Optimal Capital Taxation with Incomplete Markets and Schumpeterian Growth

This paper characterizes quantitatively the optimal capital income tax rate in an OLG economy with uninsurable income risk, incomplete markets and endogenous Schumpeterian growth. Contrary to the most recent literature, it is found that it is virtually never optimal to tax capital: under the optimal scheme, in a series of cases, the highest proportional tax rate on capital is found to be less than 0.2%. The reason for this result lies in the reduced GDP (and wage) growth rate stemming from a higher capital tax rate. In General Equilibrium, the interest rate rises, and the increased cost of capital reduces the endogenous rate of innovation, leading to a negative response of the growth rate. Although the equilibrium effect on the growth rate is found to be quantitatively modest (approximately half a percentage point), it still has a first order consequence on welfare. The results show that moving to the optimal income tax schedule entails large welfare gains, approximately 5% in consumption equivalent. The results are robust along a number of dimensions, including the specification of preferences. An alternative formulation of the utility function,taken from a class consistent with a Balanced Growth Path, is calibrated to obtain an empirically plausible value for the Frisch elasticity of 0.5, and confirms all the results, both qualitatively and quantitatively. JEL Classification: D15, E21, H21, O41