In a paper dealing with the supply side of economics, Lucas has shown that a policy that frees capital income from tax has significant positive effects on capital stock and consumption. A problem of his analysis, however, is that it has dealt only with the economies on balanced growth paths. This paper considers transitional dynamics of tax reform. While using Lucas' values of parameters but modifying his utility function to be more flexible, it shows the optimal tax rate on capital income is not zero. However, the optimal rate is also shown to be much smaller than its actual rate.
