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Nonoptimality of the Friedman Rule with Capital Income Taxation


  • This paper was written when I was visiting Nuffield College, Oxford University. I thank Steve Nickell for the hospitality. Moreover, I am grateful to Ned Phelps and Michael Woodford for fruitful discussions, and to Pierpaolo Benigno, Joseph Zeira, two anonymous referees, and one editor of the journal, Kenneth West, for constructive comments and valuable suggestions.


This paper studies the efficient taxation of money and factor income in intertemporal optimizing growth models with infinite horizons, transaction costs technologies, and flexible prices. Second-best optimality calls for a positive inflation tax and a nonzero capital income tax when there are restrictions on taxation of production factors or profits/rents. Our cases of nonoptimality of the Friedman rule—which differ from those of Mulligan and Sala-i-Martin (1997) and extend substantially those of Schmitt-Grohè and Uribe (2004a)—follow from the violation of the Diamond and Mirrlees (1971) principle on production efficiency.