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Trading with the Unborn: A New Perspective on Capital Income Taxation

Author

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  • Kent A. Smetters

    (The Wharton School and NBER)

Abstract

Security markets between generations are incomplete in the laissez-faire economy since risk sharing agreements cannot be made with the unborn. But suppose that generations could trade if, for example, a representative of the unborn negotiated on their behalf today. What would the trades look like? Can government fiscal policy by used to replicate these trades? Would completing this missing market be pareto improving when the introduction of the new security changes the prices of existing assets? This paper characterizes analytically the hypothetical trades between generations. It shows how the government can replicate these trades by taxing the realized equity premium on investments by either a positive amount or a negative amount. When technology shocks are mostly driven by changes in depreciation, a positive tax on the equity premium replicates the hypothetical trades; this tax is also driven by changes in productivity, the choice between a positive and negative tax rate is unclear. However, with log utility, Cobb-Douglas production, and a depreciation rate less than 100 percent, the equity premium is to be taxed at a negative rate; this tax is also pareto improving. Finally, simulation analysis is used to consider more complicated cases, including when depreciation and productivity are both uncertain. Under the baseline calibration for the U.S., a positive tax on the equity premium is pareto improving.

Suggested Citation

  • Kent A. Smetters, 2004. "Trading with the Unborn: A New Perspective on Capital Income Taxation," Working Papers wp066, University of Michigan, Michigan Retirement Research Center.
  • Handle: RePEc:mrr:papers:wp066
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    File URL: http://www.mrrc.isr.umich.edu/publications/Papers/pdf/wp066.pdf
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    References listed on IDEAS

    as
    1. David Bradford, "undated". "Consumption Taxes: Some Fundamental Transition Issues," EPRU Working Paper Series 95-15, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
    2. repec:fth:calaec:4-98 is not listed on IDEAS
    3. Laurence Ball & N. Gregory Mankiw, 2007. "Intergenerational Risk Sharing in the Spirit of Arrow, Debreu, and Rawls, with Applications to Social Security Design," Journal of Political Economy, University of Chicago Press, vol. 115(4), pages 523-547, August.
    4. Wang Yong, 1993. "Stationary Equilibria in an Overlapping Generations Economy with Stochastic Production," Journal of Economic Theory, Elsevier, vol. 61(2), pages 423-435, December.
    5. Agnar Sandmo, 1977. "Portfolio Theory, Asset Demand and Taxation: Comparative Statics with Many Assets," Review of Economic Studies, Oxford University Press, vol. 44(2), pages 369-379.
    6. J. E. Stiglitz, 1969. "The Effects of Income, Wealth, and Capital Gains Taxation on Risk-Taking," The Quarterly Journal of Economics, Oxford University Press, vol. 83(2), pages 263-283.
    7. Evsey D. Domar & Richard A. Musgrave, 1944. "Proportional Income Taxation and Risk-Taking," The Quarterly Journal of Economics, Oxford University Press, vol. 58(3), pages 388-422.
    8. Henning Bohn, 1999. "Should the Social Security Trust Fund Hold Equities," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(3), pages 666-697, July.
    9. Roger H. Gordon, 1985. "Taxation of Corporate Capital Income: Tax Revenues Versus Tax Distortions," The Quarterly Journal of Economics, Oxford University Press, vol. 100(1), pages 1-27.
    10. Poterba, James M., 1998. "The rate of return to corporate capital and factor shares: new estimates using revised national income accounts and capital stock data," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 48(1), pages 211-246, June.
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    Cited by:

    1. Gottardi, Piero & Kubler, Felix, 2011. "Social security and risk sharing," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1078-1106, May.
    2. Olovsson, Conny, 2010. "Quantifying the risk-sharing welfare gains of social security," Journal of Monetary Economics, Elsevier, vol. 57(3), pages 364-375, April.
    3. Jeffrey R. Brown & Peter R. Orszag, 2006. "The Political Economy of Government-Issued Longevity Bonds," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(4), pages 611-631.
    4. Olovsson, Conny, 2004. "The Welfare Gains of Improving Risk Sharing in Social Security," Seminar Papers 728, Stockholm University, Institute for International Economic Studies.
    5. Espen Henriksen & Steve Spear, 2006. "Dynamic Suboptimality of Competitive Equilibrium in Multiperiod Overlapping Generations Economies," Computing in Economics and Finance 2006 223, Society for Computational Economics.
    6. Olovsson, Conny, 2004. "Social Security and the Equity Premium Puzzle," Seminar Papers 729, Stockholm University, Institute for International Economic Studies.

    More about this item

    JEL classification:

    • D9 - Microeconomics - - Micro-Based Behavioral Economics
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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