Optimal Capital Taxation with Borrowing Constraints and Entrepreneurial Heterogeneity

This paper analyzes the optimal taxation of labor and various forms of capital in a model with entrepreneurial heterogeneity and financial frictions as in Itskhoki and Moll (2019a). We consider both a closed economy, populated by workers that buy corporate bonds, and a small open economy with hand-to-mouth workers where entrepreneurs finance capital by using their wealth and by borrowing abroad. The optimal fiscal policy differs depending on whether we consider the closed economy or the small open economy. In the former the taxes on labor and pure capital should be positive, while the tax on capital income should be zero. The wealth tax levied on workers and entrepreneurs and the pure capital tax levied on firms are equivalent fiscal instruments. When we consider a small open economy, we find that the pure capital tax should be set to zero but both the capital income tax and the labor tax should be positive. In this case the capital income tax and the wealth tax are perfect substitutes.