Second-best optimal taxation of capital and labor in a developing economy

As commercial integration reduces the reliance on foreign trade taxation, raising tax revenue has become a major concern for the governments of developing economies. This paper examines how the tax burden in a developing economy should be distributed between capital income and labor income. We study a two-sector model, where the traditional sector is “informal” and consequently cannot be taxed by the government. In this setup, we find that the optimal (second-best) tax structure in order to raise a certain amount of revenue requires to tax capital income at least as much as labor income, and possibly more.     

On the Optimal Taxation in a Growth Model of the Mixed Economy

Previous studies of second‐best taxation have shown that capital income shall not be taxed in the long run for some cases where individuals have infinite lives and a utility function of special form. The present paper improves upon this conclusion in two respects: first, the utility function may be of more general form, and second, zero capital income tax is required for the entire period, which does not depend on whether the individual's horizon is infinite or finite. Furthermore, we also show that the optimal tax rate on capital income should tend to zero in the long run if the first‐best optimum is attainable.     

A Case Against Zero Capital-Income Taxation

This paper develops a dynamic general equilibrium model to investigate the optimal level of capital income taxation in light of stochastic endogenous economic growth. Although endogenous human capital is incorporated into our model, we restrict our investigation to the issue of optimal physical capital income tax; and the labor supply is also endogenously determined. This paper proves that the optimal capital income tax should be zero provided exogenous government expenditure on production; however, capital income should be taxed if we consider endogenous government consumption.     

Intergenerational Allocation of Government Expenditures: Externalities and Optimal Taxation

This paper studies optimal capital and labor income taxes when the benefits of public goods are age‐dependent. Provided the government can impose a consumption tax, it can attain the first‐best resource allocation. This involves the uniform taxation of the cohorts' labor income and a zero capital income tax. With no consumption tax and optimally chosen government spending, labor income should be taxed nonuniformly across cohorts and the capital income tax should be nonzero. Deviations of the public goods from their respective optima create distortions. These affect the labor supply decisions of both cohorts and capital accumulation, providing a further reason to tax (or subsidize) capital income.     

Capital income taxation,tax criteria,and intergenerational welfare

In a two-period overlapping-generations model, residence criteria are shown to be optimal with lump-sum transfers to the younger generation in a dynamically efficient open economy even if all wage income, corresponding to rent income under exogenous labor supply, is not taxed away. When tax revenues are also distributed to the older generation — which indeed may be desirable for short-term intergenerational welfare distribution reasons — a weighted average rule is derived for optimal international taxation. The taxation of domestic savings income follows the inverse elasticity rule in respect to savings and, surprisingly, higher investment elasticity increases the tax level. Finally, for a small open economy and for large identical economies, tax competition with a mixed scheme of residence-based taxes and source-based subsidies yields the same tax policy as tax cooperation with no restrictions on the domestic and international capital income tax instruments.     

Optimal Factor Income Taxation in the Presence of Unemployment

According to conventional wisdom internationally mobile capital should not be taxed or should be taxed at a lower rate than labour. An important underlying assumption behind this view is that there are no market imperfections, in particular that labour markets clear competitively. At least for Europe, which has been suffering from high unemployment for a long time, this assumption does not seem appropriate. This paper studies the optimal factor taxation in the presence of unemployment which results from the union-firm wage bargaining both with optimal and restricted profit taxation when capital is internationally mobile and labour immobile. In setting tax rates the government is assumed to behave as a Stackelberg leader towards the private sector playing a Nash game. The main conclusion is that in the presence of unemployment, the conventional wisdom turns on its head; capital should generally be taxed at a higher rate than labour.     

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.     

A Note on the Taxation of International Capital Income Flows

Seemingly persuasive arguments can be made to suggest that income from foreign-owned capital should be taxed by a small open economy and that it should not be taxed I show that the case for taxing foreign capital income as part of an 'optimal' tax scheme rests on the assumption that tax rates on other forms of income are not set optimally. In particular, if economic profit is not fully taxed, a tax on foreign capital income is desirable. If all tax rates are set optimally, foreign capital income should not be taxed by the capital-importing country.     

The Optimal Tax Treatment of Housing Capital in the Neoclassical Growth Model

Should housing capital be taxed like other forms of capital? We analyze this question within a version of the neoclassical growth model. We derive the optimal tax treatment of housing capital vis‐à‐vis business capital allowing for relatively general household preferences. In the first‐best, the tax treatment of business and housing capital should always be the same. In the second‐best, in contrast, the optimal tax treatment of housing capital depends on the elasticities of substitution between nonhousing consumption, housing, and leisure. This is because housing taxation may be used to alleviate the distorting effect of taxing labor. As a result, the optimal tax treatment of housing capital may be different from that of business capital. We complement these analytical results with a numerical analysis.     

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 Capital Income Taxation with Means‐tested Benefits

This paper studies the interaction between capital income taxation and a means‐tested age pension. Our results document that the existence of a social insurance program financed from general revenue puts an upward pressure on the optimal tax rate. We also show that there is a negative relation between taper (benefit‐reduction) and optimal capital income tax rates. The potential welfare gain from optimizing capital taxation in the presence of a universal retirement transfer system is relatively higher. However, when the transfer is substantially means tested, the gain is lower, because the means test effectively operates as a tax on retirement capital.     

Optimal taxation with consumption time as a leisure or labor substitute

This paper studies the optimal commodity taxation problem when time taken in consumption is a perfect substitute for either labor or leisure. It shows that while labor substitutability affects the optimal tax structure, leisure substitutability leaves the classical optimal tax results intact. In the Ramsey tax framework with linear income taxes, whether the consumers have the same or different earning abilities, labor substitutes tend to be taxed at a higher rate than leisure substitutes with the tax differential being increasing in consumption time. This is not necessarily the case when one allows for nonlinear income taxation.     

Optimal income taxation in models with endogenous fertility

This paper studies the efficient taxation of factor income in infinite-lived models with elastic fertility choices. Two models are considered, one with physical capital only, and one with physical and human capital. In the model with physical capital only, capital income should be subsidized, while labor income taxed. In the model with two types of capital, instead, Ramsey optimality prescribes that the tax on physical capital is zero (negative), if effective labor is constant (decreasing) returns to scale in human capital and market goods, while the tax on human capital is negative and the tax on effective labor positive. Our findings depart from those obtained in immortal models with an endogenous labor supply and constant population growth, because physical and human capital affect the demand for fertility.     

Optimal fiscal policy in the Uzawa-Lucas model with externalities

Summary. This paper devises a fiscal policy by means of which the first-best optimum equilibrium is attained as a market equilibrium in the Uzawa-Lucas model when average human capital has an external effect on productivity. The optimal policy requires the use of a subsidy to investment in human capital which can be financed by a tax on labor income. Lump-sum taxation is not required to balance the government budget either in the steady state or in the transitional phase. Physical capital income should not be taxed. Alternatively, the optimal growth path can be attained by means of a subsidy to human capital. Received: March 21, 2002; revised version: September 4, 2002 RID="*" ID="*" Financial support from the Spanish Ministry of Science and Technology through PNICDYIT grant SEC2002-03663 is gratefully acknowledged.     

Markets as beneficial constraints on the government

We study the role of anonymous markets in which trades cannot be monitored by the government. We adopt a Mirrlees approach to analyze economies in which agents have private information and a benevolent government controls optimal redistributive tax policy. While unrestricted access to anonymous markets reduces the set of policy instruments available to the government, it also limits the scope of inefficient redistributive policies when the government lacks commitment. Indeed, the restrictions that anonymous markets impose on the optimal fiscal policy, especially on capital taxation and the history-dependence of income taxation, can have positive welfare effects in this case.     

Redistribution with Unobservable Bequests: A Case for Taxing Capital Income

This paper addresses the question of the optimal taxation of labour and interest income in an overlapping generations model with two unobservable characteristics, ability and inheritance. We assume realistically that saving can only be taxed anonymously, whereas the tax on labour earnings can be individualized and made non-linear. In such a setting, we show that a withholding tax on interest income along with a non-linear tax on labour income is desirable. The role of interest income taxation is to indirectly tax inherited wealth.
JEL Classification D 63, H 2     

Income Shifting within a Dual Income Tax System: Evidence from the Finnish Tax Reform of 1993*

Dual income tax systems can suffer from income that shifts from progressively taxed labour income to capital income, which is taxed at a lower, flat rate. This paper empirically examines the 1993 Finnish dual income tax reform, which radically reduced the marginal tax rates on capital income for some, but not all, taxpayers. We measure how overall taxable income and the relative shares of capital income and labour income reacted to the reform. We find that the reform led to a small positive impact on overall taxable income, but part of the positive response was probably offset by income shifting among the self‐employed.     

Time-consistent taxation in a dynastic family model with human and physical capital and a balanced government budget

Abstract .  This paper analyzes optimal, time consistent taxation in a dynastic family model with human and physical capital and with a balanced government budget. When tax revenue is used for publicly provided consumption or lump-sum transfers, leisure would be higher than its social optimum. Pareto optimal taxation requires taxing capital income more heavily than labour income and subsidizing investment at the same rate of the tax. Also, it requires either subsidizing labour at the same rate as a consumption tax or subsidizing consumption at the same rate as a labour income tax, and hence it is not a practical guide to policy. Further, a consumption tax, or equivalently a uniform income tax with investment subsidies at the same rate, can be improved on by taxing capital income more heavily than labour income.     

Age-related taxation of bequests in the presence of a dependency risk

This paper studies the properties of the optimal taxes on bequests when individuals differ in wage and in their risks of mortality and old-age dependance. Survival is positively correlated to income but dependency is negatively correlated with it. The government cannot distinguish between bequests motives, that is whether bequests resulted from precautionary reasons or from pure joy of giving reasons. Instead, it observes the timing of bequests and the health status at death. Under the utilitarian social welfare criterion, we show that bequests taxation results from a combination of equity, insurance, and public revenue motives. If redistribution concerns dominate insurance concerns, it is desirable to tax the most bequests of those individuals living long in good health and to tax the least bequests of those dying early. This is a direct consequence of the socio-demographic structure we assumed where richer agents live longer and in better health than poorer agents. To the opposite, if insurance concerns dominate redistributive concerns, early bequests should be the most taxed and, bequests under dependency the least taxed. Under the Rawlsian criterion, we find that early bequests should be the least taxed and bequests left by the healthy long-lived individuals should be the most taxed.