Macroeconomic Effects of Capital Tax Rate Changes

We study aggregate, distributional, and welfare effects of a permanent reduction in the capital tax rate in a quantitative model with capital-skill complementarity and household heterogeneity. Such a tax reform leads to expansionary long-run aggregate output and investment effects, but those are coupled with increases in wage, consumption, and income inequality. The tax reform is not self-financing and its effects depend crucially on whether the government cuts lump-sum transfers or raises distortionary labor or consumption tax rates for financing. The former results in a larger aggregate expansion, but at the expense of a greater rise in inequality. As a result, the latter is relatively more beneficial for unskilled households. We find that the tax reform, when the consumption tax rate adjusts, leads to a Pareto improvement in terms of life-time welfare. For transition dynamics, monetary policy, in addition to the fiscal adjustments, matters. In particular, if monetary policy inflates away a portion of the public debt, the economy can avoid the short-run contraction that would arise otherwise.