Optimal income taxation with human capital accumulation and limited record keeping

This paper characterizes optimal income taxes in a dynamic economy where human capital is unobservable and the government is restricted to use taxes that depend only on current income. I show that unobservability of human capital tends to decrease the labor wedge, while the effect on the human capital wedge is uncertain. I also analyze the relationship between optimal taxes in economies with and without endogenous human capital and identify two qualitative reasons why the optimal tax codes will differ. I perform numerical simulations to calculate the quantitative relevance of endogenous human capital formation for optimal tax policy. I find that endogenous human capital lowers marginal tax rates by about 9% on average, as compared with a static model without human capital.     

Optimal Taxation in Life-Cycle Economies

We use a very standard life-cycle growth model, in which individuals have a labor-leisure choice in each period of their lives, to prove that an optimizing government will almost always find it optimal to tax or subsidize interest income. The intuition for our result is straightforward. In a life-cycle model the individual's optimal consumption-work plan is almost never constant and an optimizing government almost always taxes consumption goods and labor earnings at different rates over an individual's lifetime. One way to achieve this goal is to use capital and labor income taxes that vary with age. If tax rates cannot be conditioned on age, a nonzero tax on capital income is also optimal, as it can (imperfectly) mimic age-conditioned consumption and labor income tax rates. Journal of Economic Literature Classification Numbers: E62, H21.     

The incidence of a tax on pure rent in a small open economy

This paper analyzes the effects of a land rent tax on capital formation and foreign investment in a life-cycle small open economy with endogenous labor-leisure choices. The consequences of land taxation critically depend on how the tax proceeds are used by the government. A land tax depresses capital formation, crowds out foreign investment and increases national wealth and consumption when the land tax revenues are distributed as lump-sum payments. If the proceeds from land taxation are used to finance unproductive government expenditure, the land tax will be neutral in its effects on the capital stock, nonhuman wealth and labor. When the tax revenues are used to reduce labor taxes, the land rent tax spurs nonhuman wealth accumulation and ambiguously affects the capital stock and labor.     

The optimal taxation of risky capital income: An elasticity rule

Should risky capital income be taxed like safe income or should tax rates be differentiated? The question is analyzed in a 2-assets model of portfolio choice. Flat tax rates are chosen in order to maximize the investor's expected utility from terminal wealth subject to an expected tax revenue constraint. If lump-sum taxes are not available, optimal tax rates are characterized by an elasticity rule: The relative change in the risk remuneration should be equal to the inverse of the product of two elasticities. One is the output elasticity of capital. The other is the demand elasticity for risky investments with respect to a revenue preserving tax variation.     

Some aspects of the taxation of capital gains

The analysis of the effects of capital gains taxation requires a careful modelling both of the details of the tax code and the imperfections in the capital market. Under the standard assumptions concerning perfect capital markets and under the standard idealizations of the tax code, there are several strategies by which rational investors can avoid note only all taxes on their capital income, but also all taxes on their wage income; these strategies leave individuals' consumption and bequests in each state of nature and at each date unchanged from what they would have been in the absence of taxes. Although certain detailed provisions of the tax code may limit the extent to which rational investors can avail themselves of these tax avoidance activities, there are ways, in a perfect capital market, by which the effects of these restrictions can be ameliorated. Accordingly, any analysis of the effects of capital taxation must focus on imperfect capital markets.If individuals face limitations on the amounts which they can borrow and/or if there are limitations on short sales, then under some circumstances there is a locked-in effect (individuals do not sell securities which they would have sold in the absence of taxation); but under other circumstances individuals are induced to sell securities that they otherwise would have held, in order to take advantage of the asymmetric treatment of short-term losses and long-term gains. A policy of realizing gains as soon as they become eligible for long term treatment dominates the policy of postponing the realization of capital gains, provided the gains are not too large.A simple general equilibrium model is constructed within which it is shown that the taxation of capital gains may increase the volatility of asset prices, and lead individuals not to trade when they otherwise would. While the analysis casts doubt on the significance of the welfare losses resulting from these exchange inefficiencies, there are circumstances in which the tax leads to production inefficiencies, e.g. terminating projects at other than the socially optimal date.Finally, we argue that the focus of some recent policy debates on the short-run revenue impact of a decrease in the tax rate on capital gains is misplaced: even when the short-run revenue impact is positive, consumption may increase (thus exacerbating inflationary pressures) and private savings may decrease (thus leading to a lower level of investment in the private sector). Moreover, there is some presumption that the long-run revenue impact is negative.Our analysis has some important implications for empirical research. In particular, it suggests that the impact of the tax is not adequately summarized by a single number, such as the ‘effective tax rate’ representing the average ratio of tax payments to capital gains. Moreover, the impact of the tax cannot be assessed by looking only at reported capital gains and losses.     

Royalty taxation under tax competition and profit shifting

Multinational corporations increasingly use royalty payments for intellectual property rights to shift profits globally. This not only threatens the tax base of countries worldwide but also affects the nature of tax competition. Against this background, our theoretical analysis suggests a surprising solution to the problem of curbing profit shifting without suffering major outflows of capital: a strictly positive withholding tax on royalty payments is both the Pareto-efficient solution under international coordination and the optimal unilateral response. If internal debt is sufficiently responsive, governments can even implement optimal targeting. Then, the royalty tax closes the profit-shifting channel, while all competition for mobile capital is relegated to internal-debt regulation. Our results question the ban on royalty taxes in double tax treaties and the EU Interest and Royalty Directive.     

Cross-base tax elasticity of capital gains

This paper studies the cross-base tax elasticity of capital gains realizations to labour income taxes when capital gains are taxed at a separate proportional tax rate. Using a longitudinal panel of over 265 000 individuals in Sweden, this paper shows in a regression kink design that labour income taxes affect capital gains realizations in two ways. An increase in the marginal labour income tax rate increases the likelihood of realizing capital gains and the amount of realized capital gains. One implication of this result is that labour income taxes have a lock-out effect but that the magnitude of this effect is smaller than the lock-in effect of the actual capital gains tax.     

Optimal climate and fiscal policy in an OLG economy

This paper develops a climate–economy model to study the joint design of optimal climate and fiscal policies in economies with overlapping generations (OLGs). I demonstrate how capital taxation, if optimal, drives a wedge between the market costs of carbon (the net present value of marginal damages using the market interest rate) and the Pigouvian tax (the net present value of marginal damages using the consumption discount rate of successive OLGs). In contrast to deterministic infinitely lived representative agent models, at the optimum, the capital income tax is positive, the carbon price equals the market costs of carbon but it falls short of the Pigouvian tax when (i) preferences are not separable over consumption and leisure; and (ii) labor income taxes cannot be age-dependent. I also show that restrictions on climate change policy provide a novel rationale for positive capital income taxes.     

The distributional effects of progressive capital taxes

Rising inequality since the 1980s has spurred much research examining the underlying causes and potential policy responses. Among the more controversial, One of the more controversial policy proposals is a progressive capital tax in response to rising top wealth shares around the world proposes a progressive capital tax in response to rising top wealth shares around the world. This paper introduces rank-based econometric methods for dynamic power laws as a tool for estimating the effect of progressive capital taxes on the distribution of wealth under different assumptions about the impact of these taxes on household behavior. In most scenarios, we find that a small tax levied on 1% of households would substantially reshape the US wealth distribution and reduce inequality.     

Constrained Inefficiency and Optimal Taxation with Uninsurable Risks

When individuals' labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two‐period general equilibrium model with production, we derive a decomposition formula of the welfare effects of these taxes into insurance and distribution effects. This allows us to determine how the sign of the optimal taxes on capital and labor depend on the nature of the shocks and the degree of heterogeneity among consumers' income, as well as on the way in which the tax revenue is used to provide lump‐sum transfers to consumers. When shocks affect primarily labor income and heterogeneity is small, the optimal tax on capital is positive. However, in other cases a negative tax on capital is welfare‐improving.     

Optimal Indirect and Capital Taxation

We consider an environment in which agents' skills are private information and follow arbitrary stochastic processes. We prove that it is typically Pareto optimal for an individual's marginal benefit of investing in capital to exceed his marginal cost of doing so. This wedge is consistent with a positive tax on capital income. We also prove that it is Pareto optimal for the marginal rate of substitution between any two consumption goods to equal the marginal rate of transformation. This lack of a wedge is consistent with uniform taxation of consumption goods within a period.     

Improving Mineral Taxation Policy in Australia*

Australian State governments have begun to increase royalty rates and other mineral taxes. The most instructive approach to taxation policy for the minerals sector is to set up a general model of mines which year the optimal structure of taxes. A model of mine production under uncertainty is presented. The optimal tax is a single tax with two parts. a bonus bid and conditional tax payments based on the ex-post rent of the mine. The actual structure of taxes levied by State and Commonwealth governments is seen to be distinctly sub-optimal in several respects. Proposals to move the actual to word the optimal structure are made, recognizing some of the constraints on information and the maximum acceptable rate of tax reform .     

Optimal policy and the risk properties of human capital reconsidered

This paper considers how optimal education and tax policy depends on the risk properties of human capital. A key feature of human capital investments is whether they increase or decrease wage risk. In a benchmark model it is shown that this feature alone determines whether a constrained optimal allocation should be characterized by a positive or a negative education premium. In the same model a positive intertemporal wedge is optimal. The robustness of these results is explored in two generalizations: nonobservability of education and nonobservability of consumption. Finally, policies that implement the constrained efficient allocations are considered.     

Laffer strikes again: Dynamic scoring of capital taxes

We set up a neoclassical growth model extended by a corporate sector, an investment and finance decision of firms, and a set of taxes on capital income. We provide analytical dynamic scoring of taxes on corporate income, dividends, capital gains, other private capital income, and depreciation allowances and identify the intricate ways through which capital taxation affects tax revenue in general equilibrium. We then calibrate the model for the US and explore quantitatively the revenue effects from capital taxation. We take adjustment dynamics after a tax change explicitly into account and compare with steady-state effects. We find, among other results, a self-financing degree of corporate tax cuts of about 70–90% and a very flat Laffer curve for all capital taxes as well as for tax depreciation allowances. Results are strongest for the tax on capital gains. The model predicts for the US that total tax revenue increases by about 0.3–1.2% after abolishment of the tax.     

Taxation for the 21st century: the automated payment transaction (APT) tax

This paper examines the desirability and feasibility of replacing the present system of personal and corporate income, sales, excise, capital gains, import and export duties, gift and estate taxes with a single comprehensive revenue neutral Automated Payment Transaction (APT) tax. In its simplest form, the APT tax consists of a flat tax levied on all transactions. The tax is automatically assessed and collected when transactions are settled through the electronic technology of the banking/payments system. The APT tax introduces progressivity through the tax base since the volume of final payments includes exchanges of titles to property and is therefore more highly skewed than the conventional income or consumption tax base. The wealthy carry out a disproportionate share of total transactions and therefore bear a disproportionate burden of the tax despite its flat rate structure. The automated recording of all APT tax payments by firms and individuals eliminates the need to file tax and information returns and creates a degree of transparency and perceived fairness that induces greater tax compliance. Also, the tax has lower administrative and compliance cost. Like all taxes, the APT tax creates new distortions whose costs must be weighted against the benefits obtained by replacing the current tax system.     

Imperfect Capital Mobility and Local Government Behaviour in a Two‐Period Economy

One clear result in the tax competition literature is that, when head taxes on immobile residents are available, the optimal capital tax rate for local government is zero. However, zero tax rate, when resident taxes are available, is incompatible with the phenomenon actually observed. In most countries, local governments use capital taxes as policy variables for choosing a nonzero tax rate. This paper presents a model of a two‐period economy with imperfect mobile capital to explain the behaviour of local government providing capital subsidies on capital. It further examines an equilibrium tax rate where local government’s objectives include Niskanen‐type revenue‐maximizing.     

Equilibrium capital taxation in open economies under commitment

This paper analyzes equilibrium capital taxation in open economies with strategic interaction in a neo-classical growth model. Under perfect commitment, I show that non-cooperative capital taxes are zero in the long run for a large open economy, thereby generalizing the result previously established only for the special cases of a closed and a small open economy. This does not represent a race to the bottom, though, since the result is independent of the degree of capital mobility, the number of countries, or a country׳s size relative to the rest of the world. Moreover, when countries cooperate, they still set capital taxes to zero in the long run. These outcomes are robust to different equilibrium specifications, the inclusion of endogenous government spending, and heterogeneous agents and non-linear labor income taxation. Governments find it optimal to implement the efficient capital allocation in the long run, both in a closed and an open economy; this trumps incentives to tax foreigners’ domestic capital holdings by raising capital taxes and attracting capital from abroad by lowering capital taxes.     

Taxation of capital income in overlapping generations economies

Whether capital income should be taxed in overlapping generations economies is vividly discussed. It is shown that intergenerational lump‐sum taxes cannot implement the Golden Rule allocation when agents have private information on their earnings potential. Hence, the seminal Atkinson–Stiglitz result that optimal income taxation pre‐empts any role for indirect taxation cannot be interpreted to imply that capital income taxation (affecting intertemporal relative prices) should not be taxed. Specifically, capital income should unambiguously be taxed in small open economies, and the optimal tax rate depends inversely on the elasticity of total savings to disposable income and the after‐tax rate of return.     

Investment subsidies and redistributive capital income taxation in a neoclassical growth model

How do investment subsidies bear on pure redistribution when coupled with capital income taxes? In a heterogeneous agent, neoclassical growth framework it is found that on impact, with no optimizing behavior, investment subsidies are good for growth but bad for redistribution. The opposite holds for capital income taxes. But when the government acts as a Stackelberg leader vis-à-vis the private sector (the follower), the optimal feedback policy is by construction time-consistent and implies that in a long-run optimum the tax scheme does not distort accumulation. This holds regardless of social preferences. For the feedback Stackelberg equilibrium I find that (pure) redistribution can go either way and capital income taxes are nonzero in the long-run, time-consistent optimum, depending on the social weight of those who receive redistributive transfers, the distribution of pretax factor incomes, and the intertemporal elasticity of substitution. It is argued that investment subsidies may be an important indirect tool for redistribution, and may allow for the separation of “efficiency” and “equity” concerns.     

Taxes on capital in a specific factor model with international capital mobility

The efficiency and distributional effects of sundry capital taxes are analyzed in a simple two-sector specific factor model where capital is mobile both between the two sectors and between the home country and the rest of the world. Two cases are discussed: the small country case where factor and commodity prices are parametric; and the large country case. The optimal tax on capital export is illustrated when commodity prices are parametric. A simple approach to the case when both factor and commodity prices are variable is demonstrated.