This paper introduces wealth into the utility function in an otherwise standard dynamic optimal taxation framework. The optimal tax on capital income is positive in steady state. This stands in contrast to the classic results of Chamley (1986) and Judd (1985) where the optimal steady state capital tax rate is zero. When consumers get direct utility from their holdings of wealth, they are willing to accept a lower rate of return on those holdings: their intertemporal marginal rate of substitution (IMRS) is reduced. It is this reduction in the IMRS that drives the positive optimal capital tax rate in steady state.

This paper explores tax arbitrage incentives and behaviours in OECD countries, and their implications for tax systems more broadly. It focuses on how OECD tax systems might encourage business owners, in particular owners of unincorporated businesses and owner-managers of closely held incorporated businesses, to minimise their tax burdens through tax arbitrage. The paper finds that tax incentives to incorporate and earn capital income through corporations have increased in the last two decades. It shows that there has been an increase in incorporated businesses in many OECD countries, and that this has at least partly been driven by widening PIT-CIT differentials. The paper also finds that, in many countries, a combination of tax system features – related to corporate, dividend, capital gains and inheritance taxation – provide particularly strong incentives to retain earnings inside corporations.

Interest paid by U.S. state and local bonds is tax-exempt, making these bonds attractive to investors – though a tax rule limits arbitrage opportunities by restricting associated interest expense deductions. Prior to 1986, U.S. banks were not subject to the interest deduction limitation, making banks preferred holders of tax-exempt debt. U.S. banks used tax-exempt debt to reduce their tax liabilities by roughly 20% in the 1950s and 45% in the 1960s, rising to as much as 80% by the early 1980s. Despite their special exemption, and in part because of their widespread holdings, banks did not benefit from investing in tax-exempt bonds, as competition between banks reduced bond yields to the point of investor indifference.