Nonoptimality of the Friedman Rule with Capital Income Taxation

This paper studies the efficient taxation of money and factor income in intertemporal optimizing growth models with infinite horizons, transaction costs technologies, and flexible prices. Second‐best optimality calls for a positive inflation tax and a nonzero capital income tax when there are restrictions on taxation of production factors or profits/rents. Our cases of nonoptimality of the Friedman rule—which differ from those of Mulligan and Sala‐i‐Martin (1997) and extend substantially those of Schmitt‐Grohè and Uribe (2004a)—follow from the violation of the Diamond and Mirrlees (1971) principle on production efficiency.