The Optimal Taxation of Capital

A Survey of Theories and Empirical Evidence

Under the supervision of,
Professor Jean Pisani-Ferry

Devvart Poddar
MPP Batch of 2016
Hertie School of Governance

The Current Debate;

Taxation of income has been a subject of much interest in economic and political theory as it
revolves around an idea of equality and fairness. Taxation of capital income within this large
literature has attracted much interest of its own. The current debate in capital taxation has revolved
around the contentious zero (o) tax result presented by Chamley and Judd. In two separate papers,
the authors posited that under stringent assumptions of infinitely lived agents and neoclassical
growth, it would be sub optimal to tax capital income, and in the long run the tax must tend towards
zero (0). The logic behind the result was quite straightforward; there exists a significant cumulative
impact of the taxation of capital income.
The result was not solitary, and similar results were derived by several other authors. Most notably,
Atkinson and Stiglitz in their 1976 paper, postulated that in a two period model, with only one
period of work, a differential taxation of consumption would be suboptimal. Taxation on
consumption, in presence of a positive earnings tax, would distort spending choices and create an
efficiency cost. The result could be further extended to capital taxation, as such a tax would
penalise future consumption for the present, without increasing efficiency. Thus Atkinson Stiglitz
model too prescribed zero tax on capital income as optimal.
Unfortunately, most of the underlying assumptions of the models above were quite stringent,
without whom the model failed to present the desired results. A primary assumption is the
existence of a perfect capital market, i.e. there were no borrowing constraints. However any

relevant tax policy will need to acknowledge asymmetries in the capital market, where those with
high capital income are those who will not be constrained by the borrowing limitations versus
those that do not earn high capital income and thus are constrained in their borrowings. As capital
income taxes fall on the former, they allow the state to raise revenue as well as lead to equity gains,
making capital taxes optimal. Chamley (2001) considered agents constrained by borrowing in his
original neoclassical growth model, and found that positive capital taxes may then become optimal.
A further assumption in the above papers was the ability to make a strict differentiation between
capital and labour income. However such an ability is often rare in practice. Income from
entrepreneurial activities can be claimed to be a part of both, as they accrue from the labours of
the entrepreneur as well as the income earned on the capital invested by him. Similarly, it is
difficult to create a strict differentiation in income earned from human capital, in terms of if the
returns are to labour of the individual or to capital invested in creating the skill level of the
individual. In such a grey zone, the zero (0) capital taxes on capital cannot remain optimal. A zero
capital tax with a positive labour earning tax, would lead to a significant tax shifting between the
two bases. A positive labour tax must be met with a positive capital tax to prevent such a tax
optimisation industry.
Finally the zero (0) tax result fails to hold under different models of growth. Aghion, Akcigit and
Villaverde (2013) proved that it could be optimal to subsidise or tax capital, in the presence of
innovation led growth. Their paper introduced several important dimensions to the debate, and
warrants a brief discussion on the repercussions of growth on the optimal tax literature.
Optimal Capital Taxes with Innovation led Growth;
A brief introduction of the model is necessary before its results can be appropriately understood.
Aghion, Akcigit and Villaverde (2013) introduced innovation led growth into the classic Chamley
(86) model. They modelled the innovation after the paper of Acemoglu and Akcigit (2012), where
productivity enhancing innovations result from profit motivated R&D investments (Aghion et
al, op cit.).
The model is vast, and spells out the inter-temporal utility structure of households. The households,
who own labour as well as capital, seek to maximise their utility subject to a budget constraint.
1+

(ln 1+
)

(1)

The production function of the economy is taken to be an ordinary Cobb-Douglas production

function, with the added change of introducing productivity (Qt) as a factor influencing production.
For convenience it is assumed that only one good is produced in the economy and households may
consume the produced good, or invest it.

 = ( )1

(2)

In the model, each period starts with a given amount of Productivity (Qt) and Capital (Kt). The
producers then decide to invest in R&D, following which successful innovators are granted
monopoly power in their sector. It is assumed that the costs of R&D have to be borne by the
innovators, and there are no subsidies for the same. If none of the innovations were successful, one
producer at random is selected to be a monopolist. This simplification does not lead to changes in
the results of the paper, only providing a mathematical convenience. The now monopolists,
produce the goods, and consumption takes place, determining the capital for the next period (Kt+1).
Finally the period ends with quality improvements, as laid out earlier occurs, increasing
productivity by a factor , where > 1. The improvements take place at the end of the period, the
convention being a practical approach. Innovative methods and technology do not directly
influence the production of the period they were discovered at, but do so with a lag.
Finally, following the model of Chamley, the government with perfect foresight, announces the
entire range of taxes at the beginning of the entire process subject to a balanced budget constraint.
= , + ,

(3)

While they major results follow the broad contours laid out above, Aghion et al, relax several
assumption made above, including allowing for government debt and R&D subsidies. Finally the
paper has skimmed through their original model to allow the reader to better understand the context
behind their results, and the mathematics have not been reproduced for this paper.
Following the model, the authors calibrated the same to fit the economy of the United States post
19th century. They further engaged in experiments to determine the optimal rate of tax on capital.
Their result is captured in Figure 1 below;

Figure 1: Optimal tax rates on capital for varying labour elasticities and G.
Source: Aghion, Akcigit and Villaverde (op. cit.), pg. 25

There are three major takeaways from the above results. The first is that the taxes on capital are
dependent on the elasticity of labour. The intuition of the result follows quite simply. If labour is
not highly elastic, high taxation of labour would have a minute impact of the labour supply and
thus the production in country. The revenues from the tax on labour can be used to finance G, and
subsidise labour. Similarly, when labour elasticity is high, it would be optimal to increasingly tax
capital to prevent further distortions in the labour supply.
Takeaway: Labour elasticity and taxes on capital are positively related, i.e.
high labour elasticity should be met with high taxes on capital.
Similarly, the results show that taxes on capital are also positively dependent on the levels of
government expenditure. The intuition follows the results above. The revenue from taxation of
labour is sufficient to meet low levels of government expenditure as well as subsidise capital and
thus boost production in the country. However at higher levels of government expenditure, further
taxes on labour income would prove to be distortionary. Aghion, Akcigit and Villaverde
summarise stating: In particular the higher the level of public expenditure and income elasticity
of labour supply, the less should it capital income be subsidized and the more it should be taxed.
Takeaway: High levels of government expenditure cannot be financed by
labour taxation alone and capital taxation is required to reduce distortions.
Finally, the consequence of the introduction of an innovation led growth model is the most
important result of the paper. The introduction of innovation and R&D significantly alter the zero
tax results. The authors explain it in terms of the market size. Capital as well as labour taxes
adversely affect the size of the market in the economy and thus affect the profit incentives of
producers and innovators. This in turn has a detrimental impact on the growth on the economy.
The optimal tax structure would entail reducing the distortions to the economy by controlling for
elasticities, size of government expenditure, the discount rate of the households and more. To
summarise, under innovation led growth, capital taxes cease to remain zero.
Takeaway: Optimal capital taxation must take into account the structure and
form of economic growth.
Though the paper by Aghion, Akcigit and Villaverde provide deep insights into the structure of
the optimal tax, they remain a guiding light and not the solution. Tax policies are seldom easily
and neatly discernible from mathematical models. The optimal taxation of capital must take several
other factors into account, including income inequalities, propensity of individuals towards tax
optimisation, presence of inheritance and related issues.

Income Inequalities and the role of Capital Taxation;

25
20
15
10
5
0
1880

France
1900

Germany
1920

UK (pre 1990)
1940

1960

UK (post 1990)
1980

US
2000

2020

Figure 2: Top 1% income shares in United States, Germany, France and UK.
Source: World Top Income Database; (http://topincomes.parisschoolofeconomics.eu/#Home:)

Thomas Piketty has been quite critical of the rising income inequality in the Anglo-Saxon
countries, and has often used Figure 2 to illustrate his cause. In the United States and United
Kingdom, the income shares of the top 1 percent ranged between 15% to 20% for most of the
1920s and 1930s. This figure started declining after the Second World War, and remained around
9% for most of the next 5 decades. However post the 1980s there has been a spectacular rise in the
shares of the top 1%, and they have reached historic proportions. The income shares in the United
States have more than doubled from 9% to nearly 20% in 2013. The rise has been much more
dramatic in the United Kingdom where they almost tripled from around 5% in 1978 to nearly 13%
in 2013. Other Anglo-Saxon countries of Australia and Canada similarly show a strong
asymmetrical U shaped curve.
The Anglo-Saxon experience has not been recreated in continental Europe, where countries like
France and Germany, show an L shaped curve. Income shares of the top 1% fell with the other
countries post the Second World War, but remained stable at those levels. The share of the top 1%
in France is not much higher than that at the end of the Second World War, while it nearly doubled
in the US. Alvaredo, Atkinson, Piketty and Saez (2013) attributes the divergence to policy and
institutional factors writing; the fact that high-income countries with similar technological and
productivity developments have gone through different patterns of income inequality at the very
top supports the view that institutional and policy differences play a key role in these
transformations.

Alvaredo et al focus on the effects of taxation as a key factor in determining the shares of the top
1% in the countries. They found that the top marginal income tax rates followed an inverse Ushaped time-path in most countries i.e. the marginal taxes for the top started rising pre-World
War 2, and peaked during the War, before they started falling in the 1980s. Furthermore, the
authors found a strong negative correlation between the marginal tax rates and the share of the top
1% as captured by Figure 3.

Figure 3: Changes in Top Income shares and Top Marginal Tax rates
Source: Alvaredo, F. Atkinson, A. Piketty, T. and Saez, E. (op. cit.) pg. 8.

Figure 3 denotes the change in the income shares of the top 1% and the change in the top marginal
income tax rates from 1960-64 to 2005-2009 in 18 OECD countries. The figure displays a strong
correlation between falling marginal tax rates and the rise in the income share of the top 1%. In
countries like the US and the UK, where marginal tax rates fell by more than 40 percentage points,
the shares of the top 1% rose by 9 and 6 percentage points respectively. Meanwhile in countries
like Germany and France, where the tax cuts were not so deep, the shares of the top did not rise,
and even fell from the levels of 1960s.
Several authors have posited different causes for the correlation ranging from reduction of tax
avoidance strategies to simple supply side economics of growth. The former has been refuted by
Alvaredo et al, as they claim that such effects are highly possible and even probable in the
immediate aftermath of tax cuts, but cannot be cited as the cause for sustained rise in the share of
the top 1%. Regardless of the outcome of the debate, it is hard to ignore the strong relationship
between tax rates and the income share of the top 1%. Any optimal tax will need to address the
despairing income inequality which Alvaredo et al provide a strong defence for.

Takeaway: Income taxes have a strong equality role and effect. The optimal
tax must address the rising income inequality.
Inheritance Flows and Capital Income Taxation;
The discussion above focused on inequalities ranging from income flows, i.e. income that is earned
either as dividends, interests, or wages. However in practice, inequalities reflect not only
divergences in earned income but also in inheritances and bequests.
Alvaredo et al, write that a key factor determining the capacity to transmit wealth is the difference
between the internal rate of accumulation (the savings rate times the rate of return) and the rate of
growth of the economy. As long as the rate of accumulation of wealth will be greater than the
rate of growth, wealth will continue to concentrate in the hands of a few. This was the central

theme of Pikettys Capital in the Twenty First Century, and is encapsulated in Figure 4.
Figure 4: Annual Inheritance flows in France
Source: Alvaredo, F. Atkinson, A. Piketty, T. and Saez, E. (op. cit.) pg. 13.

Figure 4 shows the annual inheritance flows as a fraction of disposable income in France from
1820s to 2008. Annual inheritance flows remained constant around 20-25% for nearly a century,
before falling sharply to around 5% at the end of the Second World War. However since then, it
has been rising regularly, reaching levels seen a 100 years ago. As Alvaredo et al write, the annual
inheritance flow of 20% is quite large, larger than the annual flow of new savings and almost as
large as the annual flow of capital income. Thus inheritance, is increasingly becoming an important
part of income inequality. However the inheritance wealth differs across countries, with a similar
pattern visible for continental Europe countries such as Germany, while it remains much weaker
in UK and the US. Such variations could be because of the differences in pension systems and
percentage of annuitized (therefore non-transferable) wealth between states.

The effect if inheritance on lifetime inequality has been studied by various authors. Piketty and
Saez (2012) found that those who receive no bequests, leave smaller than average bequests
themselves. Thus they argue in shifting from labour taxation to inheritance or wealth taxation.
However, the argument for inheritance tax is strengthened only when the inherited capital becomes
a significant factor in lifetime inequalities, i.e. when the economy starts to slow down relative to
the rate of return on capital.
Takeaway: Inheritance promotes lifetime inequality of income and should be
taxed. However the effect of inheritance differs across nations.
Capital Taxes and Tax Exile;
The entire discussion above has focused on the equity aspect of capital income taxes. However
any relevant tax policy must be designed with the efficiency of the tax as well. Specifically, as
capital in mobile internationally, directed in accordance to the post-tax return, taxation of capital
income may well limit the finances of the state and thereby its ability to grow.
The tax competition between countries takes different forms depending on whether it applies to
businesses or households. Business houses, invest higher in countries which have a higher real rate
of return adjusted for taxation. This creates incentives for countries to reduce capital taxes in order
to attract businesses. Artus, Bozio and Penalosa estimate that reducing corporate taxes by one
percentage points would attract around 3% of additional foreign direct investments.
The degree of capital mobility is far more limited in case of households. The only (legal) manner
of taking advantage of the tax competition between countries is to physically move to countries
that offer a lesser rate of taxation. As income remains concentrated in the hands of a few, it is
highly possible for countries to attract wealthy individuals through means of specific tax treatments
to the upper distribution, without affecting the majority of their tax base.

Figure 5: Tax Exile among households liable for ISF in France

Source: Artus, P. Bozio, A. and Penalosa, C. (2013), pg. 7

Figure 5 above captures the cases of tax exile in France for households liable to pay the solidarity
tax on wealth (ISF). The data is discontinuous and available only until 2010. However as the figure
shows, around 0.15% of the total number of households left in 2010, amounting to nearly 800
households.
To summarise, mobile international capital creates an incidence of tax competition among
countries, where nations attempt to lure high income firms or households with specific tax
treatments. The competition is made easier by the fact that income in concentrated in the hands of
a few. Data on exile of taxes is not entirely present, but nonetheless it shows that high capital taxes
cause tax exiles among the households in the upper percentiles of income.
Takeaway: Efficiency of taxes a concern as much as equity. High capital taxes
may lead to capital flight, underpinning the growth of the state.
Recommendations and Conclusion;
The entire discussion of optimal capital taxes have so far been devoid of any sacrosanct formulae
to follow. There are several reasons why there might not be an optimal formulae for the optimal
capital tax in economic literature. The biggest obstacle to any mathematical derivation of an
optimal formulae is the sheer difference in countries, with respect to the levels of wealth, income
inequalities, form of growth and much more. As the discussion above proved, the optimal capital
tax will be dependent on all of the above factors, and the sheer divergence among countries in
these parameters makes it nigh impossible to law down an iron formulae.
However what it implies for the discussion, is that the recommendations remain general providing
guiding principles towards the design of an optimal capital tax, and does not propose any specific
rate of tax itself. Following from the discussions above, there are two primary recommendations;
Recommendation: Tax all capital income neutrally, i.e. without differentiation with a few
exceptions.
The principle of neutrality of taxation follows from the idea that distorting investment choices to
favour a particular savings product is irrelevant. Distorting choices creates a tax optimisation
industry, whereby households seek to invest in areas with the most post tax return. This tax
optimisation industry is the source of efficiencies in itself and leads to a loss of revenue.
Meanwhile the principle of neutrality offers several benefits over differential capital income
taxation. The optimal tax literature has spoken volumes about the Ramsay Rule; whereby all
products are taxed inverse to their elasticities. While the Ramsay rule obviously proposes
differential taxation, it requires perfect information regarding the elasticities of production and
consumption, one that is rarely obtainable practically. Principle of neutrality, allows us to avid the

problems associated with introducing differential capital income taxation. It creates a stable system
that does not fluctuate with the elasticities of the savings product, and improves transparency in
the fiscal environment. It also prevents income shifting among investment options, as all returns
are taxed irrespective of their investment choices. Finally differential capital income taxation as a
rule invites rent seeking from special interest groups, which obfuscate the fiscal stance of the state.
However while neutrality of taxation must remain the rule, there are two notable exceptions to the
principle that must be discussed. The first is with respect to taxation of retirement savings. These
savings accrue to individuals who own no further forms of income. As such the savings correspond
to lifetime smoothing of consumption of these individuals. Thus it would seem acceptable to ignore
the income from taxation, or to do so gently. Income from property is the other exception to the
rule. Artus, Bozio and Penalosa state that of all capital income, income from property deserves to
be more heavily taxed. This is as the type of income is rent (ground rent) that can be taxed with
no negative impact on the economy.
Recommendation: Implement Dual Income Taxation
Dual Income Taxation (DIT) follows the taxation structure adopted by the Scandinavian countries
in 1980s and 90s. As per DIT, income is split into capital income and earned income. While earned
income is taxed progressively, capital income is taxed at a flat marginal rate of tax, which is often
lesser than the rate of tax applied to the earned income. Capital income is also not subject to any
credit or deductions though, based on the discussion of principle of neutrality, a few exceptions
can be made in cases of funding ventures, retirement savings and property.
There are several benefits to the dual income taxation. It conforms to the principle of neutrality
discussed above. As all capital income are taxed at the same marginal rate, it does not distort the
investment choices in favour of any particular investment product. It is however not as equitable,
taxing capital income at much lower marginal tax rates than earned income. There are
considerations that can make the DIT more progressive, including a definite inheritance tax.
In summary, the DIT is a radical reform of the income tax structure followed by most nations. DIT
has its flaws, but they can be mitigated or resolved to a suitable degree. Morinobu (2004)
appropriately summarises the discussion on the dual income tax, stating;
The DIT aims to strike a balance between equity concerns and revenue needs on
the one hand and efficiency and neutrality on the other The application of lower
rates on capital as opposed to labour also contributes to efficiency, as capital is
more mobile internationally, its supply more elastic and the real return more
sensitive to inflation. In addition, a proportional rate reduces distortions with
respect to the choice between present and deferred consumption inherent in

10

comprehensive tax systems, in particular if taxation is heavy, and also promotes

tax neutrality between different sources of capital income The Nordic countries
seem to have fared relatively well with the DIT system. As small, open economies
with a particular preference for redistribution and relatively large public sectors,
they have been facing the challenge of raising revenue from a mobile source in an
environment with relatively high marginal tax rates. Under these circumstances,
the DIT has served as a pragmatic middle course between pure comprehensive
income and consumption taxation, while lowering overall distortions in the tax
system

References;
Aghion, P. Akcigit, U. and Villaverde, J (2013) Optimal Capital versus Labour Taxation with
Innovation led growth, Working Paper 19086, National Bureau of Economic Research.
Alvaredo, F. Atkinson, A. Piketty, T. and Saez, E. (2013) The Top 1 Percent in International and
Historical Perspective, Journal of Economic Perspectives, volume 27 Number 3.
Artus, P. Bozio, A. and Penalosa, C. (2013) Taxation of Capital Income, Les notes du conseil
danalyse economique (No. 9), Paris, France.
Boadway, R. (2005) The case for a Dual Income Tax, International Symposium of Tax Policy and
reform in Asian Countries, Hitotsubashi University, Tokyo.
Diamond, P. and Saez, E. (2011) The Case for a Progressive Tax: From Basic Research to Policy
Recommendations, CESifo Working Papers, Number 3548.
Morinobu S. (2004) Capital Income Taxation and the Dual Income Tax, PRI Discussion Paper
Series, 04A-17, Policy Research Institute, Ministry of Finance, Tokyo, Japan.
Sorensen, P. (2006) The Theory of Optimal Taxation: What is the Policy relevance?, EPRU
Working Paper Series, No. 2006-07

11