Human Capital and Optimal Positive Taxation of Capital Income

This paper analyzes optimal linear taxes on capital and labour incomes in a life-cycle model of human capital investment, financial savings, and labour supply with heterogenous individuals. A dual income tax with a positive marginal tax rate on not only labour income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labour tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labour income if savings are elastic compared to investment in human capital; substitution between inputs in human capital formation is difficult; and most investments in human capital are verifiable. Numerical calculations suggest that the optimal marginal tax rate on capital income is close to the tax rate on labour income.