Scandinavian Working Papers in Economics

Memorandum,
Oslo University, Department of Economics

No 06/2016: Optimal Taxation with Endogenous Return to Capital

Arnaldur Sölvi Kristjánsson ()
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Arnaldur Sölvi Kristjánsson: Dept. of Economics, University of Oslo, Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway

Abstract: This paper characterizes the optimal income and wealth tax schedules when rates of return are endogenous. Individuals exert investment effort in order to increase the return on their investments. Agents are heterogeneous along two dimensions: their investment ability and their labour market productivity. I show that when individuals can exert investment effort, the Atkinson-Stiglitz theorem that capital income should not be taxed does not hold. When the government observes wealth and capital income, it is optimal to tax capital income and subsidize wealth. When wealth is not observed, it is optimal to tax capital Income. The marginal tax rates on labour and capital income should not be equal, but they should be positively related to each other. The results extend to a model where individuals can hire investment advisors to increase the rate of return and also to a model with heterogeneous inheritance, in which case both capital Income and wealth should be taxed.

Keywords: Optimal taxation; capital taxation; endogenous return to capital

JEL-codes: G11; H21; H24

60 pages, April 28, 2016

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