Optimal capital and labor taxes with heterogeneous agents: making everybody happy

We study the optimal path for capital and labor taxes in a dynamic economy with heterogeneous agents. In an otherwise standard model we concentrate on tax reforms that are both Pareto effcient and Pareto improving. Also, we assume the capital tax rate can never rise above its initial level and lump-sum transfers between agents are impossible. We study the whole path for taxes, including the transition, from acurrent status quo to the long run steady state. We find that introducing all these elements in the analysis changes considerably the nature of tax reforms. In particular, capital taxes have to be maintained at their status quo level for at least about ten years in order not to harm poor agents. Labor tax rates, by contrast, are initially lowered substantially, in order to boost capital accumulation while capital taxes are still high. As a consequence, the government often accumulates debt that persists in the long run. We show that in the absence of a non-distortive means of redistribution heterogeneity imposes a severe constraint on the optimal policy that drives the solu-tion much further away from the first best than in the standard case in which only non-distortive means of raising revenue are lacking.