Pareto Improving Taxation in Incomplete Markets

When asset markets are incomplete there are almost always many Pareto improving policy interventions, provided there are multiple commodities and households. 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. It requires information about how taxes and prices affect aggregate, but not individual, demand. If taxes targeting current incomes are Pareto improving, then they must cause an equilibrium price adjustment, whose role is to redistribute wealth across states, creating insurance beyond the assets'. Conversely, I prove that 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) tax rates on purchases of assets, (b) lump-sum taxes on present income plus one flat tax rate on purchases of assets, (c) asset measurable tax rates on capital gains, (d) tax rates on net purchases of present commodities. I give a formula for the welfare impact of taxes, numerically identifying the Pareto improving 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. I estimate the rate of Pareto improvement by defining an agent's equilibrium insurance deficit. This deficit vanishes exactly when her commodity demand is as though markets were complete. The rate is quadratic in the insurance deficits, and affine in the level of trade and in the proximity to price crashes