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The Optimal Taxation Of Asset Income When Government Consumption Is Endogenous: Theory, Estimation And Welfare

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  • Michael Ben-Gad

Abstract

This paper derives the Ramsey optimal policy for taxing asset income in a model where government expenditure is a function of net output or the inputs that produce it. Extending Judd (1999), I demonstrate that the canonical result that the optimal tax on capital income is zero in the medium to long term is a special case of a more general model. Employing a vector error correction model to estimate the relationship between government consumption and net output for the United States between 1947Q1 to 2013Q2, I demonstrate that this special case is empirically implausible, and show how the cointegrating vector can be used to determine the optimal tax schedule. I simulate a version of the model using the empirical estimates to measure the welfare implications of changing the tax rate on asset income, and contrast these results with those generated in a version of the model where government consumption is purely exogenous. The shifting pattern of welfare measurements confirms the theoretical results. I calculate that the prevailing effective tax rate on net asset income in the US between 1995 and 2011 averaged 0.441. Hence abolishing the tax completely does generate welfare improvements, though only by the equivalent of less than a one percent permanent increase in consumption---less than a third the implied welfare benefit when the endogeneity of the government consumption is ignored. The maximum welfare improvement from shifting part of the burden of tax from capital to labour is the equivalent of a permanent increase in consumption of between only 1.173 and 1.304% and is attained when the tax rate on asset income is lowered to between 0.18 and 0.2. Allowing the tax rate to vary over time raises the maximum welfare benefit to 1.31%. All the results are very robust to a wide range of elasticities of labour supply.
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  • Michael Ben-Gad, 2017. "The Optimal Taxation Of Asset Income When Government Consumption Is Endogenous: Theory, Estimation And Welfare," Economic Inquiry, Western Economic Association International, vol. 55(4), pages 1689-1711, October.
  • Handle: RePEc:bla:ecinqu:v:55:y:2017:i:4:p:1689-1711
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    1. Barbara Annicchiarico & Valentina Antonaroli & Alessandra Pelloni, 2020. "Optimal Factor Taxation in A Scale Free Model of Vertical Innovation," CEIS Research Paper 485, Tor Vergata University, CEIS, revised 13 May 2020.

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    More about this item

    JEL classification:

    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)

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