Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Implications of Some Alternatives to Capital Income Taxation

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Implications of Some Alternatives to Capital Income Taxation

Article excerpt

(ProQuest-CSA LLC: ... denotes formulae omitted.)

A general prescription of economic theory is that taxes on capital income are bad. That is, a robust feature of a large variety of models is that a positive tax on capital income cannot be part of a long-run optimum. This result suggests that it may be useful to search for alternatives to taxes on capital income. Several recent proposals advocate a move to fundamentally switch the tax base toward labor income or consumption and away from capital income. The main point of this article is to demonstrate that, as a quantitative matter, uninsurable idiosyncratic risk is important to consider when contemplating alternatives to capital income taxes. Additionally, we show that tax reforms may be viewed rather differently by households that differ in wealth and/or current labor productivity.

We are motivated to quantitatively evaluate the risk-sharing implications of taxes by the findings of two recent theoretical investigations. These are, respectively, Easley, Kiefer, and Possen (1993) and Aiyagari (1995). The work of Easley, Kiefer, and Possen (1993) develops a stylized two-period model where households face uninsurable idiosyncratic risks. Their findings suggest that, in general, when households face uninsurable risk in the returns to their human or physical capital, it is useful to tax the income from these factors and then rebate the proceeds via a lump-sum rebate. However, the framework employed in this study does not provide implications for the longrun steady state. Conversely, Aiyagari (1995) constructs an infinite-horizon economy in which households derive value from public expenditures and face uninsurable idiosyncratic endowment risks and borrowing constraints. In this case, the optimal long-run capital income tax rate is positive. Specifically, Aiyagari (1995) shows that the optimal capital stock implies an interest rate that equals the rate of time preference. However, labor income risks generate precautionary savings that force the rate of return on capital below this rate. Therefore, to ensure a steady state with an optimal capital stock, a social planner will need to discourage private-sector capital accumulation. A strictly positive long-run capital income tax rate is, therefore, sufficient to ensure optimality.1

The approach we take is to study several stylized tax reforms in a setting that allows the differential risk-sharing properties of alternative taxes to play a role in determining their desirability. We, therefore, choose to evaluate a model that combines features of Easley, Kiefer, and Possen (1993) with those of Aiyagari (1995), and is rich enough to map to observed tax policy. In terms of the experiments we perform, we study the tradeoffs involved with using either (i) labor income or (ii) consumption taxes to replace capital income taxes. Our work complements preceding work on tax reform by focusing attention solely on the differences that arise specifically from the exclusive use of either labor income taxes or consumption taxes. To our knowledge, the divergence in allocations emerging from the use of either labor or consumption taxes has not been investigated.2 We study a model that confronts households with risks of empirically plausible magnitudes, and allows them to self-insure via wealth accumulation. Ourwork is most closely related to three infinite-horizon models of tax reform studied respectively by Imrohoroglu (1998), Floden and Linde (2001), and Domeij and Heathcote (2004). The environment that we study is a standard infinite-horizon, incomplete-markets model in the style of Aiyagari (1994), modified to accommodate fiscal policy. The remainder of the article is organized as follows. Section 1 describes the main model and discusses the computation of equilibrium. Section 2 explains the results and Section 3 discusses robustness and concludes the article.

1. MODEL

The key features of this model are that households face uninsurable and purely idiosyncratic risk, and have only a risk-free asset that they may accumulate. …

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