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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. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  2. 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.
  3. Larry E. Jones & Rodolfo Manuelli, 1990. "A Convex Model of Equilibrium Growth," NBER Working Papers 3241, National Bureau of Economic Research, Inc.
  4. Eva Carceles Poveda & Arpad Abraham, 2004. "Endogenous Trading Constraints with Incomplete Asset Markets," 2004 Meeting Papers 667, Society for Economic Dynamics.
  5. Julio Davila & Jay H. Hong & Per Krusell & José-Victor Rios Rull, 2005. "Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00196183, HAL.
  6. 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.
  7. 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.
  8. Marco Bassetto & Narayana Kocherlakota, 2010. "On the Irrelevance of Government Debt When Taxes are Distortionary," Levine's Working Paper Archive 506439000000000295, David K. Levine.
  9. Juan Carlos Conesa & Sagiri Kitao & Dirk Krueger, 2007. "Taxing Capital? Not a Bad Idea After All!," NBER Working Papers 12880, National Bureau of Economic Research, Inc.
  10. Tom Krebs, 2003. "Human Capital Risk and Economic Growth," The Quarterly Journal of Economics, Oxford University Press, vol. 118(2), pages 709-744.
  11. Kenichi Fukushima, 2010. "Quantifying the Welfare Gains From Flexible Dynamic Income Tax Systems," 2010 Meeting Papers 410, Society for Economic Dynamics.
  12. repec:spo:wpecon:info:hdl:2441/8623 is not listed on IDEAS
  13. Philippe Weil, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, Oxford University Press, vol. 105(1), pages 29-42.
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