Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets

Aiyagari (1995) showed that long-run optimal fiscal policy features a positive tax rate on capital income in Bewley-type economies with heterogeneous agents and incomplete markets. However, determining the magnitude of the optimal capital income tax rate was considered to be prohibitively difficult due to the need to compute the optimal tax rates along the transition path. Contrary to this view, this paper shows that in this class of models, long-run optimal fiscal policy and the corresponding allocation can be studied independently of the initial conditions and the transition path. Numerical methods based on this finding are used on a Ramsey model calibrated to the U.S. economy. I find that the observed average capital income tax rate in the U.S. is too high, the average labor income tax rate and the debt-to-GDP ratio are too low, compared to the long-run optimal levels. The implications of these findings for existing literature on the optimal quantity of debt and constrained efficiency are also adressed.