Capital Versus Labor Taxation with Heterogeneous Agents

We investigate the welfare implications of eliminating a proportional capital income tax for a model economy in which heterogeneous households face labor income risk and trade only one asset. Labor taxes rises at the time of the reform to maintain long run budget balance. Our stochastic process for labor earnings is consistent with empirical estimates of earnings risk, and also implies a distribution of asset holdings across households closely resembling that in the United States. We find that a vast majority of households prefers the status quo to the tax reform. This finding is interesting in light of the fact that our reform would be optimal if we abstracted from heterogeneity and assumed a representative agent. Initial household productivity and initial household wealth are independently important in determining a particular household's expected gain or loss, in contrast to a complete markets economy in which only the ratio of asset to labor income matters.