Econ303 Income tax or consumption tax?
More general income tax
Suppose that we have flat rate income tax. The tax rate is τ . Income tax applies to all
sources of households income, which includes:
1. labor income. The after-tax income from supplying labor is (1− τ) · w · l.
2. rental income from capital net of depreciation. Part of the rental rate of capital which
compensates capital depreciation is not taxed. When calculating the Corporate income
tax, depreciation is treated as cost thus deductible. The after-tax income from supply-
ing capital net of capital depreciation is r̂k− δk− τ · (r̂− δ) · k = (1− τ) · (r̂− δ) · k =
(1− τ)r · k.
3. interest income from financial securities. We abstract away from different risks, ma-
turity structure, and returns of various assets. We assume that all of them pay the
same real interest rate and all of them mature in one period. The financial assets in
our simplified world takes the form of real bond. The after-tax income from financial
assets is (1− τ) · rb.
We put subscripts on variables to denote time. wt and rt are the wage rate and the real
interest rate at time t. ct and lt are consumption and labor supply of households at time t,
kt is the capital stock held by households at time t. bt is the amount of real bond household
bought at period t− 1 and matures at time t. The households budget constraint at time t is
ct + kt+1 + bt+1 = (1− τ)wtlt[1 + (1− τ)rt]kt + [1 + (1− τ)rt]bt
The tax on labor income changes the household’s work vs. consumption choice as shown
before. The tax on capital and savings changes the households intertemporal choice. Under
flat rate income tax, the marginal conditions become
1. work vs. consumption
MRS between lt and ct = (1− τ)wt
2. intertemporal choice
MRS between ct+1 and ct =
1 + (1− τ)rt+1
The tax on return of capital and saving reduces the actual interest rate. It makes consump-
tion tomorrow more expensive. Households will consume more today and save less for the
future (substitution effect). Capital accumulates at a slower rate in