Optimal Capital Income Taxation with Heterogeneous Firms

We study capital income taxation in a context where firms differ in productivity and, they decide whether to produce or not after comparing after-tax profits vis-à-vis an outside alternative option. In our setup, the government taxes capital income, firms' profits and labor income but does not tax the alternative outside option. In this context, taxation distorts the firms’ decisions to participate in production (extensive margin) as well as the investment decisions once they decide to produce (intensive margin). The key feature for the capital income tax being different from zero is the distortion in the extensive margin. When all firms choose to produce there is no such distortion and not taxing capital income is optimal. However, when some firms choose not to produce the optimal income tax rate is different from zero. The magnitude and sign of this tax depends on the sensibility of capital and labor demand to a change in the interest rate.