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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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File URL: http://www.kier.kyoto-u.ac.jp/DP/DP745.pdf
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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. Gottardi, Piero & Kajii, Atsushi & Nakajima, Tomoyuki, 2014. "Constrained inefficiency and optimal taxation with uninsurable risks," Working Paper 2014-25, Federal Reserve Bank of Atlanta.
  2. Julio Dávila & Jay H. Hong & Per Krusell & José‐Víctor Ríos‐Rull, 2012. "Constrained Efficiency in the Neoclassical Growth Model With Uninsurable Idiosyncratic Shocks," Econometrica, Econometric Society, vol. 80(6), pages 2431-2467, November.
  3. 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).
  4. Marco Bassetto & Narayana Kocherlakota, 2010. "On the Irrelevance of Government Debt When Taxes are Distortionary," Levine's Working Paper Archive 506439000000000295, David K. Levine.
  5. Eva Carceles Poveda & Arpad Abraham, 2004. "Endogenous Trading Constraints with Incomplete Asset Markets," 2004 Meeting Papers 667, Society for Economic Dynamics.
  6. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  7. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
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  10. Larry E. Jones & Rodolfo Manuelli, 1990. "A Convex Model of Equilibrium Growth," NBER Working Papers 3241, National Bureau of Economic Research, Inc.
  11. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, June.
  12. Marcet, Albert & Obiols-Homs, Francesc & Weil, Philippe, 2007. "Incomplete markets, labor supply and capital accumulation," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2621-2635, November.
  13. Tom Krebs, 2003. "Human Capital Risk And Economic Growth," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 709-744, May.
  14. 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.
  15. 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.
  16. Larry E. Jones & Rodolfo E. Manuelli & Peter E. Rossi, 1993. "On the Optimal Taxation of Capital Income," NBER Working Papers 4525, National Bureau of Economic Research, Inc.
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