Capital Taxation under Political Constraints

This paper studies optimal dynamic tax policy under the threat of political reform. A policy will be reformed ex post if a large enough political coalition supports reform; thus, sustainable policies are those that will continue to attract enough political support in the future. We find that optimal marginal capital taxes are either progressive or U-shaped, so that savings are subsidized for the poor and/or the middle class but are taxed for the rich. U-shaped capital taxes always emerge when the salient reform threat consists of radically redistributing capital and individuals’ political behavior is purely determined by economic motives. ∗Email addresses: [email protected], [email protected]. We thank Christopher Sleet for an insightful discussion and Daron Acemoglu, Michael Boskin, Steven Callander, Gabriel Carroll, Mikhail Golosov, Matthew Jackson, Pablo Kurlat, Alessandro Lizzeri, Danny Yagan, Yinyu Ye and seminar participants at Stanford, the Society of Economic Dynamics (Toronto), Association for Public Economic Theory (Seattle), NBER Summer Institute (Political Economy Public Finance and Public Economics: Taxation and Social Insurance meetings) and Stanford Institute for Theoretical Economics 2014 for helpful comments.