Taxing Capital: Not a Bad Idea After All

1 In this paper we quantitatively characterize the optimal capital and labor income tax in an overlapping generations model with idiosyncratic, uninsurable income shocks and permanent productivity di¤erences of households. The welfare criterion we employ is ex-ante (before ability is realized) expected (with respect to uninsurable productivity shocks) util-ity of a newborn in a stationary equilibrium. Embedded in this welfare criterion is a concern of the policy maker for insurance against idiosyn-cratic shocks and redistribution among agents of di¤erent abilities. The policy maker trades o ¤ these concerns against the standard distortions of the tax code for labor supply and capital accumulation decisions. We nd that the optimal capital income tax rate is signi\u85cantly posi-tive at 36%. The optimal progressive labor income tax code is, to a \u85rst approximation, a at tax of 23 % with a deduction that corresponds to about $7; 200 (relative to an average income of households in the model of $42; 000). We argue that the high optimal capital income tax is mainly driven by the life cycle structure of the model whereas the optimal pro-gressivity of the labor income tax is due to the insurance and redistribu-tion role of the income tax system