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A Unified Framework For Optimal Taxation With Undiversifiable Risk

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  • Panousi, Vasia
  • Reis, Catarina

Abstract

This paper considers a model of linear capital taxation for an economy where capital and labor income are subject to idiosyncratic uninsurable risk. To keep the model tractable, we assume that investment decisions are made before uncertainty is realized, so that the realization of the capital and labor income shocks only affects current consumption. In this setting, we are able to jointly analyze capital and labor income risk and derive analytical results regarding the optimal taxation of capital. We find that the optimal capital tax is positive in the long run if there is only capital income risk. The reason for this is that the capital tax provides insurance against capital income risk. Furthermore, for high levels of risk, increasing the capital tax may actually induce capital accumulation. On the other hand, if there is only labor income risk, the optimal capital tax is zero. The sign of the optimal tax can only be negative if the two types of risk are negatively correlated and labor income risk is large enough.

Suggested Citation

  • Panousi, Vasia & Reis, Catarina, 2021. "A Unified Framework For Optimal Taxation With Undiversifiable Risk," Macroeconomic Dynamics, Cambridge University Press, vol. 25(6), pages 1331-1345, September.
    • Handle: RePEc:cup:macdyn:v:25:y:2021:i:6:p:1331-1345_1
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    Cited by:

    1. Thomas Phelan, 2019. "Efficient wealth inequality and differential asset taxation with dynamic agency," 2019 Meeting Papers 1350, Society for Economic Dynamics.
    2. Tom Phelan, 2019. "On the Optimality of Differential Asset Taxation," Working Papers 19-17R2, Federal Reserve Bank of Cleveland, revised 04 Feb 2025.
    3. Thomas Phelan, 2025. "On The Optimality Of Differential Asset Taxation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 66(1), pages 53-78, February.
    4. Krueger, Dirk & Ludwig, Alexander & Villalvazo, Sergio, 2021. "Optimal taxes on capital in the OLG model with uninsurable idiosyncratic income risk," Journal of Public Economics, Elsevier, vol. 201(C).
    5. Corina Boar & Matthew Knowles, 2020. "Entrepreneurship, Agency Frictions and Redistributive Capital Taxation," Discussion Paper Series, School of Economics and Finance 202004, School of Economics and Finance, University of St Andrews.

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