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Capital Taxation: Quantitative Explorations of the Inverse Euler Equation

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  • Emmanuel Farhi

    (MIT)

  • Ivan Werning

    (MIT)

Abstract

This paper provides and employs a simple method for evaluating the quantitative importance of distorting savings in Mirrleesian private-information settings. Our exercise takes any baseline allocation for consumption—from US data or a calibrated equilibrium model using current policy—and solves for the best reform that ensures preserving incentive compatibility. The Inverse Euler equation holds at the new optimized allocation. Our method provides a simple way to compute the welfare gains and optimized allocation—indeed, yielding closed form solutions in some cases. When we apply it, we find that welfare gains may be quite significant in partial equilibrium, but that general equilibrium considerations mitigate the gains significantly. In particular, starting with the equilibrium allocation from Aiyagari’s incomplete market model yields small welfare gains.

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Bibliographic Info

Paper provided by Laboratory for Macroeconomic Analysis in its series Working Papers with number CAS_RN_2007_3.

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Length: 32 pages
Date of creation: Feb 2007
Date of revision:
Handle: RePEc:cas:wpaper:cas_rn_2007_3

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  1. Mark Aguiar & Erik Hurst, 2005. "Consumption versus Expenditure," Journal of Political Economy, University of Chicago Press, vol. 113(5), pages 919-948, October.
  2. McCall, John J, 1970. "Economics of Information and Job Search," The Quarterly Journal of Economics, MIT Press, vol. 84(1), pages 113-26, February.
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Cited by:
  1. Alex Edmans & Xavier Gabaix & Tomasz Sadzik & Yuliy Sannikov, 2009. "Dynamic Incentive Accounts," NBER Working Papers 15324, National Bureau of Economic Research, Inc.

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