Optimal taxation and the Domar‐Musgrave effect

Abstract This article concerns the optimal choice of flat taxes on labor and capital income, and on consumption, in a tractable economic model in which agents are subject to idiosyncratic investment risk. We identify the tax rates which maximize welfare in stationary equilibrium while preserving tax revenue, finding that an increase in welfare equivalent to a permanent increase in consumption of nearly 7% can be achieved by only taxing capital income and consumption. The Domar‐Musgrave effect explains cases where it is optimal to tax capital income. We characterize the dynamic response to the substitution of consumption taxation for labor income taxation.