The Optimal Tax Rate for Capital Income is Negative

We examine the problem of optimal taxation in a dynamic economy with imperfectly competitive markets. We find that the optimal tax system will tend to provide subsidies for the purchase of capital goods to offset gaps between price and marginal cost. The average tax on capital income will be negative, even if pure profits are not taxed away and even if the alternative distortionary taxes have an infinite efficiency cost. These arguments hold even if it is necessary to tax consumption goods which also sell above marginal cost; the difference is that capital goods are intermediate goods and consumption goods are final goods. Since observed markups are greater for equipment than for construction, this analysis justifies the Investment Tax Credit's discrimination in favor of equipment over structures.