Optimal Capital Income Taxation in a Two-Sector Economy

Selim, S. 2009. Optimal Capital Income Taxation in a Two-Sector Economy. in: Duffy, D. and Shinnick, E. (ed.) Public Goods, Public Policy and Taxation: A European Perspective Berlin LIT. pp. 179-198

Chapter titleOptimal Capital Income Taxation in a Two-Sector Economy
AuthorsSelim, S.
EditorsDuffy, D. and Shinnick, E.
Abstract

We extend the celebrated Chamley-Judd result of zero capital income tax and show that the steady state optimal capital income tax is nonzero, in general. In particular, we find that the optimal plan involves zero capital income tax in investment sector and a nonzero capital income tax in consumption sector. In a two sector neoclassical economy, interdependence of labour and capital margins allows the government to choose an optimal policy that involves nonzero tax on capital income. The distortion created by capital income tax in consumption sector can be undone by setting different rates of labour income taxes. The optimal plan thus involves zero capital income tax in both sectors only if optimal labour income taxes are equal. This may not be the optimal policy if marginal disutility of work is different across sectors and/or the social marginal value of capital is different across sectors. The difference in social marginal value of capital can be undone by setting different labour income taxes across sectors. We also show that if the government faces a constraint of keeping same capital and labour income tax rates across sectors, optimal capital income tax is nonzero.

KeywordsOptimal taxation, Ramsey problem, Primal approach, Two-sector model.
Book titlePublic Goods, Public Policy and Taxation: A European Perspective
Page range179-198
Year2009
PublisherLIT
Filee2007_9.pdf
Publication dates
Published2009
Place of publicationBerlin
ISBN9783643102508
Web address (URL)http://orca.cf.ac.uk/49013/

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