An Optimal Time-Consistent Taxation with Revenue and Debt Constraints

A well-known finding in the taxation literature states that the optimal capital in-come tax rate is zero. However, this finding is often criticized for being unrealistic because this zero optimal rate entails high initial-period capital taxation and the gov-ernment self-finances public expenditures using the initial period capital tax revenues and their returns. To reflect the real world fiscal environment on our analysis, we impose three crucial restrictions on our optimal taxation problem: (ⅰ) the government needs to collect tax revenues at all times for budget balance, (ⅱ) the optimal capital income tax policy should be time-independent (hence time consistent), and (ⅲ) the government has to manage public debts at a certain sustainable level. Under these constraints, (ⅰ) we prove that the time-consistent optimal capital in-come tax rate is positive, and (ⅱ) we demonstrate that its size can be non-negligible and (ⅲ) it rises further when we include human capital and public debts in analysis. The intuition is that the distortions from taxing labor income grow more rapidly in the presence of human capital and debts, which requires a greater capital tax rate. Our calibrated model shows that the level of the optimal capital income tax rate is found to be in the range of 1~10%.