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Optimal capital taxation with idiosyncratic investment risk

  • Vasia Panousi
  • Catarina Reis

We examine the optimal taxation of capital in a Ramsey setting of a general-equilibrium heterogeneous-agent economy with uninsurable idiosyncratic investment or capital-income risk. We prove that the ex ante optimal tax, evaluated at steady state, maximizes human wealth, namely the present discounted value of agents' income from sources that are not subject to capital risk. Furthermore, when the amount of idiosyncratic risk in the economy is higher than a minimum lower bound, the optimal tax is positive and it is precisely the tax that maximizes the economy-wide aggregates, such as the capital stock and output. By contrast, when the amount of risk is exogenously very low, the social planner finds it optimal to increase social risk taking by subsidizing investment in capital.

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File URL: http://www.federalreserve.gov/pubs/feds/2012/201270/201270abs.html
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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2012-70.

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Date of creation: 2012
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Handle: RePEc:fip:fedgfe:2012-70
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  1. Sandmo, Agnar, 1977. "Portfolio Theory, Asset Demand and Taxation: Comparative Statics with Many Assets," Review of Economic Studies, Wiley Blackwell, vol. 44(2), pages 369-79, June.
  2. Panousi, Vasia & Papanikolaou, Dimitris, 2009. "Investment, idiosyncratic risk, and ownership," MPRA Paper 24239, University Library of Munich, Germany.
  3. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  4. Albanesi, Stefania, 2006. "Optimal Taxation of Entrepreneurial Capital with Private Information," CEPR Discussion Papers 5647, C.E.P.R. Discussion Papers.
  5. Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," American Economic Review, American Economic Association, vol. 92(4), pages 745-778, September.
  6. S. Rao Aiyagari, 1994. "Optimal capital income taxation with incomplete markets, borrowing constraints, and constant discounting," Working Papers 508, Federal Reserve Bank of Minneapolis.
  7. Ahsan, Syed M., 1976. "Taxation in a two-period temporal model of consumption and portfolio allocation," Journal of Public Economics, Elsevier, vol. 5(3-4), pages 337-352.
  8. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
  9. Tobias J. Moskowitz & Annette Vissing-Jorgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," NBER Working Papers 8876, National Bureau of Economic Research, Inc.
  10. Mirrlees, J A, 1990. "Taxing Uncertain Incomes," Oxford Economic Papers, Oxford University Press, vol. 42(1), pages 34-45, January.
  11. George-Marios Angeletos, 2007. "Uninsured Idiosyncratic Investment Risk and Aggregate Saving," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(1), pages 1-30, January.
  12. Varian, Hal R., 1980. "Redistributive taxation as social insurance," Journal of Public Economics, Elsevier, vol. 14(1), pages 49-68, August.
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