On the desirability of taxing capital income in optimal social insurance

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.

► Capital income should optimally be taxed. ► The Atkinson–Stiglitz theorem breaks down under risk. ► Capital income taxes boost labor supply. ► Capital income taxes insure income risks early in the life cycle. ► Retirement savings should not be actuarially fair.