Optimal taxation of normal and excess returns to risky assets

Abstract We examine optimal linear taxes on normal and excess capital income with heterogeneous rates of return, alongside an optimal nonlinear earnings tax. Households optimize a portfolio containing three types of assets: risk‐free, diversifiable risky, and private investment with idiosyncratic risk and heterogeneous expected returns. We define normal capital income as the risk‐free rate times the size of the portfolio, and excess returns as any deviations from it. In this setting, taxing excess returns is ineffective for redistribution due to a Domar–Musgrave effect and only generates revenue, to be balanced against the cost of revenue uncertainty. Taxing normal returns does serve redistribution, as they reveal information about the investors' types beyond what the earnings tax base reveals.