Capital Taxation with Heterogeneous Discounting and Collateralized Borrowing

Biljanovska, Nina; Vardoulakis, Alexandros

doi:10.17016/FEDS.2017.053

Working Paper

Capital Taxation with Heterogeneous Discounting and Collateralized Borrowing

Abstract: We study optimal long-run capital taxation in a closed economy with heterogeneity in agents' time-discount factors where borrowing is allowed but restricted by a collateral constraint. Financial frictions distort intertemporal optimization margins and the tax system serves a dual role: first, it is used to finance government consumption; second, it serves to alleviate the distortions arising from the binding collateral constraint. The discrepancy between the private and the social discount factors pushes for a subsidy on capital, while the discrepancy introduced by the collateral constraint pushes for a tax in the long-run. When consumption smoothing motives are muted, the two effects counter-balance each other and the tax is zero. With finite elasticity of intertemporal substitution, the second discrepancy dominates and the tax on capital income is positive in the long-run.

Keywords: Ramsey taxation; Collateral constraint; Heterogeneous discount factors; Tax on capital;

JEL Classification: E60; E61; E62; H21;

https://doi.org/10.17016/FEDS.2017.053