Capital Income Taxation and the Sustainability of Permanent Primary Deficits

If a government imposes a tax on capital income, it may, as a result, lower the private rate of return on capital below the growth rate of an economy, thereby giving rise to the possibility of running a permanent deficit. Since, however, the before-tax rate of return and not the after-tax rate of return is relevant for judging the dynamical efficiency of the economy, the possibility of a permanent deficit does not by itself imply a possibility for a Pareto-improving redistribution of income. To examine this issue “step by step”, we examine in general whether a government can run a deficit forever by rolling over its debt. Assuming the government to run a deficit in each period equal to a constant fraction of total output, we study several overlapping generations models, proceeding from endowment economies to neoclassical growth with a variable capital stock. We then introduce capital income taxation and show, for example, that permanent deficits are feasible in the case of a variable capital stock, provided the capital income tax is sufficiently high. We examine the welfare effects and discuss policy consequences. ∗An early draft of this paper was written while the author was an assistant professor at Princeton University I am grateful in particular to Abhijit Banerjee, Ben Bernanke, Timothy Besley, Henning Bohn, John Campbell, Glenn Donaldson, Jon Faust and Jim Hines for helpful comments. Harald Uhlig, CentER, Tilburg University, Postbus 90153, 5000 LE Tilburg, THE NETHERLANDS, [email protected], Fax: (+31) 13 4663066.