Taxing Capital in the Presence of Trickle Down-Effects

Within a general macroeconomic environment I derive the welfare effect of capital tax changes in terms of estimable sufficient statistics. Lower capital-labor substitutability in production not only induces a stronger responsiveness of wages and financial returns, but it also reduces the deadweight loss of capital tax hikes. Thus, contrary to conventional wisdom, optimal capital taxes may be higher precisely when ‘trickle down’ effects are stronger. I apply my theoretical results to US data and discipline the welfare-relevant statistics with recent evidence. Despite its depressing effect on wages, the bottom two thirds of the US income distribution would gain from an increase in the capital tax rate when marginal revenue is redistributed lump-sum and equally. I utilize the identified welfare-relevant statistics as calibration targets in a parametric version of the model and solve numerically for optimal linear capital- and progressive labor taxes. Standard welfare criteria warrant higher capital taxes as well as higher, but less progressive, labor taxes than the status quo. (JEL: E62, H21, H22, H24, H25)