Optimal Capital Income Taxation∗

In an economy with identical infinitely-lived households that obtain utility from leisure as well as consumption, Chamley (1986) and Judd (1985) have shown that the optimal tax system to pay for an exogenous stream of government purchases involves a zero tax rate on capital in the long run, with tax revenue collected by a distortionary tax on labor income. Extending the results of Hall and Jorgenson (1971) to general equilibrium, I show that if purchasers of capital are permitted to deduct capital expenditures from taxable capital income, then a constant tax rate on capital income is non-distortionary. Importantly, even though this specification of the capital income tax imposes a zero effective tax rate on capital, the capital income tax can collect substantial revenue. Provided that government purchases do not exceed gross capital income less gross investment, the optimal tax system will consist of a positive tax rate on capital income and a zero tax rate on labor income—just the opposite of the results of Chamley and Judd. ∗I thank Joao Gomes, Lars Ljungqvist, Robert Hall, Stavros Panageas, Tomas Piskorski, Leslie Reinhorn, Thomas Sargent, Skander van den Heuvel, Jianfeng Yu, and the Penn Macro Lunch Group for helpful comments and discussion. The optimal way for a government to collect revenue to pay for its purchases of goods and services is to levy lump-sum taxes. However, lump-sum taxes generally are not available, so some form of economic activity, such as labor income, capital income, cigarette purchases, etc., must be taxed. Because the taxation of economic activities is distortionary, a basic problem of public finance is how to use such taxes to collect revenue in the least distortionary way. A classic problem of this sort analyzes the optimal use of taxes on labor income and capital income to finance an exogenous stream of government purchases in a Ramsey framework with a representative infinitely-lived household. The celebrated result of Chamley (1986) and Judd (1985) is that in the long run, the optimal tax rate on capital income is zero. The Chamley-Judd result might be particularly puzzling to readers of an older literature on the conditions for the neutrality of capital income taxation. The older literature focused on the capital investment decision of a single firm, and did not embed the firm in a general equilibrium model. Hall and Jorgenson (1971) showed that for a firm that cannot deduct its cost of financing (for example, under U.S. tax law, a firm financed entirely by equity), a tax on capital income that provides for immediate expensing of capital expenditures will be neutral with respect to capital; that is, it will have no effect on a firm’s optimal capital accumulation. Tax codes generally allow purchasers of capital to reduce their calculated taxable income by some amount to reflect the cost of acquiring capital. This reduction in taxable income is usually implemented through a schedule of depreciation allowances, which may or may not be accelerated relative to the economic depreciation of the capital asset. The most accelerated version of depreciation allowances is immediate expensing, which leads to tax rate neutrality, as described above. A second neutrality result applies to the case in which a firm can deduct its cost of financing, as would be the case, under U.S. tax law, for a firm financed entirely by debt. In this case, Hall and Jorgenson show, and an earlier result of Samuelson (1964) implies, that allowing firms to deduct true economic depreciation will lead to tax rate neutrality with respect to capital investment. The existence of neutral forms of capital income taxation, i.e., forms of capital income taxation that do not affect the capital investment decision of a firm, suggests that these forms of capital taxation may provide the elusive lump-sum tax that can allow the government to finance its expenditures without distortions. To explore whether such capital income tax schemes can provide non-distortionary sources of revenue, two major questions need to be addressed. First, does the neutrality of a