Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

This paper studies optimal taxation in the standard incomplete markets model. We formulate a Ramsey problem and solve numerically for the optimal (time varying) paths of proportional capital and labor income taxes, (possibly negative) lump-sum transfers, and government debt. The solution maximizes welfare along the transition between an initial steady state, calibrated to replicate key features of the US economy, and an endogenously determined final steady state. We find that in the optimal (utilitarian) policy: (i) capital income taxes are front-loaded hitting the imposed upper bound of 100 percent for 33 years before decreasing to 45 percent in the long-run; (ii) labor income taxes are reduced to less than half of their initial level, from 28 percent to about 13 percent in the long-run; and (iii) the government accumulates assets over time reducing the debt-to-output ratio from 63 percent to 􀀀17 percent in the long-run. This leads to an average welfare gain equivalent to a permanent 4.9 percent increase in consumption. Though distortive, taxes reduce the variance both cross-sectionally and over time of after-tax income, increasing welfare for both a redistributive and an insurance motive which we quantify.