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

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  • Tomoyuki Nakajima

    (Kyoto University)

  • Atsushi Kajii

    (Kyoto University)

  • Piero Gottardi

    (European University Institute)

Abstract

How should capital and labor be taxed when individuals' labor income is subject to uninsurable 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 signicantly affects the optimal tax rates and the optimal amount of the government debt.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 455.

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Date of creation: 2011
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Handle: RePEc:red:sed011:455

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  1. 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.
  2. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  3. Juan Carlos Conesa & Sagiri Kitao & Dirk Krueger, 2009. "Taxing Capital? Not a Bad Idea after All!," American Economic Review, American Economic Association, vol. 99(1), pages 25-48, March.
  4. 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.
  5. Larry E. Jones & Rodolfo E. Manuelli & Peter E. Rossi, 1993. "On the Optimal Taxation of Capital Income," NBER Working Papers 4525, National Bureau of Economic Research, Inc.
  6. Marco Bassetto & Narayana Kocherlakota, 2010. "On the Irrelevance of Government Debt When Taxes are Distortionary," Levine's Working Paper Archive 506439000000000295, David K. Levine.
  7. Eva Carceles Poveda & Arpad Abraham, 2004. "Endogenous Trading Constraints with Incomplete Asset Markets," 2004 Meeting Papers 667, Society for Economic Dynamics.
  8. 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.
  9. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  10. Larry E. Jones & Rodolfo Manuelli, 1990. "A Convex Model of Equilibrium Growth," NBER Working Papers 3241, National Bureau of Economic Research, Inc.
  11. Tom Krebs, 2003. "Human Capital Risk And Economic Growth," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 709-744, May.
  12. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, December.
  13. 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.
  14. repec:spo:wpecon:info:hdl:2441/8623 is not listed on IDEAS
  15. 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. 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.

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