Book-Value Wealth Taxation, Capital Income Taxation, and Innovation

When is a wealth tax preferable to a capital income tax? When is the opposite true? More generally, can capital taxation be structured to improve productivity, incentivize innovation, and ultimately increase welfare? We study these questions theoretically in an infinite-horizon model with entrepreneurs and workers, in which entrepreneurial firms differ in their productivity and are subject to collateral constraints. The stationary equilibrium features heterogeneous returns and misallocation of capital. We show that increasing the wealth tax increases aggregate productivity. The gains result from the “use-it-or-lose-it” effect of wealth taxes when returns are heterogeneous, which causes a reallocation of capital from entrepreneurs with low productivity to those with high productivity. Furthermore, if the capital income tax is adjusted to balance the government's budget, aggregate capital, output, and wages also increase. We then study the welfare maximizing combination of wealth and capital income taxes and show that the optimal mix shifts towards a higher wealth tax and a lower capital income tax as the capital intensity of production increases. For a range of plausible parameter values, the optimal wealth tax is positive, whereas the capital income tax can be positive or negative (a subsidy). We then endogenize the entrepreneurial productivity distribution by introducing either ex ante innovation or entrepreneurial effort in production and show that this strengthens our results: by allowing entrepreneurs to keep more of the upside relative to a capital income tax, a wealth tax incentivizes more innovation and entrepreneurial effort, leading to larger increases in productivity, output, and welfare.