Optimal Design of Forest and Capital Income Taxation in an Economy with an Austrian Sector

This paper develops an intertemporal harvesting model under future timber price risk to re-examine the optimal design of forest and capital income taxes in an economy with an Austrian sector. The previous literature sought a tax structure which would give a neutral tax system in the sense of yielding the same discounted net return from investment in both sectors. While tax neutrality is a desirable goal in the first-best situation where government does not face budget constraint, the situation may change in the second-best case when the government tax revenue requirement is taken into account. This paper shows that both introducing uncertainty and allowing for the government tax revenue requirement in the expected value sense changes the results from the optimal design of tax structure. Given a (non-distortionary) site productivity tax it is generally desirable to use both the yield tax on harvesting and the capital income subsidy or tax. The level of the yield tax reflects a trade-off between its social insurance and distortionary properties. Under these circumstances the task of the capital income tax is to alleviate distortion created by the yield tax. This can be done by a capital income subsidy (tax) when the substitution effect of the yield tax is negative (positive) and current harvesting is too small (too large) from the viewpoint of society.