Taxing Capital: Not a Bad Idea After All

In this paper we argue that it might not be such a bad idea to tax capital income in the long run. We address this question in an environment in which individuals are finitely lived and face uninsurable idiosyncratic labor income risk. In choosing a tax system a benevolent planner trades off concerns for equity and insurance with efficiency considerations. In our environment there are two ways of redistributing resources either via progressive labor income taxes or through the taxation of capital income. We show that the optimal tax mix depends crucially on the elasticity of the tax base. If the rich are relatively old and are both rich in terms of capital and labor income, then we demonstrate that the labor income tax base is very elastic to changes in labor income taxes while the capital income tax base is much more inelastic. Consequently it is optimal to tax capital instead of the labor income of the rich. Our results stand in sharp contrast with the standard zero capital taxation results derived in environments with infinitely lived agents and are complementary to recent findings on optimal fiscal policy in overlapping generations economies