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Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets

  • Piero Gottardi

    (European University Institute)

  • Atsushi Kajii

    (Institute of Economic Research, Kyoto University)

  • Tomoyuki Nakajima

    (Institute of Economic Research, Kyoto University)

How should capital and labor be taxed when individuals' labor income is subject to unin- surable idiosyncratic risks? To address this question, we develop a tractable infinite horizon model with incomplete markets and consider a dynamic optimal taxation problem with linear taxes on the wage and interest income. We derive two general principles for public policy in such an environment: (i) providing an insurance for the idiosyncratic income risks; and (ii) allocating tax burdens efficiently over time. The first principle calls for taxing the labor income. The second principle clarifies when accumulating government debt is welfare improving, and also when the tax rate on physical capital needs to be strictly positive in the long run. We also calibrate our model to the U.S. economy and find that the presence of idiosyncratic income risks significantly affects the optimal tax rates and the optimal amount of the government debt.

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Paper provided by Kyoto University, Institute of Economic Research in its series KIER Working Papers with number 745.

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Length: 36pages
Date of creation: Dec 2010
Date of revision:
Handle: RePEc:kyo:wpaper:745
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  1. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2015. "Constrained Inefficiency and Optimal Taxation with Uninsurable Risks," UTokyo Price Project Working Paper Series 046, University of Tokyo, Graduate School of Economics.
  2. repec:spo:wpecon:info:hdl:2441/8623 is not listed on IDEAS
  3. Julio Davila & J.H. Jong & Per Krusell & José-Victor Rios Rull, 2012. "Constrainted efficiency in the neoclassical growth model with uninsurable idiosyncratic skocks," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00751900, HAL.
  4. repec:hal:journl:halshs-00196183 is not listed on IDEAS
  5. Conesa, Juan Carlos & Kitao, Sagiri & Krueger, Dirk, 2006. "Taxing capital? Not a bad idea after all!," CFS Working Paper Series 2006/21, Center for Financial Studies (CFS).
  6. Kenichi Fukushima, 2010. "Quantifying the Welfare Gains From Flexible Dynamic Income Tax Systems," 2010 Meeting Papers 410, Society for Economic Dynamics.
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  9. Bassetto, Marco & Kocherlakota, Narayana, 2004. "On the irrelevance of government debt when taxes are distortionary," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 299-304, March.
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  11. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  12. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  13. Jones, Larry E & Manuelli, Rodolfo E, 1990. "A Convex Model of Equilibrium Growth: Theory and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 1008-38, October.
  14. Philippe Weil, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, Oxford University Press, vol. 105(1), pages 29-42.
  15. Ábrahám, Árpád & Cárceles-Poveda, Eva, 2010. "Endogenous trading constraints with incomplete asset markets," Journal of Economic Theory, Elsevier, vol. 145(3), pages 974-1004, May.
  16. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  17. Larry E. Jones & Rodolfo Manuelli, 1990. "A Convex Model of Equilibrium Growth," NBER Working Papers 3241, National Bureau of Economic Research, Inc.
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