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Constrained Inefficiency and Optimal Taxation with Uninsurable Risks

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  • Piero Gottardi
  • Atsushi Kajii
  • Tomoyuki Nakajima

Abstract

Should capital and labor be taxed, and if so how when individuals' labor and capital income are subject to uninsurable idiosyncratic risks? In a two period general equilibrium model with production, we first show that reducing investment is welfare improving if households are homogeneous enough ex ante. On the other hand, when the degree of heterogeneity is sufficientlyhigh a welfare improvement is achieved by increasing investment, even if the investment level is already higher than at the e¢ cient allocation obtained when full insurance markets were available. Consequently, the optimal capital tax rate might be negative. We derive a decomposition formula of the e¤ects of the tax which allow us to determine how the sign of optimal tax on capital and labor depends both on the nature of the shocks and the degree of heterogeneity among consumers as well as on the way in which the tax revenue is allocated.

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Bibliographic Info

Paper provided by European University Institute in its series Economics Working Papers with number ECO2010/02.

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Date of creation: 2010
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Handle: RePEc:eui:euiwps:eco2010/02

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  1. Julio Davila & Jay H. Hong & Per Krusell & Jose-Victor Rios-Rull, 2005. "Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks," PIER Working Paper Archive 05-023, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  2. Stiglitz, Joseph E, 1982. "The Inefficiency of the Stock Market Equilibrium," Review of Economic Studies, Wiley Blackwell, vol. 49(2), pages 241-61, April.
  3. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
  4. Atsushi Kajii & Antonio Villanacci & Alessandro Citanna, 1998. "Constrained suboptimality in incomplete markets: a general approach and two applications," Economic Theory, Springer, vol. 11(3), pages 495-521.
  5. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  6. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
  7. N. Gregory Mankiw & Matthew Weinzierl & Danny Yagan, 2009. "Optimal Taxation in Theory and Practice," Journal of Economic Perspectives, American Economic Association, vol. 23(4), pages 147-74, Fall.
  8. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  9. Julio Davila & Jay H. Hong & Per Krusell & José-Victor Rios Rull, 2005. "Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks," Post-Print halshs-00196183, HAL.
  10. George-Marios Angeletos, 2007. "Uninsured Idiosyncratic Investment Risk and Aggregate Saving," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(1), pages 1-30, January.
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Cited by:
  1. Acikgoz, Omer, 2013. "Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets," MPRA Paper 50160, University Library of Munich, Germany.
  2. Sigrid Röhrs & Christoph Winter, 2011. "Wealth inequality and the optimal level of government debt," ECON - Working Papers 051, Department of Economics - University of Zurich.
  3. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2011. "Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets," Economics Working Papers ECO2011/18, European University Institute.

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