This model shows that capital income taxation does not affect real wages. Judd's theorem (1985) that a zero capital income tax rate is optimal for workers is based on the assumption that all capital has the effect of increasing the marginal productivity of labor. However, in reality, some capital lowers the marginal productivity of labor through automation (technological unemployment). Therefore, this model assumes two types of capital. Labor-complementing capital increases the marginal productivity of labor (real wages), while labor-substituting capital decreases it. The rates of return are kept equal between the two. Using such an economic growth model, we analyze the long-run effects of taxes on real wages. Even if capital income tax is imposed, real wages don’t change because both labor-complementing capital and labor-substituting capital decrease. In contrast, value-added tax results in reduced real wages. This is because labor costs are deducted in capital income tax, but not in value-added tax. Capital income tax is more suitable for income redistribution than value-added tax. These conclusions also apply to an open economy.
Unemployment rate dynamics in small open economy: The case of Serbia