Labor-dependent capital income taxation

Capital taxation which is negatively correlated with labor supply is proposed. This paper uses a life-cycle model of heterogeneous agents that face idiosyncratic productivity shocks and shows that the tax scheme provides a strong work incentive when households possess large assets and high productivity later in the life-cycle, when they otherwise would work less. The system also adds to the saving motive of prime-age households and raises aggregate capital. The increased economic activities expand the tax base and the revenue neutral reform results in a lower average tax rate. The negative cross-dependence generates a sizable welfare gain in the long-run relative to the tax system that treats labor and capital income separately as a tax base. The reform, however, can hurt the elderly during the transition with a high marginal tax on their capital income.