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Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets

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Author Info

  • Piero Gottardi

    (European University Institute)

  • Atsushi Kajii

    (Institute of Economic Research, Kyoto University)

  • Tomoyuki Nakajima

    (Institute of Economic Research, Kyoto University)

Abstract

How should capital and labor be taxed when individuals' labor income is subject to unin- surable idiosyncratic risks? To address this question, we develop a tractable infinite horizon model with incomplete markets and consider a dynamic optimal taxation problem with linear taxes on the wage and interest income. We derive two general principles for public policy in such an environment: (i) providing an insurance for the idiosyncratic income risks; and (ii) allocating tax burdens efficiently over time. The first principle calls for taxing the labor income. The second principle clarifies when accumulating government debt is welfare improving, and also when the tax rate on physical capital needs to be strictly positive in the long run. We also calibrate our model to the U.S. economy and find that the presence of idiosyncratic income risks significantly affects the optimal tax rates and the optimal amount of the government debt.

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Bibliographic Info

Paper provided by Kyoto University, Institute of Economic Research in its series KIER Working Papers with number 745.

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Length: 36pages
Date of creation: Dec 2010
Date of revision:
Handle: RePEc:kyo:wpaper:745

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Keywords: incomplete markets; constrained inefficiency; optimal taxation; Ramsey equilibrium.;

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  1. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
  2. 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.
  3. Tom Krebs, 2003. "Human Capital Risk And Economic Growth," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 709-744, May.
  4. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  5. Marcet, Albert & Obiols-Homs, Francesc & Weil, Philippe, 2007. "Incomplete markets, labor supply and capital accumulation," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2621-2635, November.
  6. Bassetto, Marco & Kocherlakota, Narayana, 2004. "On the irrelevance of government debt when taxes are distortionary," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 299-304, March.
  7. repec:spo:wpecon:info:hdl:2441/8623 is not listed on IDEAS
  8. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, December.
  9. DAVILA, Julio & HONG, Jay H. & KRUSELL, Per & RIOS-RULL, José-Victor, . "Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks," CORE Discussion Papers RP -2463, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  10. Conesa, Juan Carlos & Kitao, Sagiri & Krueger, Dirk, 2006. "Taxing capital? Not a bad idea after all!," CFS Working Paper Series 2006/21, Center for Financial Studies (CFS).
  11. Larry E. Jones & Rodolfo Manuelli, 1990. "A Convex Model of Equilibrium Growth," NBER Working Papers 3241, National Bureau of Economic Research, Inc.
  12. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2014. "Constrained inefficiency and optimal taxation with uninsurable risks," CIGS Working Paper Series 14-002E, The Canon Institute for Global Studies.
  13. Eva Carceles Poveda & Arpad Abraham, 2004. "Endogenous Trading Constraints with Incomplete Asset Markets," 2004 Meeting Papers 667, Society for Economic Dynamics.
  14. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  15. 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.
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Cited by:
  1. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2014. "Constrained inefficiency and optimal taxation with uninsurable risks," CIGS Working Paper Series 14-002E, The Canon Institute for Global Studies.
  2. Acikgoz, Omer, 2013. "Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets," MPRA Paper 50160, University Library of Munich, Germany.

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