Capital Taxation and Accumulation in a Life Cycle Growth Model

Abstract

Almost all of the serious economic work on savings decisions within the past decade has relied on some variant of the life cycle hypothesis in which savings arise out of individual choices of an optimum lifetime consumption path. This paper reexamines the incidence and welfare consequences of capital income taxes within a realistic life cycle model. The results suggest that the elimination of capital income taxation would have very substantial economic effects. For example, a complete shift to consumption taxation might raise steady-state output by as much as 18 percent, and consumption by 16 percent. The long-run welfare gain from such a shift would for plausible parameter values exceed $150 billion annually. Stated somewhat differently, shifting to consumption taxation would raise the lifetime utility of the representative consumer by the equivalent of about six years' income in the new steady state. These estimates dwarf estimates of the static welfare cost of taxation, and significantly exceed even extreme previous estimates of the dynamic loss. This study departs from earlier analyses of the effects of taxes on capital income in several respects. Probably the most important difference between this treatment and most preceding ones lies in the assumptions about the interest elasticity of saving. It is shown below that the common two-period formulation of saving decisions yields quite misleading results. A more realistic model of life cycle savings demonstrates that, for a wide variety of plausible parameter values, savings are very interest elastic. This implies that shifting away from capital income taxation would significantly increase capital formation, making possible long-run increases in consumption. Many studies of the welfare effects of capital income taxation have ignored the general equilibrium effects of increased capital formation. In an economy with life cycle savings, there is no presumption that the undistorted growth path corresponds to any sort of social optimum. As Peter Diamond has shown, life cycle savings can lead to a steady-state capital intensity either greater or less than the Golden Rule level. More generally, it is clear that there is no reason to believe that a life cycle economy will maximize any particular intertemporal social welfare function. A fundamental tenet of welfare evaluation is that preexisting distortions must be considered in evaluating the consequences of tax changes. The results presented in this paper take explicit account of the nonoptimal character of the no-tax steady state. This explains in large part why such a sizeable welfare effect of capital taxes is found. In an economy far from the Golden Rule level of capital intensity, there are substantial gains in steady-state consumption achievable through increased capital formation. Section I of the paper examines the aggregate savings function in a continuous-time life cycle framework. The second section clarifies the differences between wage and consumption taxes. An aggregate production function is added to complete the model in the third section. The effects of changes in capital taxes on both steady-state incidence and welfare are considered within a general equilibrium framework. The final section of the paper discusses some implications of the results and suggests areas which appear to warrant further study. *Assistant professor of economics, Massachusetts Institute of Technology, and research analyst, National Bureau of Economic Research. I am grateful to Alan Auerbach, Martin Feldstein, Laurence Kotlikoff, to the participants in the NBER Workshop on Business Taxation, and to the Harvard Public Finance Seminar for useful discussions. James Poterba and James Buchal performed the numerical calculations.

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