The Welfare Cost of Capital Taxation: An Asset Market Approach (Working Paper 2011-03)

Working Paper
August 17, 2011

Marika Santoro and Chao Wei

We use an asset pricing perspective to provide a novel interpretation of the marginal welfare cost of capital income taxes. We show that the marginal welfare cost can be interpreted as the normalized present discounted value of consumption distortions from capital income taxes. Such an interpretation emphasizes the importance of the discount rate used to value future consumption distortions, especially in the presence of uncertainty. We find that the discount rate decreases as the capital income tax rate increases, thus increasing the welfare cost of taxes. The variations in the discount rate are caused by the amplified responses of consumption to exogenous shocks as a result of capital income taxation. We find that the welfare cost may be
underestimated if variations in risky discount rates are ignored, especially when tax rates are high.