Pareto-Improving Optimal Capital and Labor Taxes

We study optimal Pareto-improving fiscal policy in a model where agents are heterogeneous in their labor productivity and wealth and markets are complete. We first argue that recent results that find positive long-run capital taxes in the Ramsey equilibrium in standard models obtain for special parameter values. If the government is prevented from immiserating future generations the Chamley-Judd result reemerges. In addition, we question the traditional focus on long-run taxes. We show that a gradual reform is crucial: labor taxes should be cut and capital taxes should remain high for a very long time in order to achieve a Pareto improvement. Therefore, the long-run optimal tax mix is the opposite of the short- and medium-run one. The length of the transition determines who benefits more from the tax reform. The initial labor tax cut causes early deficits which lead to a positive level of government debt in the long run. Further, we show that a Benthamite policy (equal weights for all agents) is often not Pareto improving, and that, given significant heterogeneity, the optimal fiscal policy is time-consistent if a Pareto improvement is required at the time of reoptimization. We address a number of technical issues: sufficiency of first-order conditions for the Ramsey optimum, asymptotic behavior, and solution algorithms.