Human capital and optimal positive taxation of capital income

This paper analyzes optimal linear and non-linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heterogenous individuals. A dual income tax with a positive marginal tax rate on not only labor income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labor tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labor income if savings are elastic compared to investment in human capital, substitution between verifiable and non-verifiable inputs in human capital formation is difficult, and most investments in human capital are verifiable so that education subsidies can directly reduce the tax wedge on learning. Numerical calculations suggest that the optimal marginal tax rate on capital income is substantial.     

Labor-dependent capital income taxation

Capital taxation which is negatively correlated with labor supply is proposed. This paper uses a life-cycle model of heterogeneous agents that face idiosyncratic productivity shocks and shows that the tax scheme provides a strong work incentive when households possess large assets and high productivity later in the life-cycle, when they otherwise would work less. The system also adds to the saving motive of prime-age households and raises aggregate capital. The increased economic activities expand the tax base and the revenue neutral reform results in a lower average tax rate. The negative cross-dependence generates a sizable welfare gain in the long-run relative to the tax system that treats labor and capital income separately as a tax base. The reform, however, can hurt the elderly during the transition with a high marginal tax on their capital income.     

From the global income tax to the dual income tax: Recent tax reforms in the Nordic countries

The paper discusses the recent drive toward a system of dual income taxation (DIT) in the Nordic countries. The pure version of this system combines progressive taxation of labor and transfer incomes with a proportional tax on income from capital at a level equal to the corporate income tax rate. The paper considers the motives for the introduction of this new income tax system, ranging from abstract theoretical arguments to very pragmatic considerations. While the Nordic DIT system violates the principles of the conventional personal income tax, it is argued that it may in fact be more in line with the philosophy of a true Haig-Simons comprehensive income tax. It is also suggested that the DIT system may cause fewer distortions to resource allocation than the conventional income tax. On the debit side, the paper points out several practical problems of taxing income from small enterprises under the differentiated income tax.     

Optimal taxation and redistribution in an OLG model with unemployment

This paper concerns redistribution via nonlinear income taxation in an overlapping generations model with two ability-types. We assume that the wage rates are determined by bargaining between unions and firms, meaning that the equilibrium is characterized by involuntary unemployment. We show that the policy instruments that are used to calculate the marginal labor income tax rate for each ability-type give rise to intertemporal tax base effects. In addition, since the relationship between the employment and the capital stock implies intertemporal production inefficiency at the second best optimum, imperfect competition in the labor market may itself justify capital income taxation.      

On the optimal progressivity of the income tax code

This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labor productivity risk gives rise to a nontrivial income and wealth distribution. A progressive tax system serves as a partial substitute for missing insurance markets and enhances an equal distribution of economic welfare. These beneficial effects of a progressive tax system have to be traded off against the efficiency loss arising from distorting endogenous labor supply and capital accumulation decisions.Using a utilitarian steady state social welfare criterion we find that the optimal US income tax is well approximated by a flat tax rate of 17.2% and a fixed deduction of about $9,400. The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 1.7% higher consumption in each state of the world. An explicit computation of the transition path induced by a reform of the current towards the optimal tax system indicates that a majority of the population currently alive (roughly 62%) would experience welfare gains, suggesting that such fundamental income tax reform is not only desirable, but may also be politically feasible.     

A growth oriented dual income tax

This paper proposes a growth oriented dual income tax by combining an allowance for corporate equity with a broadly defined flat tax on personal capital income. Revenue losses are compensated by an increase in the value added tax. The paper demonstrates the neutrality properties of the reform with respect to investment, firm financial decisions and organizational choice. Tax rates are chosen to prevent income shifting from labor to capital income. The reform decisively strengthens investment of domestically owned firms as well as home and foreign based multinationals and boosts savings. Simulations with a calibrated growth model for Switzerland indicate that the reform could add between 4 to 5 percent of GNP in the long-run, depending on the specific scenario. Given the slow nature of capital accumulation, it imposes considerable costs in the short-run. We consider a tax smoothing scenario to offset the intergenerationally redistributive effects. JEL Classification: D58, D92, E62, G32, H25     

Married couple work participation and earnings elasticities: evidence from tax data

This paper uses administrative tax panel data to estimate work participation and earnings elasticities of married couples by exploiting variation in tax policy. Not only may individuals alter labor supply by working more or less in response to changes in tax policy, they may also alter reported earnings or shift income between taxable and tax-deferred compensation. As a result, in addition to estimating the standard extensive and intensive labor supply elasticities, we also examine elasticities by type of income (wage earnings vs. self-employment earnings) and compensation (taxable vs. tax-deferred). We find that wives have more elastic work participation and earnings than husbands. Furthermore, self-employment income is more responsive to net-of-tax price changes than wage earnings for both husbands and wives, suggesting that it is easier for the self-employed to alter their work hours, work intensity, and/or reported income than wage earners. Finally, we find that wives respond to changes in the net-of-tax price of earnings by altering the amount of earnings subject to current-year taxes through adjustments of tax-deferred contributions to employer-provided retirement accounts.     

Political Sustainability and the Design of Environmental Taxes

This paper studies the issue of political support for environmental taxes. The environmental tax is determined by majority voting, given a refund rule that specifies the allocation of tax proceeds. The refund rule is chosen by a welfare-maximizing constitutional planner. We show that: (i) The equilibrium tax rate is increasing in the proportion of tax reductions based on wage incomes. (ii) If labor and capital income taxes are reduced in the same proportion, to keep the government's budget balanced, majority voting yields a rate of environmental taxation that is lower than the optimal (Pigouvian) level. (iii) To mitigate this negative bias, the government reduces wage taxes by a higher proportion than capital income taxes. (iv) The final outcome will either be the Pigouvian tax or else all reductions will be given in wage taxes. This depends on individuals' preferences for the polluting good as well as wage and capital income distributions.     

Optimal redistributive tax and education policies in general equilibrium

This paper studies optimal linear and non-linear income taxes and education subsidies in two-type models with endogenous human capital formation, endogenous labor supply, and endogenous wage rates. Assuming constant human capital elasticities, human capital investment should be efficient under optimal linear policies, whether general equilibrium effects are present or not. Hence, education subsidies should not be used for distributional reasons. Due to general equilibrium effects, optimal linear income taxes may even become negative. Optimal non-linear policies exploit general equilibrium effects for redistribution. The high-skilled type optimally has a negative marginal income tax rate and a positive marginal education subsidy. The low-skilled type optimally faces a positive marginal income tax rate and a marginal tax on education. Simulations demonstrate that general equilibrium effects have only a modest effect on optimal non-linear policies.     

Taxation and Income Distribution Dynamics in a Neoclassical Growth Model

We examine how changes in tax policies affect the dynamics of the distributions of wealth and income in a Ramsey model in which agents differ in their initial capital endowments. The endogeneity of the labor supply plays a crucial role, as tax changes that affect hours of work will affect the distribution of wealth and income, reinforcing or offsetting the direct redistributive impact of taxes. We consider different ways of financing government expenditure and find that policies that reduce the labor supply are associated with lower output but also with a more equal distribution of after‐tax income. We illustrate these effects by examining the impact of recent tax changes observed in the United States and in European economies.     

Second-best income taxation and education policy with endogenous human capital and borrowing constraints

We formulate a two-period life cycle model of saving, labor supply, and human capital investment when individuals differ in their ability and initial wealth. Borrowing constraints result in sub-optimal choices for consumption and investments in human capital. We analyze optimal linear income taxes and education subsidies. The optimal income tax is shown to be positive—even in the absence of any redistributional concerns. A redistributive income tax relaxes borrowing constraints by redistributing resources from the unconstrained to the borrowing constrained stages of the life cycle. The income tax thus alleviates preexisting non-tax distortions in the capital market. Human capital is subsidized on a net basis in the absence of redistributional concerns. Education subsidies help to relax credit constraints and to reduce distortions from explicit and implicit taxes on human capital formation. When redistributional concerns are present, education is subsidized more if this helps to alleviate distortions on labor supply, but is subsidized less if education subsidies have a very regressive incidence. Simulations demonstrate that optimal income taxes are substantially higher when credit constraints are present. Education is generally subsidized on a net basis, and the more so if credit constraints are more severe.     

Income Shifting in the Spanish Dual Income Tax*

Based on a model of behavioural response to taxes, and using the Taxpayers Panel from the Instituto de Estudios Fiscales for the period 1999–2009, we analyse whether the dual nature of the Spanish personal income tax (PIT), reinforced by the 2007 reform, has influenced taxpayers’ behaviour, causing them to convert part of their ‘general income’ (from labour, real estate or economic activities) into ‘savings income’ (from movable capital or capital gains). We also extend the analysis of income shifting and study whether Spanish taxpayers also responded to the different tax treatments given to the two types of savings income (from movable capital and capital gains) until 2007, transforming savings income from one type to the other. The results of our study demonstrate three facts. First, Spanish taxpayers did respond to the different tax rates, shifting income from the general base to different forms of savings, especially capital gains. The highest‐income individuals and the self‐employed and business owners are the groups where this behaviour was most marked. Second, the self‐employed and business owners also turned income from movable assets into capital gains, guided by their different tax rates. And third, we find signs of ‘anticipation’ and ‘learning’ effects caused by the 2007 tax reform. We believe that the results obtained will enrich the growing literature on income shifting.     

Asymmetric capital tax competition and choice of tax rate

This article provides an alternative mechanism that explains differences in capital tax rates, which applies to small jurisdictions. In the framework of standard capital tax competition models, regions have to be large, in the sense of having market power, otherwise they will tax capital, a mobile factor, at the same rate. In this paper, we consider a second mobile factor, labor, which is mobile only within metropolitan areas. We will show that this spatially limited mobile factor may explain the capital tax rate differences levied on the global mobile factor as long as no source-based wage tax is available. In addition to the theoretical treatment, numerical simulations also confirm this result and show a significant tax differential.     

Personal taxation of capital income and the financial leverage of firms

Tax competition for capital has led to a trend where many countries levy lower taxes on interest income, often introducing differential taxation between interest and business income. This study analyzes the effect on firm debt usage. We exploit Germany’s 2009 tax reform, which introduced a final withholding tax on interest income with a flat rate 18 percentage points below the unchanged tax rate on income from unincorporated businesses, as a quasi-experiment. The results, based on firm-level panel data, indicate that firms increase their leverage when the tax rate on interest income decreases, albeit to a small degree.     

Direct evidence on the marginal rate of taxation on dividend income

Miller and Scholes (1978) hypothesize that the marginal tax rate on dividend income may be less than the marginal rate of tax on capital gains. Their hypothesis is dependent upon individuals utilizing existing provisions of the Code which serve to reduce the taxation of dividends. In this study, estimates of the marginal and effective rates of tax on dividend income for the year 1979 are presented using the Statistics of Income sample of returns. The average marginal rate of tax on dividend income is estimated to be 40%, while the average effective rate of tax is estimated to be 30%.     

Uninsurable investment risks and capital income taxation

This paper studies the capital accumulation and welfare implications of reducing capital income taxation in a general equilibrium economy with uninsurable investment risks. It has been shown that, with uninsurable investment risks, under-accumulation of capital may result compared to the complete markets economy. We show that reducing somewhat the capital income tax rate increases the capital stock and leads to a welfare gain. The complete elimination of the capital income tax, however, is not necessarily welfare improving.     

Tax treatment of dividends and capital gains and the dividend decision under dual income tax

The paper analyses efficiency aspects of a dual income tax system with a higher tax on capital gains than dividends. It argues that apart from the distortions to investments claimed in earlier literature, the system puts even more emphasis in creating incentives for entrepreneurs to participate in tax planning. The paper suggests that the owner of a closely held company can avoid all personal taxes on entrepreneurial income by two tax-planning strategies. The first is the avoidance of distributions, which would be taxed at the tax rate on labour income. These funds would instead be invested in the financial markets. The second strategy is a distribute and call-back policy, converting retained profits into new equity capital. Interestingly, the outcome is that investment in real capital is not distorted in the long-run equilibrium. Empirical evidence using microdata is also provided.      

The role of political elites in income tax system design and tax fairness

Given the importance of fairness in the public acceptance of tax systems (Mirrlees et al., 2011), understanding the role of political elites in the tax design process and how this impacts fairness is important. In this paper, we use an interpretative approach to examine the design and ultimate rejection of the Kansas tax policy experiment that ran from May 2012 to June 2017. The central design element of this experiment was the fundamental disruption of the long-standing principle of horizontal equity (fairness), in which non-wage business income was relieved of income tax, while wage income was taxed. By interpreting this experiment through a Bourdieusian lens, we identify five key themes that are helpful in understanding income tax design, tax fairness, and the role played by political elites. Overall, we contribute to the literature by highlighting the way in which cultural capital may be used by political elites to reformulate groups of taxpayers in order to justify unequal treatment of equal taxpayers, which represents a violation of the notion of horizontal equity (fairness). We also highlight that although such violations of fairness in income tax system design may be sustainable in the short run, over the longer term, notions of fairness are so deeply embedded in the habitus of individual taxpayers that a return to the status quo is likely.     

The effects of population aging on optimal redistributive taxes in an overlapping generations model

The impact of population aging on the steady-state solution to an Ordover and Phelps (J. Public Econ. 12:1?C26, 1979) overlapping generations optimal nonlinear income tax problem with two types of worker and quasilinear-in-leisure preferences is investigated. A decrease in the rate of population growth, which leads to an aging population, increases the relative price of consumption per person in retirement, which tends to decrease optimal consumption for retirees of both skill types. Nevertheless, it is also shown that the optimal marginal income tax rates are independent of the rate of population growth. In addition, the steady-state interest rate unambiguously declines when the rate of population growth declines. Resulting adjustments in production plans have an ambiguous effect on the aggregate wage rate. This article identifies factors contributing to an increase in the aggregate wage when the population ages, namely normality of consumption in retirement, complementarity between capital and labor in production, and a large capital deepening effect relative to the increase in dependency owing to demographic change. Depending on the sign of this wage effect, ambiguities may arise in the direction of change in the optimal steady-state consumption and production plans. However, when the dependency effect is sufficiently strong, it is possible to sign the direction of change in all production and consumption plans. Moreover, regardless of the direction of change in optimal consumption plans, the absolute value of the changes in consumption plans are smaller for low-skilled workers than for high-skilled when utility is time-separable and preferences exhibit decreasing absolute risk aversion. Adopting, instead, a quasilinear-in-consumption specification of preferences sharpens the comparative statics of consumption allocations, but introduces ambiguity into the effect of the rate of population growth on the optimal marginal income tax rate.