On the Desirability of Taxing Capital Income in Optimal Social Insurance

Abstract

This paper analyzes optimal linear taxes on labor income and savings in a two-period life cycle model with ex ante identical households, endogenous leisure demands in both periods, and general processes of skill shocks over the life cycle. We demonstrate that the Atkinson-Stiglitz theorem breaks down under risk. Capital taxes are employed besides labor income taxes for two distinct reasons: i) capital taxes reduce labor supply distortions on second-period labor supply, since second-period labor supply and saving are substitutes, ii) capital taxes insure first-period income risk, although this benefit is partially off-set because first-period labor supply and saving are complements. Our results imply that (retirement) saving should not be actuarially fair.