Optimal Capital Income Taxation with Means‐tested Benefits
| DOI | http://doi.org/10.1111/sjpe.12130 |
| Author | John Piggott,Cagri S. Kumru |
| Date | 01 July 2017 |
| Published date | 01 July 2017 |
OPTIMAL CAPITAL INCOME
TAXATION WITH MEANS-TESTED
BENEFITS
Cagri S. Kumru*
,
** and John Piggott**
,
***
ABSTRACT
This paper studies the interaction between capital income taxation and a means-
tested age pension. Our results document that the existence of a social insurance
program financed from general revenue puts an upward pressure on the optimal
tax rate. We also show that there is a negative relation between taper (benefit-
reduction) and optimal capital income tax rates. The potential welfare gain from
optimizing capital taxation in the presence of a universal retirement transfer sys-
tem is relatively higher. However, when the transfer is substantially means
tested, the gain is lower, because the means test effectively operates as a tax on
retirement capital.
II
NTRODUCTION
In their seminal papers, Judd (1985) and Chamley (1986) stated that the gov-
ernment should not tax capital income in the long run, i.e., the optimal capital
income tax rate is zero. The recent literature documents two major channels
that invalidate Judd and Chamley’s results. First, if a life-cycle framework is
used (as opposed to the infinite horizon framework adopted by Chamley and
Judd) and an age-specific taxation is not available, capital income taxation
may be a second-best solution.
1
Second, if markets are incomplete, resulting
in liquidity constraints and/or uninsurable idiosyncratic income risk, then a
non-zero capital income tax may dominate a zero capital tax environment,
because higher net-of-tax labor earnings relax liquidity constraints and/or pro-
vide more opportunity for self-insurance. Conesa et al. (2009) showed that the
optimal capital income tax rate may be non-zero by using a life-cycle incom-
plete market overlapping generations (OLG) model. They calculate an optimal
rate of 36% for the United States.
Taking the above observation as a point of departure, this paper studies
the impact of means testing (resource testing) public pensions, a feasible
*The Australian National University
**The ARC Centre of Excellence in Population Ageing Research (CEPAR)
***The University of New South Wales
1
Gervais (2012) shows that a progressive tax on labor income can also be used to mimic
an optimal age-dependent tax policy.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12130, Vol. 64, No. 3, July 2017
©2017 Scottish Economic Society.
227
policy action equivalent to introducing a capital income tax on retirement
capital. The United Kingdom is one of a number of countries with a means-
tested pension program: the means-tested social insurance program provides
an old age pension income subject to a means testing of income and asset
holdings. Over the last several years various reforms have been enacted to the
UK means-tested pension. It is therefore suitable for our analytic purposes.
This paper contributes to the literature from two perspectives. First, it
extends on Conesa et al. (2009) by adding a means-tested pension program
that interacts with the capital income tax rate. As our main aim was to ana-
lyze the interaction between means-tested pension programs and taxes on cap-
ital income, we have intentionally kept our benchmark model similar to that
of Conesa et al. (2009).
2
Yet, we have chosen to calibrate our model to the
UK economy as the United Kingdom already has a means-tested pension
program. As a result, we were able to assign real values to the pension
program parameters. This allows us to determine the effect of an implicit tax
on capital income on the optimal capital income tax rate. Second, it carries
Sefton and van de Ven (2009) study on the relation between means-tested
benefits and taxation to a richer modeling environment so that we can quan-
tify the optimal income tax rates as in Conesa et al. (2009) for the United
Kingdom.
In means-tested pension programs, the retirement benefit function depends
on individual income at the time the benefits are paid. This dependence is
assumed to be linear, with a constant negative slope (taper rate), i.e., the
benefits are reduced by a fraction of current income. The taper cannot turn
the benefits negative. This introduces non-linearity. As dissaving is a source
of income later in the life-cycle, the taper can act as a non-linear tax on
savings.
We start with a benchmark model, in which the taper rate is 100% and the
income tax system (baseline tax system) mimics that of the United Kingdom,
and calibrate the model economy to the UK data. Keeping everything else
constant, we calculate the optimal tax system in this economy. Later, we
reduce the taper rate to 40%, keeping the baseline tax system intact, and cal-
culate the associated optimal tax system. As the United Kingdom reformed
the means-tested pension program by reducing the taper rate from 100% to
40% in 2003, we call the former the pre-reform taper rate and the latter the
post-reform rate. We repeat our analysis assuming a zero taper (universal pen-
sion program) and the complete removal of the means-tested pension program
as well.
We find that the optimal capital income tax rates in both pre- and post-
reform economies in the United Kingdom are significantly positive at 33%
2
As in Conesa et al. (2009), we ignore the transitional dynamics, use lognormal distribu-
tions of earnings shocks, and ignore the female labor supply decisions. In a recent paper,
Fehr and Kindermann (2015) showed that incorporating transitional dynamics generates
much lower optimal capital income tax rates. Guvenen et al. (2015) showed that earnings
shocks display substantial deviations from lognormality-the standard assumption in the
incomplete markets. Kaygusuz (2015) showed that incorporating female supply decisions to
tax-transfer models also has important implications.
228 CAGRI S. KUMRU AND JOHN PIGGOTT
Scottish Journal of Political Economy
©2017 Scottish Economic Society
and 34%, respectively. Furthermore, we show that the optimal capital
income tax rate is 37% and 31% in the universal pension and the com-
plete removal settings, respectively. The complete removal setting is the
closest to that of Conesa et al. (2009). From here we can see that having
means-tested and universal pension programs put upward pressure on the
optimal capital income tax rate as they increase the government’s revenue
requirement.
More importantly, we show that there is a negative relation between taper
rates and the optimal capital income tax rate. The taper rate substitutes for
the proportional capital tax: lower taper rates lead the planner to pick
higher capital tax rates; higher taper rates reduce the need for linear capital
taxes and the planner picks lower rates. The intuition is as follows: first, a
lower taper rate implies a higher revenue requirement (revenue effect). The
revenue effect is a mechanical reduction in the revenue needed to be raised
when the taper is higher. The higher revenue requirement leads to higher
capital and labor tax rates. Second, the means-tested pension program acts
as a non-linear capital income tax by only targeting the individuals over the
retirement age and reduces the need for the linear tax (substitution effect).
Thus, when the taper rate is higher, the optimal capital income tax rate
becomes relatively lower. Third, as in Peterman (2013a), the optimal tax on
capital increases when the size of the means-tested pension program increases
as a result of a decrease in the taper rate (pension benefit effect). Revenue
and pension benefit effects are somehow related. Lower taper rates imply
that more individuals receive more generous means-tested benefits. Hence,
the government needs to increase taxes on capital and labor incomes to ful-
fill its revenue requirement. As retired individuals now get higher benefits,
the government would prefer to tax capital income more to unwind some of
the generous retirement benefits.
Interestingly, when the taper rate is 100%, the welfare improvement as a
result of changing the tax system from the baseline to the optimal one is
the lowest among all the settings we considered. This result further
highlights the role of a means-tested pension program as an effective way of
targeting capital income. It has also been shown that a similar pattern of
life-cycle asset holdings can be generated by either reforming the baseline
tax system or changing the taper rate. From this perspective, the existence
of a means-tested pension program in the economy enhances the policy
maker’s options.
Our results suggest not only that positive capital income taxation may be
welfare improving but also that means testing publicly financed retirement
pensions has a similar impact. Means testing may not only reduce the revenue
requirement for a given pension benefit but may also improve resource alloca-
tion and aggregate welfare. This is of special interest in light of the current
global debate on public pension reform and taxation.
Although social insurance benefits have been means tested for a long time,
these policies have only recently attracted systematic attention from econo-
mists. By using a partial equilibrium model with a binary labor-leisure
OPTIMAL CAPITAL INCOME TAXATION 229
Scottish Journal of Political Economy
©2017 Scottish Economic Society
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