doi.org/10.71734/DP‑2026‑39

Can governments reduce labor income taxes without harming economic efficiency? This study explores the trade-offs of shifting taxation from labor to capital income, focusing on Germany and the European Union. By comparing taxes on savings, productive capital, and bequests, the authors reveal how different approaches affect employment, investment, and intergenerational welfare.

Introduction

This paper investigates the economic and distributional effects of reducing labor income taxes and financing the revenue loss through higher capital income taxes. The study is particularly relevant for Germany, where labor taxes are high, and the taxation of capital income is a recurring policy debate. The authors aim to determine which form of capital taxation – savings, productive capital, or bequests – minimizes economic distortions while balancing intergenerational welfare.

Methodology

The authors develop a two-region overlapping-generations (OLG) model calibrated to Germany and the rest of the European Union. The model incorporates life-cycle saving, labor market frictions, and integrated capital markets, allowing for a detailed analysis of how tax reforms affect employment, saving, investment, and international capital flows. The study simulates a revenue-neutral reduction in labor income taxes, offset by increases in one of three capital tax instruments: household savings income, productive capital, or accidental bequests.

Key Findings

The paper builds on the theory of optimal taxation, which traditionally argues against taxing capital income in the long run due to its negative effects on investment and growth. However, the authors challenge this view by considering a more realistic setting with overlapping generations, life-cycle saving, and international capital mobility. They argue that the economic and welfare effects of shifting taxation from labor to capital depend critically on which component of capital income is taxed. Taxes on savings, productive capital, and bequests operate through distinct economic channels, affecting households, firms, and international capital flows differently:

1. Benchmark Reform: Taxing Household Savings Income
   Reducing labor income taxes by 5 percentage points and financing the loss through higher taxes on household savings income leads to short-term gains in employment and output. Employment rises by 2.5 percentage points, and output increases by 2.4 percent. However, higher savings taxes reduce the after-tax return on assets, leading to a long-term decline in aggregate saving (1.5 percent) and a worsening of the net foreign asset position (10 percentage points of GDP). Future cohorts benefit from higher employment and disposable income, but older generations face welfare losses due to lower asset returns and pension income.
2. Alternative 1: Taxing Productive Capital
   Financing the labor-tax cut through a tax on productive capital performs poorly in terms of long-run efficiency. The higher user cost of capital discourages investment, leading to an 8 percent decline in the domestic capital stock and a 3 percent reduction in output. While employment increases modestly, the overall economic gains are limited. Future cohorts experience smaller welfare improvements, as lower capital accumulation depresses wages and productivity.
3. Alternative 2: Taxing Accidental Bequests
   A tax on accidental bequests avoids directly distorting firms’ investment decisions, resulting in the strongest employment and output gains among the three reforms. Employment rises by over 3 percentage points, and output increases by 3.5 percent in the long run. However, this approach generates a highly uneven intergenerational welfare profile. Working-age cohorts benefit significantly, but the first post-reform cohort and distant future generations experience welfare losses due to weaker net foreign assets and reduced consumption opportunities.

Conclusions

The study highlights the importance of distinguishing between different forms of capital taxation when designing tax reforms. While shifting taxation from labor to household savings income delivers the most balanced trade-off between efficiency and intergenerational welfare, taxing productive capital leads to significant economic inefficiencies, and taxing bequests creates sharp intergenerational disparities. Policymakers should carefully consider the composition of capital taxation to achieve desired economic and distributional outcomes. Future research could extend this analysis by incorporating demographic changes.

Schön, M., N. Stähler (2026), Taxing capital, rewarding labor? The international and generational dimensions, Bundesbank Discussion Paper, No 39/2026.