A Normative Case for Positive Capital Income Taxes

We characterize a planner’s optimal allocation of consumption and capital in the presence of privately-observed idiosyncratic shocks to capital depreciation and a proportional cost of reversing investment to transform used capital into consumption. In the competitive decentralization of the planner’s optimal balanced growth path, the optimal tax rate on capital income, which implements the planner’s optimal (partial) sharing of idiosyncratic depreciation risks, equals the reversibility cost, regardless of the distribution of shocks and the parameters of the production and utility functions. The risk reduction mechanism differs from the Domar-Musgrave mechanism because the government cannot share the unobservable idiosyncratic shocks.