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Optimal Capital Income Taxation and Redistribution

  • Ulrike Ludden

    (University of Mannheim)

This paper studies the effects of agent heterogeneity on optimal capital income taxes, where taxes are collected for redistributional purposes. In a finite horizon model with an arbitrary number of heterogeneous agents, we ask what forms of taxation are optimal for different causes of inequality and how correlations, e.g. between labor incomes and wealth levels, affect optimal tax rates. While steady state analyses such as Judd (1985) have found that the optimal capital income tax rate in the steady state is zero, we show that off the steady state this is generally not the case. In a two period model with arbitrarily many heterogeneous households, we find that if households are heterogeneous with respect to productivities and endowments, capital income taxes generally increase welfare. If they are heterogeneous only with respect to productivities, it is optimal not to tax capital income. The extent of the inequality and the joint distribution of its different components (productivities and endowments in our model) are crucial for the size of the marginal welfare effects of taxation. A positive correlation between endowments and productivities, for example, increases the marginal welfare effects of capital income taxation. The paper emphasizes the analogy between commodity taxes and capital income taxes, which effectively tax consumption goods at different points in time. With the help of the literature on optimal commodity taxation based on Atkinson and Stiglitz (1976), we can check the robustness of our results. We find that zero capital income taxation is optimal only if endowments are homogeneous and production is weakly separable between labor and capital and utility functions are homothetic and identical across agents. When we link our model to the infinite horizon steady state analyses as described in Judd (1985), we find that the models are compatible under appropriate assumptions.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 0658.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:0658
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  1. Plug, Erik J. S. & van Praag, Bernard M. S. & Hartog, Joop, 1999. "If we knew ability, how would we tax individuals?," Journal of Public Economics, Elsevier, vol. 72(2), pages 183-211, May.
  2. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  3. Paul Klein & JosÈ-VÌctor RÌos-Rull, 2003. "Time-consistent optimal fiscal policy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(4), pages 1217-1245, November.
  4. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal fiscal policy in a business cycle model," Staff Report 160, Federal Reserve Bank of Minneapolis.
  5. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
  6. Cremer, Helmuth & Pestieau, Pierre & Rochet, Jean-Charles, 2001. "Direct versus Indirect Taxation: The Design of the Tax Structure Revisted," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(3), pages 781-99, August.
  7. Anthony B. Atkinson, 1976. "Optimal Taxation and the Direct versus Indirect Tax Controversy," Working Papers 247, Queen's University, Department of Economics.
  8. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  9. Jonathan Heathcote & David Domeij, 2000. "Capital Versus Labor Income Taxation With Heterogeneous Agents," Computing in Economics and Finance 2000 346, Society for Computational Economics.
  10. Atkinson, A. B. & Stiglitz, J. E., 1976. "The design of tax structure: Direct versus indirect taxation," Journal of Public Economics, Elsevier, vol. 6(1-2), pages 55-75.
  11. Gian Maria Milesi-Ferretti & Nouriel Roubini, 1995. "Growth Effects of Income and Consumption Taxes: Positive and Normative Analysis," Working Papers 95-18, New York University, Leonard N. Stern School of Business, Department of Economics.
  12. Sheshinski, Eytan, 1972. "The Optimal Linear Income-Tax," Review of Economic Studies, Wiley Blackwell, vol. 39(3), pages 297-302, July.
  13. S. Rao Aiyagari, 1994. "Optimal capital income taxation with incomplete markets, borrowing constraints, and constant discounting," Working Papers 508, Federal Reserve Bank of Minneapolis.
  14. Naito, Hisahiro, 1999. "Re-examination of uniform commodity taxes under a non-linear income tax system and its implication for production efficiency," Journal of Public Economics, Elsevier, vol. 71(2), pages 165-188, February.
  15. Deaton, Angus, 1979. "Optimally uniform commodity taxes," Economics Letters, Elsevier, vol. 2(4), pages 357-361.
  16. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  17. David R. Stockman, 2001. "Balanced-Budget Rules: Welfare Loss and Optimal Policies," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(2), pages 438-459, July.
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