Preference heterogeneity and optimal capital income taxation

We examine a prominent justification for capital income taxation: goods preferred by those with high ability ought to be taxed. In an environment where commodity taxes are allowed to be nonlinear functions of income and consumption, we derive an analytical expression that reveals the forces determining optimal commodity taxation. We then calibrate the model to evidence on the relationship between skills and preferences and extensively examine the quantitative case for taxes on future consumption (saving). In our baseline case of a unit intertemporal elasticity, optimal capital income tax rates are 2% on average and 4.5% on high earners. We find that the intertemporal elasticity of substitution has a substantial effect on optimal capital taxation. If the intertemporal elasticity is one-third, the optimal capital income tax rates rise to 15% on average and 23% on high earners; if the intertemporal elasticity is two, the optimal rates fall to 0.6% on average and 1.6% on high earners. Nevertheless, in all cases that we consider the welfare gains of using optimal capital taxes are small.

► Characterize optimal nonlinear commodity taxes if preferences vary with ability. ► Calibrated model yields modest optimal rates and welfare gains for baseline case. ► Optimal distortions larger if intertemporal elasticity low, but gains remain small.