What Does the Capital Income Tax Distort?

In addition to taxing future consumption (including leisure), capital income taxation subsidizes the consumption of durables. The taxation of future consumption may be characterized as an intertemporal distortion, while the subsidy to durables may be characterized as a static distortion. The magnitude of this intertemporal distortion has received considerable attention, but few analyses have dealt with the static distortion. This paper decomposes the excess burden arising from capital income taxation into its static and intertemporal components. The analysis is based on a life-cycle model with a constant elasticity of substitution utility function in one durable and one nondurable good. Calculations indicate that for reasonable utility parameters, the static component of the excess burden is of the same order of magnitude as the intertemporal component. In the case of major durable goods such as housing, which have relatively low depreciation rates, the static component is large and may exceed the intertemporal component. This suggests that an additional tax on the purchase of new durable goods would significantly reduce the overall excess burden arising from a capital income tax.