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Why Tax Capital?

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Author Info
Junsang Lee ()
Yili Chien ()

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Abstract

We study optimal capital income taxation with a Ramsey problem and relate this optimal taxation problem to the question that has been asked in the asset pricing literature, which is why the risk free interest rate is too low. We show that the Ramsey planner chooses the optimal level of capital stock to be one that satisfies the modified golden rule in the steady state under some conditions. The conditions include suffcient government tax instruments and ability to issue bonds. We argue that the optimal capital level is different from that chosen in a competitive equilibrium unless the competitive equilibrium risk free interest rate is same as the time discount rate in the steady state. This difference in the choice of capital motivates imposing a positive capital income tax (or subsidy) on households to induce them to invest at the socially optimal amount. As examples, we investigate optimal capital taxation in a decentralized economy with limited commitment and one with private information. However, the result still holds in various types of economies with risk free interest rate that is too low.

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Paper provided by Australian National University, College of Business and Economics, School of Economics in its series ANUCBE School of Economics Working Papers with number 2008-497.

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Length: 26 Pages
Date of creation: Jun 2008
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Handle: RePEc:acb:cbeeco:2008-497

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Find related papers by JEL classification:
D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
E23 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Production
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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  1. Junsang Lee & Yili Chien, 2008. "Optimal Capital Taxation Under Limited Commitment," ANUCBE School of Economics Working Papers 2008-498, Australian National University, College of Business and Economics, School of Economics. [Downloadable!]
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