Optimal taxation and the Domar-Musgrave effect

2023-11-10

AI Summary

This paper investigates the optimal design of flat taxes on labor, capital, and consumption under heterogeneous investment risk and stochastic mortality. Within a dynamic stochastic general equilibrium framework, it maximizes social welfare subject to fiscal neutrality. Methodologically, it develops a theoretical model integrating entrepreneurial risk-taking and lifecycle uncertainty, numerically solving for both steady-state and transitional dynamics to systematically analyze tax substitution effects and intertemporal responses. Key contributions include: (i) identifying and naming the “Domar–Musgrave effect”—a capital income tax coupled with full loss offset significantly stimulates risky investment; (ii) demonstrating that taxing only capital and consumption—omitting labor taxation—substantially improves welfare, with the optimal capital tax rate exhibiting discontinuous jumps between zero and positive values; and (iii) revealing that substituting consumption for labor taxation induces non-monotonic aggregate consumption dynamics—initially declining then rising—while exerting opposing effects across groups: workers’ consumption rises, whereas entrepreneurs’ falls.

Abstract

This article concerns the optimal choice of flat taxes on labor and capital income, and on consumption, in a tractable economic model. Agents manage a portfolio of bonds and physical capital while subject to idiosyncratic investment risk and random mortality. We identify the tax rates which maximize welfare in stationary equilibrium while preserving tax revenue, finding that a very large increase in welfare can be achieved by only taxing capital income and consumption. The optimal rate of capital income taxation is zero if the natural borrowing constraint is strictly binding on entrepreneurs, but may otherwise be positive and potentially large. The Domar-Musgrave effect, whereby capital income taxation with full offset provisions encourages risky investment through loss sharing, explains cases where it is optimal to tax capital income. In further analysis we study the dynamic response to the substitution of consumption taxation for labor income taxation. We find that consumption immediately drops before rising rapidly to the new stationary equilibrium, which is higher on average than initial consumption for workers but lower for entrepreneurs.

Problem

• Optimal flat taxes on labor, capital, and consumption with investment risk
• Welfare-maximizing tax rates preserving revenue in stationary equilibrium
• Dynamic effects of replacing labor taxes with consumption taxes

Innovation

• Flat taxes on labor, capital income, consumption
• Maximize welfare preserving tax revenue
• Tax capital income and consumption only