Should we tax capital income or wealth?

Posted

January 2024

Corina Boar

Virgiliu Midrigan

Research Paper

What is this research about and why did you do it?

This research is motivated by the observation that in the US, private businesses are an important driver of both economic activity and inequality. For example, they produce 40% of all output and though owners of private businesses represent only 12% of households, they earn one-third of all income and hold one-half of all wealth. A natural question that emerges is: How should the income and wealth of private business owners be taxed? Potential financing barriers that private businesses face lead them to earn heterogeneous rates of return to their wealth, which creates a distinction between capital income and wealth taxation.

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How did you answer this question?

We answer this question by characterizing optimal tax policy in an environment with heterogeneous private businesses that reproduces their importance for economic activity and inequality. We calculate the optimal tax on labor income, capital income, and wealth, taking into account the transition dynamics after reforms. Optimal policy balances the trade off between production efficiency, which calls for increasing the wealth share of productive business owners, and redistribution, which requires the opposite. Taxing capital income, which includes the profits of wealthy business owners, achieves substantial redistribution. Taxing wealth increases the wealth share of private business owners and improves allocative efficiency.

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What did you find?

We find that taxing capital income is preferable to taxing wealth if the planner can only use one of these two instruments. This is a consequence of two features of our model. First, as in the data, the wealth share of private business owners is very high, so there distributive motive dominates the efficiency motive. Second, financial frictions generate relatively modest misallocation. A planner who can use all tax instruments sets the wealth tax close to zero. This result is robust to the planner's preference for redistribution, as well as to allowing for non-linear income and wealth taxes.

Note: Panel A reports the optimal taxes chosen by a utilitarian planner. Panel B reports the implied welfare gains, overall, for the bottom, middle and top third of the welfare distribution, and for workers and entrepreneurs separately. In the left column, the planner is restricted to only using labor and capital income taxes. In the middle column, the planner is restricted to only using labor income and wealth taxes. In the right column, the planner is allowed to use all instruments.

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What implications does this have for the study (research and teaching) of wealth concentration or economic inequality?

Our paper has implications for the study of tax policies aimed at curbing inequality. Our result implies that a key determinant of the relative desirability of capital income and wealth taxes is the extent of misallocation generated by financial frictions. If this small, as in our economy, the efficiency gains from wealth taxation are swamped by there distributional consequences and capital income taxation is preferable.

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What are the next steps in your agenda?

Motivated by the findings in this paper, in future work we seek to understand the importance of financial frictions in generating dispersion in marginal returns to private business wealth and quantify their micro-economic and aggregate implications.

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