Use It or Lose It: Efficiency Gains from Wealth Taxation

This paper studies the quantitative implications of wealth taxation (as opposed to capital income taxation) in an incomplete markets model with return rate heterogeneity across individuals. The rate of return heterogeneity arises from the fact that some individuals have better entrepreneurial skills than others, allowing them to obtain a higher return on their wealth. With such heterogeneity, capital income and wealth taxes have different efficiency and distributional implications. Under capital income taxation, entrepreneurs who are more productive and, as a result, generate more income pay higher taxes. Under wealth taxation, on the other hand, entrepreneurs who have similar wealth levels pay similar taxes regardless of their productivity. Thus, in this environment, the tax burden shifts from productive entrepreneurs to unproductive ones if the capital income tax were replaced with a wealth tax. This reallocation increases aggregate productivity. Second, and at the same time, it increases wealth inequality in the population. To provide a quantitative assessment of these different effects, we build and simulate an overlapping generations model with individual-specific returns on capital income and with idiosyncratic shocks to labor income. Our results indicate that switching from a capital income tax to a wealth tax increases welfare by almost 8% through better allocation of capital. We also study optimal taxation in this environment and find that, relative to the benchmark, the optimal wealth tax increases welfare by 9.6% while the optimal capital income tax increases it by 6.3%.