Taxing Wealth and Capital Income when Returns are Heterogeneous

Abstract

When is a wealth tax preferable to a capital income tax? We study this question theoretically in an infinite-horizon model with entrepreneurs and workers, in which entrepreneurial firms are subject to idiosyncratic productivity shocks and collateral constraints. We focus on the steady state equilibrium that features heterogeneous returns and misallocation of capital. In this equilibrium, increasing the wealth tax always increases aggregate productivity if and only if entrepreneurial productivity is positively auto-correlated. The gains result from the use-it-or-lose-it effect, which causes a reallocation of capital from entrepreneurs with low productivity to those with high productivity. Furthermore, if the capital income tax is adjusted to balance the government’s budget, aggregate capital, output, and wages increase. We provide necessary and sufficient conditions for a switch to wealth taxes to imply higher average welfare, which amount to a lower bound on the capital-elasticity of output, α—around 1/3 for most parameter combinations. We then study the optimal tax mix when both instruments can be used to maximize welfare. Optimal policy depends on two thresholds. When α is sufficiently high, optimal policy involves a positive wealth tax and a negative capital income tax (a subsidy); the sign flips when α is sufficiently low, and both taxes are positive between these two thresholds. Finally, we consider extensions that introduce rent-seeking behavior and endogenous entrepreneurial effort.