On the Effects of Income Taxation in the Presence of Human and Physical Capital

Abstract

This Paper aims to investigate the effects of income taxation on endogenous variables and utility level in the steady state using a general equilibrium model with overlapping generation in the presence of human and physical capital. Labor income and inheritance tax has no impact on the endogenous varialbes if the government pays back the agents in the form of a lump-sum transfer, while interest tax does influence them. The Highest utility level is not achieved when the interest tax rate is zero. The Utility level increases as the interest tax rate increases up to some point, after which it decreases. This is because though the human capital increases output and raises earning capacity, the cost function of human capital investment is convex.

We show this using a simple simulation. An Implication of this is that both the contribution of human capital to earning capacity and the convexity of the cost function should be considered in determining income taxation.