Capital income taxation and the Atkinson-Stiglitz theorem

•We consider the role of financial system and money holdings in an optimal tax model.•Labor market productivity is heterogeneous across agents, and so are wage rates.•The rate of return on total savings, including cash, is heterogeneous across agents.•The labor income tax is nonlinear and is optimally chosen.•Capital income taxation is required even if individual preferences are separable.

Accounting for the role of financial system and money holdings in an optimal nonlinear income tax model, we argue that capital income taxation is a non-redundant policy tool even if individual preferences are separable between leisure and other goods.