The strongPolitical Economystrong of Nonlinear Capital Taxation.pdfVIP

The Political Economy of Nonlinear Capital Taxation ∗ Emmanuel Farhi Iv´an Werning Harvard MIT efarhi@harvard.edu iwerning@mit.edu September 23, 2008 (10:58am) Abstract We study efficient nonlinear taxation of labor and capital in a dynamic Mirrleesian model incorporating political economy constraints. Policies are chosen sequentially over time, without commitment, as the outcome of democratic elections. We study the best equilibrium for this dynamic game. Our main result is that the marginal tax on capital income is progressive, in the sense that richer agents face higher marginal tax rates. 1 Introduction Modern optimal-tax theory is founded on the trade-off between efficiency and redistribu- tion (Mirrlees, 1971). The losses in efficiency from taxation are determined mechanically by the economic environment—preferences, technology and information. In contrast, the desire to redistribute, often modeled by a social welfare function, may implicitly capture the outcome or demands of some political process. However, if anything, actual policy making not only considers this trade-off, but also constantly reconsiders it: policies chosen at some point, can be reformed or replaced by new ones at any later time. Due to this lack of commitment, the credibility of policies must be judged by projecting their effects into the future. The impact on future wealth inequality is of particular concern. Otherwise, large levels of inequality may create, ex ∗This work benefited from useful discussions and comments volunteered by Daron Acemoglu, Philippe Aghion, Alberto Alesina, George-Marios Angeletos, R