Transitional dynamics of optimal capital taxation

A known result holds that capital taxes should be high in the short run and low or zero in the long-run steady state. This paper studies the dynamics of optimal capital taxation during the transition, when a high rate is no l onger optimal but the economy is still in flux. The main result is that cap ital should be taxed whenever the sum of the elasticities of marginal utili ty with respect to consumption and labor supply are rising and subsidized w henever this sum is falling. If the utility function displays increasing re lative risk aversion, this paradoxically implies that capital should be tax ed when the capital stock is below the modified golden-rule level and subsi dized whenever it exceeds this level. Thus, savings incentives sometimes ca n be more desirable when the capital stock is large than when it is small.