Macroeconomic Effects of Capital Tax Rate Changes

70 Pages Posted: 24 May 2022

See all articles by Saroj Bhattarai

Saroj Bhattarai

University of Texas at Austin - Department of Economics

Jae Won Lee

University of Virginia - Department of Economics

Woong Yong Park

Seoul National University

Choongryul Yang

Board of Governors of the Federal Reserve System

Multiple version iconThere are 3 versions of this paper

Date Written: May 1, 2022

Abstract

We study aggregate, distributional, and welfare effects of a permanent reduction in the capital tax rate in a quantitative model with capital-skill complementarity and household heterogeneity. Such a tax reform leads to expansionary long-run aggregate output and investment effects, but those are coupled with increases in wage, consumption, and income inequality. The tax reform is not self-financing and its effects depend crucially on whether the government cuts lump-sum transfers or raises distortionary labor or consumption tax rates for financing. The former results in a larger aggregate expansion, but at the expense of a greater rise in inequality. As a result, the latter is relatively more beneficial for unskilled households. We find that the tax reform, when the consumption tax rate adjusts, leads to a Pareto improvement in terms of life-time welfare. For transition dynamics, monetary policy, in addition to the fiscal adjustments, matters. In particular, if monetary policy inflates away a portion of the public debt, the economy can avoid the short-run contraction that would arise otherwise.

Keywords: Capital tax rate, Distortionary financing, Capital-skill complementarity, Inequality, Welfare implications

JEL Classification: E62, E63, E52, E58, E31

Suggested Citation

Bhattarai, Saroj and Lee, Jae Won and Park, Woong Yong and Yang, Choongryul, Macroeconomic Effects of Capital Tax Rate Changes (May 1, 2022). FEDS Working Paper No. 2022-27, Available at SSRN: https://ssrn.com/abstract=4118172 or http://dx.doi.org/10.17016/FEDS.2022.027

Saroj Bhattarai (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

Jae Won Lee

University of Virginia - Department of Economics ( email )

237 Monroe Hall
P.O. Box 400182
Charlottesville, VA 22904-418
United States

Woong Yong Park

Seoul National University ( email )

Kwanak-gu
Seoul, 151-742
Korea, Republic of (South Korea)

Choongryul Yang

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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