Capital income taxation is a complicated issue because of the g- eral equilibrium implications these taxes have with regard to the int- sectoral and intertemporal allocation of economic resources. Together with Michael Stimmelmayr (CES, Munich) and Christian Keuschnigg (IFF, St. Gallen), Doina Radulescu from the Ifo Institute for E- nomic Research has designed a complex and particularly elegant - tertemporal general equilibrium model of the economy, called IfoMod. IfoMod makes it possible to calculate the welfare gains and losses from fundamental tax reforms in present value terms. One of the tax reforms Doina Radulescu analyses is the move - wards a dual income tax, as is used in some Scandinavian countries. She analyses this tax using German data, because it was recently p- posed, among others, by the German Council of Economic Advisors. In the meantime, IfoMod has become a standard tool for the Ifo Institute. According to the Council of Economic Advisors, it is not only sta- of-the-art, but one of the world s most developed and advanced CGE models for the purpose of analysing intertemporal allocation problems in growing economies. Hans-Werner Sinn Preface This book was written during my time acting as a PhD candidate in the Public Finance Department at the Ifo Institute for Economic Research in Munich.

1 Introduction 1 2 Why Does Germany Need a Reform of Capital Income Taxation? 5 2.1 The German Tax System of Corporate Taxation 5 2.2 The German Tax Reform 2000 7 2.3 Theoretical and Empirical Arguments for Lower Capital Income Taxation 10 2.4 Germany's Declining Economy and the Increasing Tax Competition in the EU 11 2.5 The Non-Transparent and Complicated German Tax System 16 2.6 Decreasing Revenues From Corporate Taxes 19 2.7 Summary 21 3 The Dual Income Tax 23 3.1 Definition and Main Features of the Dual Income Tax 23 3.2 The Case for a Dual Income Tax 25 3.2.1 The DIT and the Basic Principles of Taxation: Efficiency and Equity 26 3.2.2 Administrative Simplicity 33 3.2.3 Revenue Aspects 34 3.3 The Experience of Nordic Countries 35 3.3.1 Denmark 39 3.3.2 Finland 39 3.3.3 Norway 40 3.3.4 Sweden 42 3.4 Problems Related to the DIT Implementation 45 3.4.1 Difficulties Arising from the Separation of Labor and Capital Income 45 3.4.2 Solutions Applied by the Nordic Countries 45 3.5 Concrete Proposals for Germany 47 3.5.1 Main Features of a DIT System as Proposed by the GCEA (2003) 47 3.5.2 The DIT Proposal of Sinn (2003a) 48 3.6 Summary 51 Appendix - A Reform Proposal for Switzerland 53 4 The Model 55 4.1 Overview of Different CGE Models and Their Characteristics 55 4.2 The Model 59 4.2.1 Business Sector 59 4.2.2 Stylized Analysis of Tax Policy and Effective Marginal Tax Rates 76 4.2.3 Households and General Equilibrium 78 4.2.4 General Macroeconomic Equilibrium 86 4.2.5 Welfare Analysis and the Marginal Excess Burden of Taxes 88 4.2.6 Rest of the World 91 5 Simulation Results 93 5.1 Model Calibration 93 5.1.1Production Technology Parameters 94 5.1.2 Macroeconomic Data 96 2.2 The Marginal Excess Burden 97 5.3 Implementing a DIT as Suggested by the GCEA (2003) 98 5.3.1 Partial Analysis of the Effects of Each Individual Tax Rate Change 100 5.3.2 Steady State Comparisons of the Overall Reform Package 105 5.3.3 Transition Paths 112 5.4 Implementing a DIT as Suggested by Sinn (2003a) 119 5.4.1 Steady State Comparisons 120 5.4.2 Transition Paths 125 5.5 The Two Proposals Compared 129 5.6 Sensitivity Analysis 133 6 Conclusion 137 Appendix A 141 Appendix B 143 Appendix B.1 Hayashi's Proof 143 Appendix B.2 Intertemporal Optimization of Domestic Households 145 Appendix B.3 Walras Law 147 Appendix B.4 Savings Investment Identity 150 Appendix C Functional Forms 153 Appendix C.1 Trend Growth 153 Appendix C.2 Factor Demands 155 Appendix C.3 Adjustment Cost Function 156 Appendix C.4 Agency Cost Function 157 Appendix D Computational Strategy 159 References 161