Capital Taxation under Political Constraints

This paper studies optimal dynamic tax policy under the threat of political reform. A policy will be reformed ex post if a large enough political coalition supports reform; thus, credible policies are those that will continue to attract enough political support in the future. If the only credible reform threat is to fully equalize consumption, we find that optimal marginal capital taxes are U-shaped, so that savings are subsidized for the middle class but are taxed for the poor and rich. If ex post the government may strategically propose a reform other than full equalization in order to secure additional political support, then optimal capital taxes are instead progressive throughout the income distribution.