Optimal Taxation of Normal and Excess Returns to Risky Assets

Abstract

We study the optimal taxation of risk-free and excess capital income with heterogeneous rates of return, alongside an optimal nonlinear earnings tax. Households can hold three assets: one risk-free, one risky but diversifiable, and one a private investment with idiosyncratic risk whose expected return differs among households. The optimal tax on excess returns to risky assets is ineffective for redistribution, because its effects are annulled by a Domar-Musgrave effect. It assumes only an insurance role, and is positive. The optimal tax on risk-free returns fulfills a redistributive role, insofar as the risk-free returns reveal information about the investors’ types beyond what is revealed by the earnings tax base.

Keywords: optimal capital taxation, Rate-of-Return Allowance, risk, excess returns