Globalization Institute Working Paper
Macroeconomic Effects of Capital Tax Rate Changes
Abstract: We study aggregate, distributional and welfare effects of a permanent reduction in the capital tax rate in a quantitative equilibrium model with capital-skill complementarity. Such a tax reform leads to expansionary long-run aggregate effects, but is coupled with an increase in wage and income inequality. Moreover, the expansionary aggregate effects are smaller when distortionary labor or consumption tax rates have to increase to finance the capital tax rate cut, driven by effects on labor supply decisions. An extension to a model with heterogeneous households shows that consumption inequality also increases in the long run, which leads to a further rise in wage inequality. We study transition dynamics and show that joint modeling of monetary and fiscal policy response is important for analyzing short-run effects. Finally, we contrast the long-term aggregate welfare gains with short-term losses, regardless of how the tax cut is financed. In the model with heterogeneous households, we additionally show that welfare gains for the skilled go together with welfare losses for the unskilled.