Redistribution with unobservable bequests: a case for taxing capital income

This paper addresses the question of the optimal taxation of labour and interest income in an overlapping generations model with two unobservable characteristics, ability and inheritance. We assume realistically that saving can only be taxed anonymously, whereas the tax on labour earnings can be individualized and made non-linear. In such a setting, we show that a with- holding tax on interest income along with a non-linear tax on labour income is desirable. The role of interest income taxation is to indirectly tax inherited wealth.