Optimal Income Taxation with Asset Accumulation

By Árpád Ábrahám, Sebastian Koehne and Nicola Pavoni

http://d.repec.org/n?u=RePEc:zbw:vfsc14:100406&r=dge

Several frictions restrict the government’s ability to tax assets. First of all, it is very costly to monitor trades on international asset markets. Moreover, agents can resort to non-observable low-return assets such as cash, gold or foreign currencies if taxes on observable assets become too high. This paper shows that limitations in asset observability have important consequences for the taxation of labor income. Using a dynamic moral hazard model of social insurance, we find that optimal labor income taxes typically become less progressive when assets are imperfectly observed. We evaluate the effect quantitatively in a model calibrated to U.S. data.

This is timely research given the recent crackdown on tax havens around the world. But tax havens are always going to exist, from some distant island to the shoe box dug in the garden. The paper shows that the ability to hide asset from the view of the tax authority has a dramatic impact on the tax schedule and even on labor income tax. And this is before considering issues of tax competition which may amplify these pressures.