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Can capital income tax improve welfare in an incomplete market economy with a labor-leisure decision?

  • Danijela Medak Fell

    (Institute of Public Finance, Zagreb)

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    This paper is a quantitative exercise in the economic analysis of optimal fiscal policy. We look at an incomplete market economy where agents face idiosyncratic labor productivity shocks and borrowing constraints. We find the steady state equilibrium of this economy and then analyze the effect of a government policy introducing a capital income tax and redistributing the proceeds of tax collection back to the agents in the form of a labor subsidy. We find that this type of policy can indeed improve the welfare of the economy, but its quantitative effect is small. We thus conclude that using capital income tax as fiscal policy instrument is not an effective way to cure the problem of market incompleteness.

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    File URL: http://www.ijf.hr/eng/FTP/2006/1/medak-fell.pdf
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    Article provided by Institute of Public Finance in its journal Financial Theory and Practice.

    Volume (Year): 30 (2006)
    Issue (Month): 1 ()
    Pages: 67-76

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    Handle: RePEc:ipf:finteo:v:30:y:2006:i:1:p:67-76
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    1. Teresa Garcia-Milà & Albert Marcet & Eva Ventura, 1995. "Supply side interventions and redistribution," Economics Working Papers 115, Department of Economics and Business, Universitat Pompeu Fabra.
    2. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
    3. Aiyagari, S Rao, 1995. "Optimal Capital Income Taxation with Incomplete Markets, Borrowing Constraints, and Constant Discounting," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1158-75, December.
    4. Fernando Alvarez & Urban J. Jermann, 2000. "Efficiency, Equilibrium, and Asset Pricing with Risk of Default," Econometrica, Econometric Society, vol. 68(4), pages 775-798, July.
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