Should-Read: Robert Waldmann (2008): Optimal Capital Income Taxation It Is

Should-Read: A veritable Samson armed with the jawbone of an ass—that is, the standard public finance model of capital-income taxation—Robert Waldmann wreaks havoc on the intellectual hosts of the Philistines by the mere expedient of taking the view that the most useful way to use the model is to ask what it tells us is optimal policy from a random initial starting position, rather than what optimal policy will be after a long period of optimal adjustment has passed. Very smart. But not of great interest because it brings with it unwelcome political conclusions to the overwhelming bulk of those who are etched up to follow the argument; Robert Waldmann (2008): Optimal Capital Income Taxation It Is: “The simplest… standard growth… aK model with optimizing consumers with logarithmic utility…

…or… Cass-Koopmans with Cobb-Douglas production and logarithmic utility…. The distribution of wealth is unequal at time 0. A utilitarian state would want to redistribute income… first best… with a lump sum transfer… rule that out by setting an upper limit on… tax [rates]…. What is the best policy?… Tax capital income at the maximum… until perfect equality is achieved…. [Then] there is no more reason to tax and taxes are zero….

A simple-minded application of the model to policy would suggest that we should tax as much as we can until everybody is perfectly equal. Now the model is not the world, and this would be terrible policy. However, the argument for roughly the opposite policy is based on the same silly model plus totally turning its implications upside down by pretending that time has already gone to infinity.

The assumption of logarithmic utility… makes a huge difference…. Constant elasticity of substitution…. If the state can’t precommit, the implications are just like those for logarithmic utility…. With recommitment, if the intertemporal elasticity of substitution is less than one… tax as much as possible until the initially rich are as poor as the initially poor, and then tax them so more.

These conclusions follow from analysis using standard techniques of the simplest case of the standard model. I think that they are not noted in the literature. In conclude… that… mathematical analysis of stylized models is taken seriously so long as the conclusions fit… prejudices…