On the Optimality of the Nordic System of Dual Income Taxation
In recent years the Nordic countries have introduced a so-called dual income tax which combines a proportional tax on capital income with progressive taxation of labour income. The paper argues that this asymmetric treatment of the two types of income can be defended on pure efficiency grounds, because the progressivity of the labour income tax serves to reduce the private return to human capital investment, thereby offsetting the tendency of a proportional comprehensive income tax to discrimate in favour of such investment. The analysis is based on an overlapping generations model of a small open economy where consumers face a tradeoff between investment in human capital and investment in non-human capital. However, if government is free to choose all of its tax rates, the optimal tax policy would combine a zero tax on capital income with purely proportional taxation of labour income.
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