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On the Optimality of Differential Asset Taxation


How should a utilitarian government balance redistributive concerns with the need to provide incentives for business creation and investment? Should they tax business profits, the (risk-free) savings of owners, or some combination of both? To address this question, this paper presents a model in which the desirability of differential asset taxation emerges endogenously from the presence of agency frictions. I consider an environment in which entrepreneurs hire workers and rent capital to produce output subject to privately observed shocks and have the ability to both divert capital to private consumption and abscond with a fraction of assets. To provide incentives to invest, the wealth of an agent must depend on the performance of his/her firm, leading to ex-post inequality in all efficient allocations. I show that the efficient stationary distribution of wealth exhibits a thick right (Pareto) tail, with the degree of inequality monotonically increasing in the number of workers per entrepreneur. The efficient allocation is then implemented in a general equilibrium model using history-independent linear taxes on risk-free savings and (reported) business profits. The tax on entrepreneurs’ savings may be positive or negative, while the tax on business profits depends solely upon the degree of private information and is independent of all technological and preference parameters.

Keywords: Optimal taxation, moral hazard, optimal contracting, entrepreneurship.
JEL Codes: D61, D63, E62.


Suggested citation: Phelan, Thomas. 2019. “On the Optimality of Differential Asset Taxation.” Federal Reserve Bank of Cleveland, Working Paper no. 19-17. https://doi.org/10.26509/frbc-wp-201917.

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