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The Second Best Theory of Differential Capital Taxation

Listed author(s):
  • Martin Feldstein

An important proposition in the theory of efficient taxation is that, if capital income is taxed, all types of capital income should be taxed at the same rate. This conclusion has motivated extensive empirical analysis of the tax rates on different types of capital income. It has also been the basis for a variety of proposals to revise actual tax rules.The present paper emphasizes that the comventional view must be modified in the very common situation in which some capital tax rate is politically constrained to something other than its optimal value, e.g., the zero rates on the imputed income on owner-occupied housing. The formal analysis of the paper examines the case in which there are three types of capital income and one of the tax rates is arbitrarily constrained to be zero.Three general "rule of thumb" results emerge from the specific analysis: First, if the several types of capital can be regarded as independent in production, the optimal tax rates on the taxable types of capital income should depart from equality in the direction of an inverse elasticity rule. Second, in comparison to these rates, capital that is a complement to the untaxed capital should generally be taxed more heavily while capital that is a substitute for the untaxed capital should be taxed less heavily. Third, variations in the degree of complementarity or substitutability between the two types of capital should alter the two tax rates in a way that maintains a constant difference in the total taxes on each type of capital. Although these rule-of-thumb results help to modify the conventional equal-tax-rates rule in an appropriate way, the most important implication of the present analysis is that any departure from optimal taxation makes it very difficult to set other capital tax rates optimally.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1781.

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Date of creation: Dec 1985
Publication status: published as Feldstein, Martin. "The Second Best Theory of Differential Capital Taxation," Oxford Economic Papers, Oxford University Press, vol. 42(1), pages 256-67, January 1990
Handle: RePEc:nbr:nberwo:1781
Note: PE
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  1. Alan J. Auerbach, 1979. "The Optimal Taxation of Heterogeneous Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 93(4), pages 589-612.
  2. Shoven, John B. & Whalley, John, 1972. "A general equilibrium calculation of the effects of differential taxation of income from capital in the U.S," Journal of Public Economics, Elsevier, vol. 1(3-4), pages 281-321, November.
  3. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production: I--Production Efficiency," American Economic Review, American Economic Association, vol. 61(1), pages 8-27, March.
  4. Alan J. Auerbach, 1983. "Corporate Taxation in the United States," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 14(2), pages 451-514.
  5. Mervyn A. King & Don Fullerton, 1984. "The Taxation of Income from Capital: A Comparative Study of the United States, the United Kingdom, Sweden, and Germany," NBER Books, National Bureau of Economic Research, Inc, number king84-1, December.
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