of the majority voters.

Capital Income Taxation in the Netherlands

Capital Income Taxation in the Netherlands

The Psychology of Taxing Capital Income: Evidence from a Survey Experiment on the Realization Rule

How to tax capital income is a critical issue today. The realization rule—requiring that property usually must be sold before gains are taxed—is central to taxing capital income, but often decreases the efficiency, equity, and simplicity of the tax system. Estimates suggest that the realization rule costs the government over $2 trillion over 10 years. Given these problems, it is unclear why the rule exists for assets that are easy to value and sell. Scholars have long speculated about the role of the public’s views here, but little is known empirically about them. We conduct the first survey experiment to understand the psychology of the realization rule, which has broad implications for the taxation of capital income. We have three main findings. First, respondents strongly prefer to wait to tax gains on stocks until sale: 75% to 25%. This pattern persists across a variety of other assets and policy framings: indeed, nearly half of those without stock prefer raising everyone’s taxes (including their own) to taxing unsold stock gains. But the flip side is that there is surprisingly strong support for taxing gains on assets at sale or transfer, including at death, in areas where current law never taxes those gains. Second, these views change only modestly after randomized participants observe a policy debate composed of videos explaining both the pros and cons of taxing before sale, though the pro and con treatments have large effects individually. And, third, among many possible explanations of these attitudes, we find particular evidence for four: using a different mental account for unsold gains than other ways of getting richer; a tendency to support the status quo; concerns about complexity; and a desire to tax consumption, not income, in the context of capital gains.

Overreaction to Capital Taxation in Saving Decisions

We study the response of saving decisions to two alternative capital taxation, i.e., wealth tax and capital income tax. We conduct an online “life-cycle” experiment on Amazon Mturk, where subjects make dynamic saving decisions. Subjects exhibit an overreaction to the wealth tax, not to the capital income tax: the subject saves significantly less with the introduction of wealth tax than with a financially equivalent drop in capital return. Furthermore, we build a parsimonious behavioral model of individual optimization to characterize the overreaction. Finally, to quantitatively illustrate the policy implication of overreaction for optimal capital taxation analysis, we use the same model and calibration as the seminal study of Conesa et al. (2009), but modified it to allow for behavioral overreaction. The results show that a larger overreaction bias generates more welfare loss for the economy. The optimal capital tax rate decreases as households overreact more to capital taxation.

Optimal Taxation of Normal and Excess Returns to Risky Assets

We study the optimal taxation of risk-free and excess capital income with heterogeneous rates of return, alongside an optimal nonlinear earnings tax. Households can hold three assets: one risk-free, one risky but diversifiable, and one a private investment with idiosyncratic risk whose expected return differs among households. Contrary to expectations, the optimal tax on excess returns to risky assets is ineffective for redistribution, because its effects are annulled by a Domar-Musgrave effect. It assumes only an insurance role, and is positive. The optimal tax on risk-free returns does fulfill a redistributive role, insofar the risk-free returns reveal information about the investors' types beyond what is revealed by the earnings tax base. The optimal nonlinear earnings tax takes the standard Mirrleesian form amended to take account of the stochasticity of capital income tax revenue.

Optimal Taxation of Capital in the Presence of Declining Labor Share

We analyze the implications of the decline in labor’s share in national income for optimal Ramsey taxation. It is optimal to accompany the decline in labor share by raising capital taxes only if the labor share is falling because of a decline in competition or other mechanisms that raise the share of pure profits. This result holds under various alternative institutional arrangements that are relevant for optimal taxation of capital income. A quantitative application to the U.S. economy shows that soaring profit shares since the 1980's can justify a significantly increasing path of capital income taxes.

Testimony Before the Subcommittee on Select Revenue Measures: Increasing Progressivity by Reforming the Taxation of Capital Income

Testimony Before the Subcommittee on Select Revenue Measures: Increasing Progressivity by Reforming the Taxation of Capital Income