Human Capital and Optimal Positive Taxation of Capital Income

This paper analyzes optimal linear taxes on capital and labor incomes in a life-cycle model of human capital investment, financial savings, and labor supply with heteroge- nous individuals. A dual income tax with a positive marginal tax rate on not only labor income but also capital income is optimal. The positive tax on capital income serves to alleviate the distortions of the labor tax on human capital accumulation. The optimal marginal tax rate on capital income is lower than that on labor income if savings are elastic compared to investment in human capital; substitution between inputs in human capital formation is difficult; and most investments in human capital are verifiable. Numerical calculations suggest that the optimal marginal tax rate on capital income is close to the tax rate on labor income.