Optimal Capital Income Taxation with Housing

Abstract

This paper quantitatively investigates the optimal capital income taxation in the general equilibrium overlapping generations model, which incorporates characteristics of housing and the U.S. preferential tax treatment for owner-occupied housing. Housing tax policy is found to have a substantial effect on how capital income should be taxed. Given the U.S. preferential tax treatment for owner-occupied housing, the optimal capital income tax rate is close to zero (1%), contrary to the high optimal capital income tax rate implied by overlapping generations models without housing. A lower capital income tax rate improves welfare by narrowing tax wedge between housing and non-housing capital; the narrowed tax wedge indirectly nullifies the subsidies (taxes) for homeowners (renters) and corrects the over-investment to housing.

Keywords: Capital Taxation, Housing Taxation, Optimal Taxation, Heterogeneous Agents, Incomplete Markets

JEL Classification: E21, E62, H21, H24, R21