The Redistributive Benefits of Progressive Labor and Capital Income Taxation

In this paper we argue that a capital income tax is an effective tool for redistribution and insurance even when progressive labor income taxes are available to the policy maker. To make this point we construct a large scale Overlapping Generations Model with uninsurable income risk, show that it has a wealth distribution that matches the data well, and then use it characterize fiscal policies that achieve a desired degree of redistibution in society. We find that it is suboptimal to rely exclusively on progressive labor income taxes to achieve any given level of redistribution in society, and thus that a positive capital income tax should be part of a government policy aimed at redistributing welfare across ex ante homogenenous, but ex post heterogeneous households. We finally characterize the optimal Rawlsian poliy and find that it includes a significantly positive capital in addition to a redistributive labor income tax.