Optimal Dual Income Taxation

There is a strong case for arguing that, in contradiction to some traditional arguments in public economics, capital income should be taxed, though not necessarily under the same rate schedule as labour earnings. The Dual Income Taxation (DIT) system consists of two parallel piecewise linear tax schedules, in which that for capital income has a zero lower bracket rate and an upper bracket rate equal to the "standard rate" under the labour earnings system. Pioneered in the Nordic countries, it has also been introduced in a number of other OECD countries, including Germany. This paper for the first time analyses this system from the point of view of optimal tax theory, and sheds considerable doubt on the optimality of the particular structure of the DIT, though it confirms the general principle of taxing capital income, and provides a firm analytical foundation for further consideration of how this should be undertaken. JEL numbers: D14,H21, H24.