Tabarrok on Feldstein on Capital Taxation

The plethora of discount
rates and taxes obscures the basic point in Feldstein’s argument against
capital taxation.  Here is a bare-bones version.

There are three
goods, labor, apples and oranges.  Assume that the government taxes
oranges at a higher rate than apples.  A tax on oranges is also a tax
on labor since you need labor to buy oranges and if the price of
oranges is high the value of your labor is low.

Now let’s show
that a reduction in the orange tax matched by an increase in the labor
tax to keep total tax revenues constant can make everyone better
off.  The simplest case is to assume a tax on oranges so high
that no one buys any oranges.  Orange tax revenue is therefore zero.
Now we get rid of the tax on oranges and add an equal-revenue tax on labor
(zero).  So long as the consumer cares at all about oranges he now buys
more oranges and is better off (because he now consumes a variety of
fruit and has an increased incentive to work).  The consumer will still be better off even if we replace the zero-revenue orange tax with a
small labor tax which increases government revenues.  The zero-revenue assumption makes the argument obvious but is not at all necessary for the results.

The basic point is that the tax on oranges distorts the labor-leisure choice and the apples-oranges choice.  A tax on labor distorts only the labor-leisure choice and so is preferred.

For Feldstein’s argument rename oranges as savings, apples as present consumption and labor as income.  To see a counter-argument introduce more people into the model and rename oranges as yachts.