The taxation of capital returns in overlapping generations models

This paper shows that in the Diamond (1965) overlapping generations economy with production and capital savings, there is a period-by-period balanced fiscal policy supporting a steady state allocation that Pareto-improves upon the laissez-faire competitive equilibrium steady state (whether dynamically inefficient or efficient) without resorting to intergenerational transfers. The policy consists of taxing linearly (or subsidizing, in the dynamically efficient case) the returns to capital, while balancing the budget period by period through a lump-sum transfer (or tax, respectively) in second period. This intervention grants every generation the highest steady state utility attainable through markets (i.e. remunerating factors by their marginal productivities and without transfers) which under laissez-faire is not a competitive equilibrium outcome. A transition from the competitive equilibrium steady state to this other steady state is also Pareto-improving when the former is dynamically inefficient. The result disentangles from redistributive considerations the impact of the taxation of capital returns on steady state welfare, and thus provides a rationale for the taxation of capital returns that is based on efficiency considerations and not on redistributive goals.