Optimal Taxation of Capital Income in Models with Endogenous Fertility



1 Introduction

A recurrent question vivifies the doctrinary and policy debate regarding the
desiderable tax structure: given the highly distortionary nature of capital
taxes, should capital income be alleviated from the burden of taxation? See,
for example, Boskin (1996 and 2005), Altig et alii (2001), Slemrod and Bakija
(2004), and the 2005 Economic Report of the President’s Tax Chapter.

The idea of a zero capital income tax rate, largely in the background of
this debate, originates from Judd (1985) and Chamley (1986), who address
the question of factor income taxation by using an intertemporal second-best
perspective. Judd (1985) analyzes the redistributive potential of a capital in-
come tax in a neoclassical growth model with Kaldorian heterogeneity where
capital tax revenues are lump-sum transferred from capitalists to workers.
He discovers, surprisingly, that setting capital income taxes equal to zero in
the long-run is optimal also from the workers’ standpoint; this is because
a capital levy depresses workers’ disposable income, as the long-run supply
of capital is infinitely elastic. In a representative agent economy with labor
endogenously supplied, Chamley (1986) argues that the optimal dynamic tax
configuration is one in which capital income should be exempted from tax-
ation, while labor income should bear the tax burden required to finance a
given stream of government expenditure.1 The Chamley discovery is only

1 As evidenced by Chari and Kehoe (1999), and Judd (1999), the intuitive foundation
for the optimal zero tax on capital income can be derived from two classic principles
of commodity tax theory: i) intermediate goods should be exempted from taxation as
taxes are to be levied only on final goods (Diamond and Mirrlees, 1971); and ii) all
commodities should be taxed at a uniform rate (Atkinson and Stiglitz, 1972). While a
labor income tax solely distorts the static consumption-leisure decisions, a tax on capital
income generates an intertemporal distortion between the marginal rate of substitution of
consumption at two different dates and the corresponding marginal rate of transformation;
such a distortion increases exponentially in time. Therefore, taxing capital income entails
taxing consumption at different dates differently, thus violating the normative principle
of uniform taxation of consumption goods. Moreover, productive efficiency requires that
the capital stock (an intermediate good since it does not enter the utility function) should



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