| This article explores the proposition that the optimal capital income tax is zero. The standard view is that capital returns should not be taxed at all. This view is built on a well-established theory of optimal fiscal policy. In standard neoclassical growth models with infinitely lived consumers, Judd (1985) and Chamley (1986) show that the optimal policy predicts zero capital taxes in the long run.1 This article explores the proposition that the optimal capital income tax is zero using overlapping generations economies. The main contribution of the article is to show that in a standard overlapping generations model, it is very difficult to obtain zero optimal capital taxes either in steady state or along the transition path. We provide sufficient conditions in preferences for zero capital taxation in these models and show that these conditions are more restrictive than the standard uniform commodity tax result needed in infinitely lived models with perfect competition. For a general class of preferences, the optimal policy implies a nonzero capital income tax violating the standard uniform commodity tax result that specifies under which circumstances taxing all goods at the same rate is optimal. To provide some intuition, it is useful to relate the present findings with the economic intuition presented in Judd (1999) for an infinitely lived consumer economy. From general equilibrium theory, we know that the static Arrow–Debreu model can be applied to a dynamic context, so the principle from the commodity tax literature also applies. As a result, a positive capital income tax is equivalent to a commodity tax on the time t good that grows exponentially in t. In infinitely lived consumer economies, if preferences are separable and exhibit some degree of substitutability, this policy entails an ever-growing distortion between the marginal rate of substitution and the marginal rate of transformation. Given that individuals have a preference to smooth consumption, they prefer a constant consumption tax to an ever-increasing consumption tax. This policy can be implemented by removing the tax rate on capital income and replacing it with a tax on labor income. In contrast, if individuals live a finite number of periods, the distortions associated with this policy are not that important because, for a given generation, today’s consumption and period T consumption are not perfectly substitutable. Hence, the effect of capital distortions is much smaller and not necessarily bigger than distortions caused by other taxes. The key to the general result is the existence of consumers of different ages making the same type of decisions (consumption/savings and labor supply) at a given point in time. Given that consumption and hours worked are not constant over the life cycle even in the steady state, consumption should be taxed when it is relatively higher. The government can imperfectly affect consumption by setting a nonzero capital tax. In particular, if we interpret consumption at different ages as different goods that can be taxed at a different rate, in general, we find that the optimal policy implies an increasing consumption tax over the life cycle. |
