First-best optimality in capital income taxation

Abstract

In case of risk, especially aggregate risk which cannot be insured, the literature states that for achieving first-best optimality state-dependent lumpsum taxes are absolutely necessary. However, we show in a two-asset portfolio choice model that a suitably designed capital income tax can ensure a first-best solution without using state-dependent lump-sum taxes. Therefore, taxation must not focus on the single assets’ returns but on the prices of commodities, embedded in these assets. Hence, our tax system uses the prices for resource shifting into the future and for incurring risk as tax bases.