Optimal Taxation in Life-Cycle Economies

Abstract

We use a very standard life-cycle growth model, in which individuals have a labor-leisure choice in each period of their lives, to prove that an optimizing government will almost always find it optimal to tax or subsidize interest income. The intuition for our result is straightforward. In a life-cycle model the individual’s optimal consumption-work plan is almost never constant and an optimizing government almost always taxes consumption goods and labor earnings at different rates over an individual’s lifetime. One way to achieve this goal is to use capital and labor income taxes that vary with age. If tax rates cannot be conditioned on age, a non-zero tax on capital income is also optimal, as it can (imperfectly) mimic age-conditioned consumption and labor income tax rates.

Keywords: optimal taxation, uniform taxation, life cycle

JEL Classification: E62, H21