Optimal Taxation of Capital Income with Heterogeneous Rates of Return

We derive the Pareto-efficient mix of non-linear taxes on labour income and capital income if people differ in their rates of return on capital. We allow for two reasons why rates of return differ: because individuals with higher ability are better able to invest their capital or because wealthier i...

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Bibliographic Details
Published inThe Economic journal (London)
Main Authors Gerritsen, Aart, Jacobs, Bas, Spiritus, Kevin, Rusu, Alexandra V
Format Journal Article
LanguageEnglish
Published 04.11.2024
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Summary:We derive the Pareto-efficient mix of non-linear taxes on labour income and capital income if people differ in their rates of return on capital. We allow for two reasons why rates of return differ: because individuals with higher ability are better able to invest their capital or because wealthier individuals enjoy scale effects in wealth accumulation. In both cases, a strictly positive tax on capital income is part of any Pareto-efficient tax system. We derive a condition for the Pareto-efficient tax mix that relies solely on empirical sufficient statistics—not on social welfare weights—and find that Pareto-efficient taxes on capital income increase with the degree of return heterogeneity. Numerical simulations for empirically plausible return heterogeneity suggest that Pareto-efficient marginal tax rates on capital income are positive and substantial.
ISSN:0013-0133
1468-0297
DOI:10.1093/ej/ueae083