Efficiency gains from wealth taxation: A theoretical analysis; Ocampo Sergio (Western Ontario)

Abstract 

When is a wealth tax preferable to a capital income tax? We study this question in an infinite-horizon model with entrepreneurs and workers, in which entrepreneurial firms are subject to idiosyncratic productivity shocks and collateral constraints. There are two types of steady-state equilibria: one that is efficient and exhibits homogeneous returns, but requires unreasonably high borrowing limits, and a second one that is inefficient and exhibits capital misallocation and heterogeneous returns, which emerges under a wide set of plausible parameter values. In the heterogeneous returns equilibrium, replacing a capital income tax with a wealth tax increases steady-state aggregate productivity and output if (and only if) entrepreneurial productivity is persistent. These gains result from the use-it-or-lose-it effect of wealth taxes, which causes a reallocation of capital from entrepreneurs with low productivity to those with high productivity. We also provide necessary and sufficient conditions for a switch to wealth taxes to imply higher average welfare. These conditions amount to a lower bound on the output elasticity with respect to capital, which is close to 1/3 for most parameter combinations. We then turn to the optimal taxation problem of a government that can choose any combination of a wealth tax and capital income taxes to maximize welfare. We show that the optimal wealth tax is positive and the capital income tax is negative (a subsidy) when the output elasticity with respect to capital is sufficiently high, the signs flip when the elasticity is sufficiently low, and both taxes are positive in the range between these two thresholds.