Optimal progressive capital income taxes in the infinite horizon model

Abstract

This paper analyzes optimal progressive capital income taxation in an infinite horizon model where individuals differ only through their initial wealth. We consider progressive capital income tax schedules taking a simple two-bracket form with an exemption bracket at the bottom and a single marginal tax rate above a time varying exemption threshold. Individuals are taxed until their wealth is reduced down to the exemption threshold. The fraction of individuals subject to capital income taxation vanishes to zero in the long-run in analogy to the zero long-run capital tax result of Chamley and Judd with optimal linear taxes. However, in contrast to linear taxation, optimal nonlinear capital taxation can have a drastic impact on the long-run wealth distribution. When the intertemporal elasticity of substitution is not too large and the top tail of the initial wealth distribution is infinite and thick enough, the optimal exemption threshold converges to a finite limit. As a result, the optimal tax system drives all the large fortunes down a finite level and produces a truncated long-run wealth distribution.