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Pareto Improving Taxation in Incomplete Markets

When asset markets are incomplete there are almost always many Pareto improving policy interventions. Remarkably, these interventions do not involve adding any new markets. Focusing on tax policy, I create a framework for proving the existence of Pareto improving taxes, for computing them, and for estimating the size of the Pareto improvement. The protagonist is the price adjustment following an intervention. Its role is to improve on asset insurance by redistributing endowment wealth across states. If taxes targeting current incomes are Pareto improving, then they must cause an equilibrium price adjustment. Conversely, if the price adjustment is sufficiently sensitive to risk aversions, then for almost all risk aversions and endowments, Pareto improving taxes exist. I show how to verify this sensitivity test with standard demand theory, which Turner (2003a) extends from complete to incomplete markets. I show that different policies generically admit Pareto improving taxes, by showing they all pass this same sensitivity test. These include (a) taxes on asset purchases, (b) lump-sum taxes on present income plus one flat tax on asset purchases, (c) asset measurable taxes on capital gains, (d) excise taxes on current commodities. To numerically identify the Pareto improving taxes, I give a formula for the welfare impact of taxes. The formula requires information about individual marginal utilities and net trades, and about the derivative of aggregate, not individual, demand with respect to prices and taxes. To bound the rate of Pareto improvement, I define an equilibrium's insurance deficit. Pareto optimality obtains exactly when the insurance deficit is zero. If the tax policy targets only current incomes, then the implied price adjustment determines the best rate, by integration against the covariance of the insurance deficit and net trades across agents

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Paper provided by Brown University, Department of Economics in its series Working Papers with number 2006-03.

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Date of creation: 2006
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Handle: RePEc:bro:econwp:2006-03
Contact details of provider: Postal: Department of Economics, Brown University, Providence, RI 02912

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  1. Elul Ronel, 1995. "Welfare Effects of Financial Innovation in Incomplete Markets Economies with Several Consumption Goods," Journal of Economic Theory, Elsevier, vol. 65(1), pages 43-78, February.
  2. Debreu, Gerard, 1972. "Smooth Preferences," Econometrica, Econometric Society, vol. 40(4), pages 603-15, July.
  3. Geanakoplos, J D & Polemarchakis, H M, 1980. "On the Disaggregation of Excess Demand Functions," Econometrica, Econometric Society, vol. 48(2), pages 315-31, March.
  4. Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Herakles Polemarchakis, 2010. "Markets and contracts," Economics Working Papers ECO2010/29, European University Institute.
    • Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Heracles Polemarchakis, 2009. "Markets and Contracts," Working Papers 0915, University of Brescia, Department of Economics.
  5. Herakles Polemarchakis, 2001. "The taxation of trades in assests," Working Papers 2001-21, Brown University, Department of Economics.
  6. CITANNA, Alessandro & POLEMARCHAKIS, Heracles M. & TIRELLI, M., 2000. "The Taxation of Trades in assets," Les Cahiers de Recherche 721, HEC Paris.
  7. Stiglitz, Joseph E, 1982. "The Inefficiency of the Stock Market Equilibrium," Review of Economic Studies, Wiley Blackwell, vol. 49(2), pages 241-61, April.
  8. Debreu, Gerard, 1976. "Smooth Preferences: A Corrigendum," Econometrica, Econometric Society, vol. 44(4), pages 831-32, July.
  9. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  10. Duffie, Darrell & Shafer, Wayne, 1985. "Equilibrium in incomplete markets: I : A basic model of generic existence," Journal of Mathematical Economics, Elsevier, vol. 14(3), pages 285-300, June.
  11. Michael Mandler, 2004. "Policy effectiveness," Econometric Society 2004 North American Summer Meetings 480, Econometric Society.
  12. Magill, Michael & Shafer, Wayne, 1991. "Incomplete markets," Handbook of Mathematical Economics, in: W. Hildenbrand & H. Sonnenschein (ed.), Handbook of Mathematical Economics, edition 1, volume 4, chapter 30, pages 1523-1614 Elsevier.
  13. Atsushi Kajii & Antonio Villanacci & Alessandro Citanna, 1998. "Constrained suboptimality in incomplete markets: a general approach and two applications," Economic Theory, Springer, vol. 11(3), pages 495-521.
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