Machines, Buildings, and Optimal Dynamic Taxes

The effective marginal tax rates on returns to capital assets show considerable amount of variation depending on the asset type in the U.S. corporate tax code. For instance, the effective marginal tax rate on the return to communications equipment is 19% whereas it is above 35% for non-residential buildings. This feature of the tax code has been the subject of a growing debate among policymakers, because it contributes to the existence of signicant gaps between the effective tax rates faced by companies in different industries. President Obama recently called for a reform to abolish the tax rules that create differential axation of capital assets in order to "level the playing field" across companies. In contrast to the extent of these policy debates, there has been little research on whether differential taxation of capital income based on capital type is a desirable feature of the tax code. In this paper, we take a step in this direction. Our theory confirms the optimality of differential capital asset taxation, but with an important caveat. Capital assets can be divided into two groups based on the tax treatment they receive in the U.S. tax code: structures and equipment. As documented by Gravelle (2011), in the current U.S. tax code the effective tax rate on equipment capital is on average 6% below the effective tax rate on structure capital. In contrast, our theory suggests that capital equipment should be taxed at a higher rate than capital structures. We conduct a quantitative exercise to assess the quantitative importance of optimal differential capital taxation. In our baseline calibration we find that the tax rate on capital equipments should be at least 19% higher than the tax rate on structure capital.