Optimal progressive capital income taxes in the infinite horizon model

This paper analyzes optimal progressive capital income taxation in the infinite horizon dynastic model. It shows that progressive taxation is a much more powerful and useful tool to redistribute wealth than linear taxation on which previous literature has focused. We consider progressive capital income tax schedules taking a simple two-bracket form with an exemption bracket at the bottom and a single marginal tax rate above a time varying exemption threshold. Individuals are taxed until their wealth is reduced down to the exemption threshold. When the intertemportal elasticity of substitution is not too large and the top tail of the initial wealth distribution is infinite and thick enough, the optimal exemption threshold converges to a finite limit. As a result, the optimal tax system drives all the large fortunes down a finite level and produces a truncated long-run wealth distribution. A number of numerical simulations illustrate the theoretical result. (JEL H21, H62) ∗Harvard University, Department of Economics, Littauer, Cambridge MA02138. email:[email protected]. This paper owes much to stimulating discussions with Thomas Piketty. I thank Ken Judd for very helpful and detailed comments. I have also benefited from comments by seminar participants at the NBER.