Taxing Capital is Not a Bad Idea Indeed: The Role of Human Capital and Labor-Market Frictions

In a second-best optimal growth setup with only factor taxes as available instruments, is it optimal to fully replace capital by labor income taxation? The answer is generally positive based on Chamley, Judd, Lucas, and many follow-up studies. In the present paper, we revisit this important tax reform-related issue by developing a human capital- based endogenous growth framework with frictional labor search and matching. We allow each firm to create multiple vacancies and each worker to determine labor market participation and search intensity endogenously. We consider a benevolent fiscal authority to finance direct transfers to households and unemployment compensation only by factor taxes. We then conduct dynamic tax incidence exercises using a model calibrated to the U.S. economy with a pre-existing 20% flat tax on both capital and labor income. Our numerical results suggest that, due to a dominant channel via the interactions between the firm's vacancy creation and the worker's market participation, it is optimal to switch partly from labor to capital taxation in a benchmark economy with a Lucas (1988)-type human capital accumulation process, independent of physical capital. In a general two-sector model as in Bond, Wang and Yip (1996) where the accumulation of either capital is influenced by both capital stocks, it is optimal to switch partly from capital to labor taxation, even though it is never optimal to completely eliminate capital taxation by taxing labor income only. Such tax reforms based on our recommendations are found to generate nonnegligible welfare gains in consumption equivalence ranging from 0.15% to 0.24%.