Capital Taxation, Intermediate Goods, and Production Efficiency

An important controversy in public finance is whether long-run capital taxes are optimally zero or not, with a broad variety of models supporting each case. This paper examines the question whether capital is special and if so, what the underlying principle could be that explains both types of results. I find that capital is provided without distortions in a wide class of models, i.e. that its marginal product is the same in first and second best. The conditions for this to hold are that the government is able to tax all of capital's co-factors of production separately and that capital does not enter the utility function. When individually rational behavior leads to sub-optimal capital accumulation, then capital taxes are used to implement the optimal allocation. The intuition is that capital is an intermediate good; optimal taxation seeks to tax endowments and intermediate goods do not have any endowment component.