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Working Paper

On the Optimality of Differential Asset Taxation

How should a government balance risk-sharing and redistributive concerns with the need to provide incentives for investment? Should they tax firm profits or individual savings, or simply levy lump-sum transfers? I address these questions in an environment with entrepreneurs and workers in which output is subject to privately observed shocks and firm owners can both misreport profits and abscond with a fraction of assets. When frictions in financial markets restrict private risk-sharing, the stationary efficient allocation may be implemented in a competitive equilibrium with collateral constraints using (occupation-specific) linear taxes on savings and profits and lump-sum transfers to newborns. Further, the two taxes serve distinct roles and in general differ from one another. The savings tax affects consumption smoothing and may be positive or negative depending on the strength of general equilibrium effects, while the profits tax shares risk between the government and entrepreneurs, is unambiguously positive, and depends solely on the degree of frictions in financial markets.

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Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Phelan, Tom. 2022. “On the Optimality of Differential Asset Taxation.” Federal Reserve Bank of Cleveland, Working Paper No. 19-17R.