Optimal Capital Income Tax Research Articles

Optimal Taxation with Imperfect Competition and Aggregate Returns to Specialization

In this paper we explore the proposition that, in economies with imperfect competitive markets, the optimal capital income tax is negative and the optimal tax on firms profits is confiscatory. We show that if the total factor productivity as well as the measure of firms or varieties are endogenous instead of fixed, then the optimal fiscal policy can lead to different results. The government faces a trade-off between the fixed costs that the society pays for the

Accounting for the “disconnectedness” of the economy in OLG models: A case for taxing capital income

The paper extends the works by Judd [K.L. Judd, Redistributive Taxation in a Simple Perfect Foresight Model, J. Public Econ. 28 (1985), 59–83.] and Chamley [C. Chamley, Optimal taxation of capital income in general equilibrium with infinite lives, Econometrica, 54 (1986), 607–622.], who establish that in the long run the capital income tax should be zero, by considering a discrete time version of the Blanchard–Buiter–Weil perpetual youth model. We show that an independent source of non-zero taxation arises whenever the economy is “disconnected” and this feature is properly taken into account by the policymaker. More precisely, if the weight attached to each cohort in the social welfare function equals the corresponding actual share in the population, there is a force pushing towards positive taxation of capital income, which acts as a Pigouvian intervention. Moreover, room for this intertemporal correction shrinks as the relative weight of a cohort tends to zero: thus, the optimal tax rate decreases with age and tends to zero for the oldest. We also show that our result depends neither on life-cycle behavior, as pointed out by the previous literature on OLG models, nor on population growth.

Optimal Taxation of Capital Income in Models with Endogenous Fertility

This paper studies the issue of the efficient taxation of capital income in intertemporal optimizing models with infinite horizons and endogenous population growth. We discover that, in the steady state, the optimal capital income tax is negative when the economy is closed. Instead, in a small open economy facing perfect capital mobility, the Chamley-Judd result of a zero tax rate is obtained if capital taxation is source-based; otherwise, income from wealth should be subsidized if taxation is residence-based. Moreover, we find that in our setup, taxing capital income with immediate expensing of capital expenditure may replicate the first-best equilibrium when labor is subsidized. Our findings, which depart substantially from those obtained in representative agent models with an endogenous labor supply, are to be ascribed to a wealth effect in the fertility choices that directly affects the pseudo-welfare function of the social planner.

Taxing Capital? Not a Bad Idea After All!

We quantitatively characterize the optimal capital and labor income tax in an overlapping generations model with idiosyncratic, uninsurable income shocks and permanent productivity differences of households. The optimal capital income tax rate is significantly positive at 36 percent. The optimal progressive labor income tax is, roughly, a flat tax of 23 percent with a deduction of $7,200 (relative to average household income of $42,000). The high optimal capital income tax is mainly driven by the life-cycle structure of the model, whereas the optimal progressivity of the labor income tax is attributable to the insurance and redistribution role of the tax system. (JEL E13, H21, H24, H25)

Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency

Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of welfare heterogeneity between these two groups for the determination of optimal capital and labor income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate an externality along the extensive labor margin that arises from search and matching frictions. However, the consideration of heterogeneity makes our result differ in an important way: even for a well-known parameter configuration (the Hosios condition) that typically eliminates this externality, we show that the optimal capital income tax is still non-zero. We also show that labor adjustment along the intensive margin has an important effect on efficiency at the extensive margin, and hence on the optimal capital tax, independent of welfare heterogeneity. Taken together, our results show that these two empirically-relevant features of the labor market can have a quantitatively-important effect on the optimal capital tax.

Optimal capital income taxation in a small open economy

This paper considers a stochastic small open economy with a financial asymmetry between the households and the government. In this setting, it is optimal not to tax capital income beyond the initial period. This is in contrast to the existing results for stochastic closed economies.

Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency

Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of welfare heterogeneity between these two groups for the determination of optimal capital and labor income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate an externality along the extensive labor margin that arises from search and matching frictions. However, the consideration of heterogeneity makes our result differ in an important way: even for a well-known parameter configuration (the Hosios condition) that typically eliminates this externality, we show that the optimal capital income tax is still non-zero. We also show that labor adjustment along the intensive margin has an important effect on efficiency at the extensive margin, and hence on the optimal capital tax, independent of welfare heterogeneity. Taken together, our results show that these two empirically-relevant features of the labor market can have a quantitatively-important effect on the optimal capital tax.

Optimal Capital Income Taxation in an Asymmetric Small Open Economy

This paper examines the structure of the optimal capital income taxation policy for a stochastic small open economy with a financial asymmetry in which the households have access to complete financial markets, while the government is constrained to issue risk-free debt and to announce the capital income tax rate one period in advance. In this setting, the optimal capital income tax rate is nonzero in general. However, with standard restrictions on the production and utility functions, the optimal tax rate on capital income is zero in all periods except the initial one.

Comment and Discussion

Comment and Discussion Kevin A. Hassett General Discussion References Altshuler, Rosanne. 2000. "Recent Developments in the Debate on Deferral." Tax Notes (April 10): 255-68. Altshuler, Rosanne, and Harry Grubert. 2001. "Where Will They Go If We Go Territorial? Dividend Exemption and the Location Decisions of U.S. Multinational Corporations." National Tax Journal 54 (December): 787-809. Altshuler, Rosanne, Harry Grubert, and T. Scott Newton. 2001. "Has U.S. Investment Abroad Become More Sensitive to Tax Rates?" In International Taxation and Multinational Activity, edited by James R. Hines Jr., pp. 9-32. University of Chicago Press. Auerbach, Alan, and Kevin Hassett, eds. 2005. Toward Fundamental Tax Reform. Washington: AEI Press. Auerbach, Alan J., and Joel Slemrod. 1997. "The Economic Effects of the Tax Reform Act of 1986." Journal of Economic Literature 35 (June): 589-632. Bhagwati, Jagdish, Arvind Panagariya, and T. N. Srinivasan. 2004. "The Muddles over Outsourcing." Journal of Economic Perspectives 18 (Fall): 93-114. Blackorby, Charles, and R. Robert Russell. 1989. "Will the Real Elasticity of Substitution Please Stand Up? (A Comparison of the Allen/Uzawa and Morishima Elasticities)." American Economic Review 79 (September): 882-88. Chamley, Christophe. 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives." Econometrica 54 (May): 607-22. Clausing, Kimberly. 2003. "Tax-Motivated Transfer Pricing and U.S. Intrafirm Trade Prices." Journal of Public Economics 87 (September): 2207-23. ———. 2004. "Taxing Corporations in OECD Countries." Reed College. ———. 2005a. "Tax Holidays (and Other Escapes) in the American Jobs Creation Act." National Tax Journal 58 (September): 331-46. ———. 2005b. "U.S. Tax Legislation and the Activities of Multinational Firms in Europe." Working Paper. Dublin: Institute of European Affairs. Cronin, Bruce, Leslie Catchpowle, and David Hall. 2004. "Outsourcing and Offshoring." CESifo Forum 5 (Summer): 17-21. De Mooij, Ruud A., and Sjef Ederveen. 2003. "Taxation and Foreign Direct Investment: A Synthesis of Empirical Research." International Tax and Public Finance 10 (November): 673-93. Desai, Mihir A., and James R. Hines Jr. 2003. "Value Added Taxes and International Trade: The Evidence." Harvard Business School/University of Michigan. ———. 2004. "Old Rules and New Realities: Corporate Tax Policy in a Global Setting." National Tax Journal 57 (December): 937-60. Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr. 2002. "Chains of Ownership, Regional Tax Competition, and Foreign Direct Investment." Working Paper 9224. Cambridge, Mass.: National Bureau of Economic Research (September). Dunning, J. H. 1974. Economic Analysis and Multinational Enterprise. New York: Praeger. [End Page 488] Glenn, Heidi. 2004a. "House-Passed ETI Bill Sets Stage for Difficult Conference." Tax Notes (June 21): 1439. ———. 2004b. "Yin Wonders Whether Territorial System Shift Is Next." Tax Notes (December 13): 1487-88. Gordon, Roger H. and James R. Hines Jr. 2002. "International Taxation." In Handbook of Public Economics. Vol. 4, edited by Alan J. Auerbach and Martin Feldstein, pp. 1935-95. London: North Holland. Gordon, Roger H., and Jeffrey K. Makie-Mason. 1995. "Why Is There Corporate Taxation in a Small Open Economy? The Role of Transfer Pricing and Income Shifting." In The Effects of Taxation on Multinational Corporations, edited by Martin Feldstein, James R. Hines, and R. Glenn Hubbard, pp. 67-91. University of Chicago Press. Gordon, Roger H., and Joel Slemrod. 2000. "Are "Real" Responses to Taxes Simply Income Shifting Between Corporate and Personal Tax Bases?" In Does Atlas Shrug? edited by Joel Slemrod. Harvard University Press. Gropp, Reint, and Kristina Kostial. 2000. The Disappearing Tax Base: Is Foreign Direct Investment Eroding Corporate Income Taxes? Working Paper 31. Frankfurt: European Central Bank (September). Grubert, Harry. 2001. "Enacting Dividend Exemption and Tax Revenue." National Tax Journal 54 (December): 811-27. Grubert, Harry, and John Mutti. 1995. "Taxing Multinationals in a World with Portfolio Flows and R&D: Is Capital Export Neutrality Obsolete?" International Tax and Public Finance 2 (November): 439-57. ———. 2001. Taxing International Business Income: Dividend Exemption versus the Current System. Washington: American Enterprise Institute Press. Hall, Robert, and Alvin Rabushka. 1985. The Flat Tax. Stanford, Calif.: Hoover Institution Press. Hines, James R. Jr. 1994. "Credit and Deferral as International Investment Incentives." Journal of Public Economics 55 (October): 323-47. ———. 1996. "Altered States: Taxes and the Location of Foreign Direct Investment in America." American Economic Review 86 (December...

Optimal taxation in dynamic economies with increasing returns

This paper studies optimal taxation in dynamic economies with increasing returns. We show that if there exists a stable open-loop Stackelberg equilibrium, the optimal rate of tax on capital income in the steady-state is negative in order to eliminate the wedge between the private and the social rate of return to capital. This result also holds when the government expenditure has a positive effect on production activities of the private agents. In contrast, if the government takes a feedback strategy and if the government budget is balanced in every period, then the optimal capital income taxation rule obtained under the open-loop strategy may be violated. It is, however, shown that if the government can borrow from the public, the negative capital income tax rule may be established even under the feedback policy rule.

Redistributive Tax and Growth in a Model with Discrete Occupational Choice

An optimal redistributive tax‐subsidy formula is derived for a growth model where income inequality is endogenously driven by an adult's choice of occupation between work and management. Investment in human capital is the engine of growth. The world's stock of exploitable knowledge as well as the economy's average human capital determine the potential rate of return from investment in human capital in an economy. How much available knowledge would be exploited in the economy depends on the proportion of innovators in our model. A redistributive tax reform impacts growth as well as income inequality via its influence over the occupational choice. The optimal redistributive tax rate is path‐dependent in the sense that it depends on the initial wealth distribution. The normative implication of the model is that the optimal capital income tax rate could very well be positive if the initial wealth inequality exceeds a threshold. The optimal capital income tax rate depends inversely on the initial wealth inequality.

Optimal Capital Income Taxation and Redistribution

This paper studies the effects of agent heterogeneity on optimal capital income taxation. We discuss conditions for the optimality of zero capital income taxes in a multiperiod model with heterogeneous agents and explicitly derive the welfare effects of taxation depending on the distribution of the agents' characteristics. In particular, we show that the sign of the optimal capital income tax rate does not depend on the extent of inequality in goods endowments and productivities each by itself, but on a measure of inequality in their joint distribution.

Optimal taxation of capital income with imperfectly competitive product markets

Abstract We show that the steady-state optimal tax on capital income can be negative, positive, or zero in a neoclassical growth model that allows for imperfectly competitive product markets. The sign of the optimal tax rate depends crucially on (1) the degree of monopoly power, (2) the extent to which monopoly profits can be taxed, (3) the size of the depreciation allowance, and (4) the magnitude of government expenditures. For an empirically plausible set of parameters, we find that the steady-state optimal capital tax can range between −10 and 22%.

On the Optimal Taxation of Capital Income

We show that in models in which labor services are supplied jointly with human capital, the Chamley and Judd result on zero capital income taxation in the limit extends to labor taxes as long as accumulation technologies are constant returns to scale. Moreover, for a class of widely used preferences, consumption taxes are zero in the limit as well. However, we show by the construction of two examples that these results no longer hold for certains types of restrictions on tax rates or if there are profits generated.Journal of Economic LiteratureClassification Numbers: E62, H21.

Optimal Capital Income Taxes and Capital Controls in Small Open Economies

This paper studies the optimal taxation of capital income in a simplemodel of a small open economy where domestic residents can evade taxeson their foreign investment income. The national government can onlytax domestic capital income and can impose capital controls, whichhowever absorb real resources. The design of optimal policy in thismodel depends on the revenue needs of the government. For relativelylow levels of government expenditures, it turns out that the countrydoes not levy capital income taxes but may restrict capital exports.Otherwise, the country taxes domestic capital income and sets capitalcontrols such that capital exports are driven to zero, at an optimum.In contrast to other models with capital controls it turns out thatthis policy can lead to underinvestment in domestic capital.

Optimal Capital Income Taxation with Incomplete Markets, Borrowing Constraints, and Constant Discounting

For a wide class of infinitely lived agent models, Chamley has shown that the optimal capital income tax rate is zero in the long run. Lucas has argued that for the U.S. economy, there is a significant welfare gain from switching to this policy. This paper shows that for the Bewley class of models with incomplete insurance markets and borrowing constraints, the optimal tax rate on capital income is positive, even in the long run. Therefore, cutting the capital income tax to zero may well lead to welfare losses.

Optimal Fiscal and Monetary Policy: Some Recent Results

This paper studies the quantitative properties of fiscal and monetary policy in business cycle models. In terms of fiscal policy, optimal labor tax rates are virtually constant and optimal capital income tax rates are close to zero on average. In terms of monetary policy, the Friedman rule is optimal?nominal interest rates are zero?and optimal monetary policy is activist in the sense that it responds to shocks to the economy.

An optimal redistributive capital income tax formula for an economy with public investment

Abstract An optimal redistributive capital income tax formula is derived for an economy where a benevolent government is actively involved in capital accumulation. The tax does not necessarily vanish asymptotically. Its magnitude depends crucially on the technology parameters.

Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives

This paper analyzes the optimal tax on capital income in general equilibrium models of the second best. Agents have infinite lives and utility functions which are extensions from the Koopmans form. The population is heterogeneous. The important property of the models is the equality between the social and the private discount rates in the long run. I find that the optimal tax rate is zero in the long run. For a special case of additively separable utility functions, I then determine the tax rates along the dynamic path and conditions that are sufficient for the local stability of the steady state.