A Framework for Optimal Income Tax

Should labour or capital be taxed more heavily?

The Role of Taxes in a Fair and Productive Society

Taxes are one of the most powerful tools governments possess. Through taxation, governments finance public goods, redistribute resources, and shape the incentives that guide economic activity. Roads, education systems, healthcare, legal institutions, and national security all rely on tax revenues. At the same time, tax systems influence how people work, invest, and build businesses.

Role of Government Taxes

Because of this dual role, tax policy sits at the intersection of two fundamental goals of public policy: economic efficiency and social fairness.

A well-designed tax system should raise sufficient revenue to support essential public services while minimizing distortions to economic activity. At the same time, it should reflect widely shared principles of fairness and legitimacy. Citizens are more willing to contribute to public finances when they believe that the tax burden is distributed in a just and reasonable way.

Two concepts are particularly important in this discussion: equality and equity.

Equality refers to treating everyone the same under the law. In taxation, this could mean applying identical tax rates to all income sources. However, strict equality does not always produce outcomes that people perceive as fair.

Equity, by contrast, recognizes that different economic situations may justify different treatment. A system based on equity considers how income is generated, the risks taken to generate it, and the broader impact of that activity on society. Equity therefore focuses not only on how much people earn, but how they earn it.

From this perspective, labour income occupies a special place in the economy.

Labour is one of the most direct and transparent ways individuals create value. When someone works as a teacher, engineer, nurse, entrepreneur, or craftsman, their income reflects a combination of effort, skill, and time. Labour income generally requires active participation and cannot easily be generated without personal contribution.

For this reason, many people intuitively view labour as one of the fairest ways to earn income. Work represents a clear exchange: individuals contribute effort and skills, and society rewards that contribution through wages or earnings. Labour income is also broadly distributed across society, meaning that most households depend on work as their primary source of livelihood.

In contrast, some forms of income can arise with far less direct effort. Ownership of assets, scarcity of resources, or financial market movements can generate income even when little new value is created. These distinctions do not imply that investment or capital ownership is illegitimate. Investment is essential for economic growth and innovation. However, it does suggest that different income sources may reasonably be treated differently within the tax system.

A fair tax system therefore requires more than simply deciding whether labour or capital should be taxed more heavily. Instead, it requires a deeper understanding of the role different types of income play in the economy.

The framework presented in this report builds on that idea. By examining income through the lenses of effort, productive value, and risk, it becomes possible to design a tax structure that both supports economic growth and reflects widely shared principles of fairness.

Such an approach moves the debate beyond the traditional labour-versus-capital divide and toward a more nuanced question:

Which types of economic activity should society encourage, and which types should carry a greater share of the tax burden?

Three Sources of Income in the Economy

Most income can be understood as coming from three fundamental sources.

First, labour. This includes wages, salaries, and professional services. Labour income reflects human effort, skill, and time.

Second, productive capital. This includes entrepreneurial profits, business investment, and equity financing. Productive capital enables firms to build factories, develop new technologies, and create jobs.

Third, economic rents. Economic rents arise when income is generated not from creating new value, but from controlling scarce assets. Examples include land rents, monopoly profits, or passive income derived from existing assets.

Income Tax Revenue Sources

This distinction has long been recognized in economic thought. Adam Smith already distinguished between wages, profits, and rents in The Wealth of Nations. Later economists such as David Ricardo and Henry George argued that economic rents are fundamentally different from productive income because they do not require new economic activity to exist.

This insight leads to a powerful implication for taxation.

Degrees of Income

Another useful concept is the idea of degrees of income.

• First-degree income is generated directly through labour. Salaries, freelance work, and professional services all fall into this category.
• Second-degree income is generated by investing labour income. Dividends from shares, profits from business ownership, and long-term investment returns fall into this category.
• Third-degree income arises when financial activity becomes increasingly detached from productive economic activity. Examples include speculative trading, certain derivatives strategies, or purely financial asset appreciation.

As income moves further away from direct productive activity, the argument for preferential tax treatment becomes weaker.

This perspective helps explain why many people intuitively feel that wages should not be taxed more heavily than certain types of passive capital gains.

Why Some Taxes Harm Growth More Than Others

Modern research in public economics consistently shows that different taxes affect economic growth very differently.

OECD studies on tax policy and economic growth have repeatedly found that some taxes are far more damaging to long-term productivity than others. In particular, taxes on labour and corporate investment tend to reduce incentives to work, save, and invest. By contrast, taxes on economic rents tend to have much smaller effects on economic activity.

The OECD’s widely cited ranking of taxes by their impact on growth generally follows this order:

1. Corporate income taxes (most harmful for growth)
2. Personal income taxes on labour
3. Consumption taxes
4. Property and land taxes (least harmful)

Income Tax Triangle

The reason is simple. Taxes on labour can discourage work. Taxes on investment can discourage business formation and innovation. But taxes on economic rents often do not reduce production, because the underlying asset remains scarce regardless of the tax.

For example, land in the center of Brussels will remain valuable whether or not land rents are taxed. The supply of land does not change.

But from a fairness perspective, raising consumption tax is risky. Consumption taxes are usually less progressive than income taxes, and OECD analysis explicitly warns that shifting from personal income taxes toward consumption taxes reduces progressivity and can worsen inequality unless compensation is built in.

This is why many economists argue that a well-designed tax system should focus more heavily on economic rents than on productive activity.

An Optimal Income Tax Framework

To translate this insight into policy, it is useful to evaluate different income types according to several indicators.

An Optimal Income Tax Framework can be built around ten indicators combining both fairness and economic efficiency:

1. Labour contribution
2. Productive economic value
3. Capital risk
4. Investment horizon
5. Negative/Positive externalities
6. Scarcity/Economic rent
7. Distance from labour
8. International mobility
9. Inequality/Concentration
10. Administrative ease of taxation

Optimal Income Tax Framework

Each income source can be evaluated along these dimensions. The higher the score, the stronger the justification for taxation. When different income sources are scored in this way, a clear pattern appears.

Optimal Income Tax Framework Implications

Income generated directly through labour tends to score very low. Entrepreneurial income also scores relatively low because it combines effort, innovation, and risk.

Income Tax Illustration (1-low tax; 5-High tax)

By contrast, passive income streams derived from asset ownership tend to score much higher. Rental income, interest income from safe assets, and speculative financial gains tend to have low labour input, lower productive value, and higher wealth concentration.

This framework therefore produces a simple ordering principle.

The Belgian Tax Structure

Belgium provides an interesting case study because its tax system strongly taxes labour while treating some capital income relatively lightly.

Marginal tax rates on labour income can reach roughly 50 percent, with additional social security contributions applied to wages. When employer and employee contributions are combined, the effective tax burden on labour can be substantially higher than 50%.

Belgium Income Tax System

By contrast, capital gains on financial assets have historically been taxed lightly or not at all, although recent reforms have begun to change this. Dividends and interest income are typically subject to a flat withholding tax of around 30 percent.

Property income and inheritance taxes also play a role in the system, but the overall structure still places a particularly heavy burden on labour.

This pattern is not unique to Belgium. Many advanced economies have historically relied heavily on labour taxation because it is administratively easy to collect. However, this reliance can create distortions if labour becomes the most heavily taxed form of income.

A Different Tax Logic

A tax system based on effort, productive value, and risk would produce a different ranking of income types.

Labour income would generally face the lowest tax burden because it directly reflects effort and productivity.

Entrepreneurial income would also remain relatively lightly taxed because it involves both risk and innovation.

Productive capital investment, such as long-term equity investment, would face moderate taxation. While these incomes involve less labour, they still contribute to economic growth.

Passive income derived primarily from economic rents would face higher taxation. Examples include land rents or income streams that rely on asset scarcity rather than new production.

Speculative financial activity could also face higher taxation where it contributes little to real economic activity.

This approach does not eliminate taxation on capital. Rather, it distinguishes between productive capital and economic rents.

A More Balanced Tax System

The goal of such a framework is not simply to reduce taxes overall. Instead, the goal is to align taxation with economic incentives.

A tax system structured in this way would:

• Encourage work and entrepreneurship
• Support productive investment
• Reduce reliance on labour taxation
• Shift the burden toward economic rents

Many economists believe this direction would both improve economic efficiency and enhance perceptions of fairness.

After all, most people intuitively understand that income generated through effort and risk-taking is fundamentally different from income generated through passive ownership.

Is the Belgian Tax Triangle Upside Down?

In the framework presented earlier, taxation should increase as income becomes less connected to effort and productive economic activity.

In other words, the optimal tax triangle should look like this:

• Labour income should face the lowest tax burden
• Productive investment should face moderate taxation
• Economic rents and passive income should face the highest taxation

This ordering reflects both fairness and economic efficiency. Labour represents effort and participation in the economy. Productive investment carries risk and supports growth. Economic rents, by contrast, often arise from ownership of scarce assets rather than new production.

However, when we examine the Belgian tax system, the structure appears almost inverted.

In Belgium, labour income faces some of the highest effective tax rates in Europe. Marginal personal income tax rates reach around 50 percent, and when social security contributions are included, the total tax wedge on labour can exceed 55 percent for many workers.

By contrast, several forms of capital income historically faced much lighter taxation. Capital gains on financial assets were largely untaxed until very recently. Dividends and interest income are typically taxed at a flat rate around 30 percent, and certain forms of asset appreciation or inheritance may face relatively modest effective rates depending on structure and exemptions.

Viewed through the lens of the economic triangle, the result is striking:

• The labour corner carries the heaviest tax burden
• The productive capital corner faces moderate taxation
• Some forms of economic rent and speculative income face comparatively lighter taxation

In this sense, the triangle appears upside down relative to the framework based on effort, value, and risk.

Should the Triangle Be Reversed?

Instead of taxing labour most heavily, the system would shift the tax burden toward income sources that are less connected to effort and productive activity.

In practical terms, such a rebalancing could involve:

• Lower taxes on labour income
• Moderately lower taxes on entrepreneurship and productive investment
• Stable or moderately higher taxation of passive capital income
• Stronger taxation of economic rents, such as land rents or speculative gains

The goal would not be to eliminate taxation of capital. Rather, the objective would be to distinguish between productive investment and passive economic rents.

This distinction is critical. Investment that finances new businesses or technologies contributes directly to economic growth. Income derived primarily from scarcity or asset ownership does not necessarily do so.

Why Did the Triangle Become Upside Down?

Understanding why the current system looks inverted requires examining the political economy of taxation.

Several factors explain why many countries, including Belgium, rely heavily on labour taxation.

1. Labour taxes are easy to collect

Wages are visible, predictable, and easy to track through payroll systems. Employers act as tax collectors through withholding, making labour income one of the most administratively efficient tax bases.

Capital income, by contrast, is often harder to observe and easier to shift across borders or legal structures.

As a result, governments have historically relied heavily on labour taxes simply because they are easier to enforce.

2. Capital is mobile, labour is not

Capital can move internationally relatively easily. Investors can relocate assets, shift profits, or invest abroad. Labour is far less mobile, particularly for middle-income workers.

Because of this mobility, governments often compete to keep capital taxes relatively low in order to avoid capital flight.

This dynamic is sometimes referred to as tax competition.

3. Tax systems evolve incrementally

Most tax systems are not designed from scratch according to economic theory. Instead, they evolve gradually through political compromise and incremental reform.

Over time, layers of exemptions, deductions, and special rules accumulate. The result is often a system that reflects historical compromises rather than a coherent economic framework.

4. Political incentives favor hidden taxes

Labour taxes are often embedded in payroll deductions and social contributions, which makes them less visible to taxpayers than certain other taxes.

Taxes on wealth or property, by contrast, are often more politically visible and can face stronger opposition.

This can lead governments to rely more heavily on taxes that are less noticeable but economically more distortionary.

Conclusion

The debate about taxation is often framed too narrowly as a choice between taxing labour or taxing capital.

A more useful approach is to ask how income is actually generated.

Recognizing that the triangle has effectively been inverted opens the door to a different approach. A tax system designed around effort, value creation, and risk could rebalance the burden across income sources.

Such a system would aim to:

• Reduce the tax wedge on labour
• Maintain incentives for entrepreneurship and productive investment
• Shift part of the burden toward economic rents and passive income sources

This rebalancing would align taxation more closely with both economic efficiency and widely held notions of fairness.

Instead of penalizing work, the system would encourage productive activity while ensuring that income derived from ownership of scarce assets contributes appropriately to public finances.

Solutions could be:

1. Reduce the Tax Burden on Labour

Labour is one of the most direct ways people create value in the economy. Work requires effort, skills, and time, and for most households it is the primary way to earn a living.

High payroll taxes and income taxes increase the cost of hiring workers and reduce the incentive to work more hours or increase productivity.

A core reform should therefore aim to lower the tax wedge on labour. This could include reducing payroll contributions, increasing tax-free income thresholds, or lowering marginal income tax rates.

Specific reform: Reduce employer and employee social security contributions by a certain percentage points for middle-income workers.

This change would directly reduce the cost of hiring workers and increase net wages for employees. Lower labour taxes would improve work incentives while supporting job creation, particularly in sectors where labour costs represent a large share of total expenses.

2. Distinguish Productive Capital from Economic Rent

Not all capital income is the same.

Productive investment should face moderate taxation to maintain incentives for innovation and business creation. Economic rents, however, can be taxed more heavily without discouraging productive activity because they arise from scarcity rather than effort or risk.

Specific reform: Introduce a land value tax on the underlying value of land, separate from buildings or improvements.

Land value taxes target economic rents because land itself cannot be moved or reduced in supply. Unlike taxes on labour or investment, taxing land value does not discourage productive activity. Instead, it captures part of the value generated by urban development and public infrastructure. If rental taxation becomes too high, it can discourage housing investment.

Two identical houses:

House A in rural area House B in central Brussels

A land value tax would tax House B much more, because the location itself is more valuable, even if the buildings are identical. In Belgium’s case, land and property taxes are combined as one leaving room for improvement.

3. Reduce Tax Stacking Across the Economic Lifecycle

One of the striking features of many tax systems, including Belgium’s, is that the same euro is taxed repeatedly as it moves through the economy.

Income can be taxed as corporate profit, then as dividends, then again through consumption taxes when spent, and potentially once more through inheritance taxes when wealth is transferred.

Specific reform: Introduce a lifetime inheritance allowance combined with a higher tax rate on very large inheritances.

Such a rebalancing would not necessarily reduce total government revenue. Instead, it would redistribute the tax burden in a way that aligns more closely with economic incentives and widely held perceptions of fairness. Inheritance taxes often work best when they focus on very large transfers of wealth rather than small family inheritances.

4. Tax Shifts, Not Tax Increases

The most important point is that these taxes should not simply be added on top of existing taxes.

If taxes on rent or inheritance increase without reducing labour taxes, the overall tax burden simply rises.

This is why economists often argue that tax systems rely too heavily on:

• Labour taxation
• Productive capital taxation

and too little on true economic rents, especially land value.

© Adriaan Golsteyn