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Pareto-Improving Optimal Capital and Labor Taxes

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  • Katharina Greulich
  • Sarolta Laczó
  • Albert Marcet

Abstract

We study Pareto-optimal fiscal policy in a model with agents who are heterogeneous in their labor productivity and wealth. We show a natural modification of the standard Ramsey problem to guarantee that long-run capital taxes are zero. We focus on Pareto-improving policies and we find that a gradual reform is crucial in achieving a Pareto improvement: labor taxes should be cut and capital taxes should remain high for a very long time before reaching zero. Therefore, the long-run optimal tax mix is the opposite of the short- and medium-run one. This policy redistributes wealth in favor of workers so that all agents benefit, and it favors quick capital growth after the reform. The labor tax cut is financed by deficits which lead to a positive level of government debt in the long run, reversing the standard prediction that the government accumulates savings in models with optimal capital taxes. The welfare benefits from the tax reform are relatively large and they can be shifted entirely to capitalists or workers by varying the length of the transition. We address a number of technical issues such as sufficiency of Lagrangian solutions in a Ramsey problem, relation of Pareto-improving allocations with welfare functions, asymptotic behavior, and solution algorithms.

Suggested Citation

  • Katharina Greulich & Sarolta Laczó & Albert Marcet, 2016. "Pareto-Improving Optimal Capital and Labor Taxes," Working Papers 887, Barcelona Graduate School of Economics.
    • Handle: RePEc:bge:wpaper:887
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    References listed on IDEAS

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    Cited by:

    1. Konstantinos Angelopoulos & Jim Malley & Apostolis Philippopoulos, 2011. "Time-consistent Fiscal Policy under Heterogeneity: Conflicting or Common Interests?," CESifo Working Paper Series 3444, CESifo Group Munich.
    2. Chari, V. V. & Nicolini, Juan Pablo & Teles, Pedro, 2018. "Optimal Capital Taxation Revisited," Working Papers 752, Federal Reserve Bank of Minneapolis.
    3. Röhrs, Sigrid & Winter, Christoph, 2017. "Reducing government debt in the presence of inequality," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 1-20.
    4. Sofía Bauducco, 2011. "Seigniorage and Distortionary Taxation in a Model with Heterogeneous Agents and Idiosyncratic Uncertainty," Working Papers Central Bank of Chile 611, Central Bank of Chile.
    5. Ferrara, Maria & Tirelli, Patrizio, 2017. "Equitable fiscal consolidations," Economic Modelling, Elsevier, vol. 61(C), pages 207-223.
    6. Tobon Orozco, David & Molina Guerra, Carlos & Vargas Cano, John Harvey, 2016. "Extent of Expected Pigouvian Taxes and Permits for Environmental Services in a General Equilibrium Model with a natural capital constraint," BORRADORES DEPARTAMENTO DE ECONOMÍA 015258, UNIVERSIDAD DE ANTIOQUIA - CIE.
    7. Roberta, Cardani & Lorenzo, Menna & Patrizio, Tirelli, 2016. "Optimal Public Debt Consolidation with Distributional Conflicts," Working Papers 350, University of Milano-Bicocca, Department of Economics, revised 05 Oct 2016.

    More about this item

    Keywords

    fiscal policy; Pareto-improving tax reform; redistribution;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation

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