| Abstract: |
In this paper we quantitatively characterize the optimal capital and labor
income tax in an overlapping generations model with idiosyncratic, uninsurable
income shocks, where households also differ permanently with respect to their
ability to generate income. The welfare criterion we employ is ex-ante (before
ability is realized) expected (with respect to uninsurable productivity
shocks) utility of a newborn in a stationary equilibrium. Embedded in this
welfare criterion is a concern of the policy maker for insurance against
idiosyncratic shocks and redistribution among agents of different abilities.
Such insurance and redistribution can be achieved by progressive labor income
taxes or taxation of capital income, or both. The policy maker has then to
trade off these concerns against the standard distortions these taxes generate
for the labor supply and capital accumulation decision. We find that the
optimal capital income tax rate is not only positive, but is significantly
positive. The optimal (marginal and average) tax rate on capital is 36%, in
conjunction with a progressive labor income tax code that is, to a first
approximation, a flat tax of 23% with a deduction that corresponds to about
$6,000 (relative to an average income of households in the model of $35,000).
We argue that the high optimal capital income tax is mainly driven by the life
cycle structure of the model whereas the optimal progressivity of the labor
income tax is due to the insurance and redistribution role of the income tax
system. |