The optimal distribution of the tax burden over the business cycle

This paper analyses optimal capital and labour income taxation for households differentiated by labour skill, income and wealth, under a balanced government budget, over the business cycle. A model incorporating capital-skill complementarity in production and differential access to labour and capital markets is developed to capture the cyclical characteristics of the U.S. economy, as well as the empirical observations on wage (skill premium) and wealth inequality. We find that optimal taxes for middle-income households are more volatile than the remaining taxes. Moreover, the government re-allocates the total tax burden in bad times so that the share of total tax revenue paid by middle-income households rises. This share also rises for low-income households but by significantly less, while the tax share for skilled households falls.