Capital Income Taxation with Household and Firm Heterogeneity

The US tax code stipulates taxation of capital income at the firm level (corporate profits) and at the household level (dividends and capital gains). Even though all of those are capital income taxes, they have different effects both on incentives for household savings and firm investment and in terms of distribution. We argue that these effects can work both from the aggregate savings (household) side and from the aggregate investment (firms) side and provide a model that incorporates both aspects. The model features heterogeneous households and heterogeneous firms and is used to: 1. Evaluate the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, which reduced and equalized tax rates on dividends and capital gains and 2. Analyze the optimal mix between the different types of capital income taxes. We find that the JGTRRA reduces investment and capital mainly due to a wealth effect. In particular, the dividend tax cut raises stock prices and, as a result, aggregate wealth held by stockholders. In order to be willing to hold additional wealth, stockholders require a higher return which pushes capital demand and investment down. Interestingly, capital is more efficiently allocated and, as a result, GDP actually rises slightly. On the second question, we search for a tax scheme that provides incentives for investment without the usual negative redistribution side effects.