Capital Income Taxation and Public Choice

The supply-side argument that taxes on income from capital are distortionary and therefore reduce welfare is widely accepted by economists. We conduct an analysis of taxation of income from capital in a dynamic general equilibrium model. We show that, when young people face liquidity constraints, they favour taxation of income from capital, because it allows them to defer part of their of their tax bills to a point at which they can afford to pay them. Old people, on the other hand favour a shift from taxation of capital to taxation of labour and, with the population structure implied by the 1991 life table this is sufficient to provide a majority against taxation of income from capital. The outcome of a plebiscite differs from the choice made by a benevolent social planner because the former does not take into account the votes of those not yet born. We show that, if young people receive resources such as bequests at the start of their working lives, this alleviates their wealth constraint and changes the welfare implications of tax on income from capital. We also show that the outcome of a vote on capital income taxation is sensitive to the life-expectancy of the population.