Abstract:
This paper characterizes optimal labour and capital income taxation when access to income shifting opportunities is heterogeneous. I develop a two-period model in which individuals can reclassify labour income as capital income by paying a fixed cost (an extensive margin, e.g. incorporation or organisational changes) and a variable shifting cost (an intensive margin). In the benchmark without shifting, redistribution is implemented through the labour income tax while capital income is left untaxed. When shifting is possible, the optimal policy compresses the labour-capital tax wedge: stronger shifting responses call for lower labour income tax rates and higher capital income tax rates. Allowing the capital income tax to depend on reported labour income, the optimal capital tax schedule is progressive in reported labour income when shifting elasticities increase with income. A key implication is that extensive-margin participation receives disproportionate weight for capital taxation, whereas intensive and extensive responses affect the optimal labour tax symmetrically.
