Capital Income Taxation Revisited: The Roles of Information Friction and External Finance

This paper reexamines the classical issue of optimal taxation on capital income in an overlapping-generations growth model where the risky capital-producing projects are financed partially with external funds in the presence of costly state verification. In this context, we first show that the information friction creates standard credit market distortions that are exacerbated by both capital income taxation and external financing. We subsequently show from both growth and welfare perspectives that the optimal tax rate on capital income decreases with the severity of asymmetric information and the extent of external financing. Alternatively, our analysis suggests that the presence of informational friction in the credit market introduces a rationale for more conservative taxation on capital, especially when the need for external financing is high.