Board of Governors of the Federal Reserve System

January 2012

Determining the Motives for a Positive Optimal Tax on Capital

William B. Peterman

Abstract:

Previous literature demonstrates that in a computational life cycle model the optimal tax on capital is positive and large. Given the computational complexities of these overlapping generations models it is helpful to determine the relative importance of the economic factors driving this result. I highlight the impact of changing two common assumptions in a benchmark model that generates a large optimal tax on capital similar to the model in Conesa et al. (2009). First, the utility function is altered such that it implies an agent's Frisch labor supply elasticity is constant, as opposed to increasing, over his lifetime. Second, the government is allowed to tax accidental bequests at a separate rate from ordinary capital income. The main finding of this paper is that these two changes cause the optimal tax on capital to drop by almost half. Furthermore, I find that the welfare costs of adopting the high optimal tax on capital from the benchmark model in the model with the altered assumptions, which calls for a lower tax on capital, are equivalent to 0.35 percent of total lifetime consumption. Quantifying the impact of these assumptions in the benchmark model is important because the first has limited empirical evidence and the second, although included for tractability, confounds a motive for taxing capital with a motive for taxing accidental bequests.

Keywords: Opitmal taxation, capital taxation

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