Accounting for the disconnectedness of the economy in OLG models: a case for taxing capital income

The paper extends the works by Judd [K.L. Judd, Redistributive Taxation in a Simple Perfect Foresight Model, J. Public Econ.28 (1985), 59–83.] and Chamley [C. Chamley, Optimal taxation of capital income in general equilibrium with infinite lives,Econometrica, 54 (1986), 607–622.], who establish that in the long run the capital income tax should be zero, by considering adiscrete time version of the Blanchard–Buiter–Weil perpetual youth model. We show that an independent source of non-zerotaxation arises whenever the economy is “disconnected” and this feature is properly taken into account by the policymaker. Moreprecisely, if the weight attached to each cohort in the social welfare function equals the corresponding actual share in thepopulation, there is a force pushing towards positive taxation of capital income, which acts as a Pigouvian intervention. Moreover,room for this intertemporal correction shrinks as the relative weight of a cohort tends to zero: thus, the optimal tax rate decreaseswith age and tends to zero for the oldest. We also show that our result depends neither on life-cycle behavior, as pointed out by the previous literature on OLG models, nor on population growth.