Several frictions might prevent (or make undesirable) the full taxation of
savings. Due to international capital mobility, for instance, the government
may not have perfect control over agents’ saving and consumption decisions.
We show in this paper that a restricted ability to tax savings has important
implications for the taxation of labor income. Specifically, when agents
have preferences with convex absolute risk-aversion, we find that optimal
marginal tax rates on labor income become more regressive when savings
cannot be fully taxed.
We derive this result in a two-period model of social insurance. By exerting
effort, agents can influence their labor income realizations. Moreover,
agents can accumulate a risk-free bond. We show that the trade-offs in
designing optimal effort incentives depend crucially on the tax rate on bond
returns. Through this channel, the ability of taxing savings interacts with
the structure of optimal labor income taxes.