IDEAS home Printed from https://ideas.repec.org/p/red/sed016/1245.html
   My bibliography  Save this paper

Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

Author

Listed:
  • Marcelo Zouain Pedroni

    (University of Amsterdam)

  • Sebastian Dyrda

    (University of Toronto)

Abstract

This paper studies optimal taxation in the standard incomplete markets model. We formulate a Ramsey problem and solve numerically for the optimal (time varying) paths of proportional capital and labor income taxes, (possibly negative) lump-sum transfers, and government debt. The solution maximizes welfare along the transition between an initial steady state, calibrated to replicate key features of the US economy, and an endogenously determined final steady state. We find that in the optimal (utilitarian) policy: (i) capital income taxes are front-loaded hitting the imposed upper bound of 100 percent for 33 years before decreasing to 45 percent in the long-run; (ii) labor income taxes are reduced to less than half of their initial level, from 28 percent to about 13 percent in the long-run; and (iii) the government accumulates assets over time reducing the debt-to-output ratio from 63 percent to ô€€€17 percent in the long-run. This leads to an average welfare gain equivalent to a permanent 4.9 percent increase in consumption. Though distortive, taxes reduce the variance both cross-sectionally and over time of after-tax income, increasing welfare for both a redistributive and an insurance motive which we quantify.

Suggested Citation

  • Marcelo Zouain Pedroni & Sebastian Dyrda, 2016. "Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks," 2016 Meeting Papers 1245, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:1245
    as

    Download full text from publisher

    File URL: https://red-files-public.s3.amazonaws.com/meetpapers/2016/paper_1245.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Douglas Holtz-Eakin & David Joulfaian & Harvey S. Rosen, 1993. "The Carnegie Conjecture: Some Empirical Evidence," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 108(2), pages 413-435.
    2. Erosa, Andres & Gervais, Martin, 2002. "Optimal Taxation in Life-Cycle Economies," Journal of Economic Theory, Elsevier, vol. 105(2), pages 338-369, August.
    3. 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.
    4. Chari, V.V. & Kehoe, Patrick J., 1999. "Optimal fiscal and monetary policy," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 26, pages 1671-1745, Elsevier.
    5. Aiyagari, S. Rao & McGrattan, Ellen R., 1998. "The optimum quantity of debt," Journal of Monetary Economics, Elsevier, vol. 42(3), pages 447-469, October.
    6. Edward Nathan Wolff, 2011. "Recent Trends in Household Wealth, 1983-2009: The Irresistible Rise of Household Debt," Review of Economics and Institutions, Università di Perugia, vol. 2(1).
    7. Iván Werning, 2007. "Optimal Fiscal Policy with Redistribution," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 122(3), pages 925-967.
    8. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(3), pages 659-684.
    9. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2010. "The Macroeconomic Implications of Rising Wage Inequality in the United States," Journal of Political Economy, University of Chicago Press, vol. 118(4), pages 681-722, August.
    10. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
    11. Mikhail Golosov & Narayana Kocherlakota & Aleh Tsyvinski, 2003. "Optimal Indirect and Capital Taxation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 70(3), pages 569-587.
    12. Carroll, Christopher D., 2006. "The method of endogenous gridpoints for solving dynamic stochastic optimization problems," Economics Letters, Elsevier, vol. 91(3), pages 312-320, June.
    13. Roland Benabou, 2002. "Tax and Education Policy in a Heterogeneous-Agent Economy: What Levels of Redistribution Maximize Growth and Efficiency?," Econometrica, Econometric Society, vol. 70(2), pages 481-517, March.
    14. Guido W. Imbens & Donald B. Rubin & Bruce I. Sacerdote, 2001. "Estimating the Effect of Unearned Income on Labor Earnings, Savings, and Consumption: Evidence from a Survey of Lottery Players," American Economic Review, American Economic Association, vol. 91(4), pages 778-794, September.
    15. Fatih Guvenen, 2011. "Macroeconomics with hetereogeneity : a practical guide," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 97(3Q), pages 255-326.
    16. Javier Diaz-Gimenez & Andrew Glover & José-Víctor Ríos-Rull, 2011. "Facts on the distributions of earnings, income, and wealth in the United States: 2007 update," Quarterly Review, Federal Reserve Bank of Minneapolis.
    17. Juan Carlos Conesa & Sagiri Kitao & Dirk Krueger, 2009. "Taxing Capital? Not a Bad Idea after All!," American Economic Review, American Economic Association, vol. 99(1), pages 25-48, March.
    18. Markus Poschke & Baris Kaymak & Ozan Bakis, 2012. "On the Optimality of Progressive Income Redistribution," 2012 Meeting Papers 837, Society for Economic Dynamics.
    19. Emmanuel Farhi & Iván Werning, 2012. "Capital Taxation: Quantitative Explorations of the Inverse Euler Equation," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 000.
    20. Catarina Reis & Vasia Panousi, 2012. "Optimal Capital Taxation with Idiosyncratic Investment Risk," 2012 Meeting Papers 732, Society for Economic Dynamics.
    21. Acikgoz, Omer, 2013. "Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets," MPRA Paper 50160, University Library of Munich, Germany.
    22. Raj Chetty & Adam Guren & Day Manoli & Andrea Weber, 2011. "Are Micro and Macro Labor Supply Elasticities Consistent? A Review of Evidence on the Intensive and Extensive Margins," American Economic Review, American Economic Association, vol. 101(3), pages 471-475, May.
    23. Dirk Krueger & Fabrizio Perri, 2006. "Does Income Inequality Lead to Consumption Inequality? Evidence and Theory -super-1," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 73(1), pages 163-193.
    24. Maxim Troshkin & Aleh Tsyvinski & Mikhail Golosov, 2010. "Optimal Dynamic Taxes," 2010 Meeting Papers 320, Society for Economic Dynamics.
    25. David Domeij & Jonathan Heathcote, 2004. "On The Distributional Effects Of Reducing Capital Taxes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(2), pages 523-554, May.
    26. Alexander Ludwig & Dirk Krueger, 2010. "Optimal Progressive Taxation and Education Subsidies in a Model of Endogenous Human Capital Formation," 2010 Meeting Papers 388, Society for Economic Dynamics.
    27. repec:mea:meawpa:13267 is not listed on IDEAS
    28. Chatterjee, Satyajit, 1994. "Transitional dynamics and the distribution of wealth in a neoclassical growth model," Journal of Public Economics, Elsevier, vol. 54(1), pages 97-119, May.
    29. 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.
    30. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-622, May.
    31. Ludwig Straub & Iván Werning, 2020. "Positive Long-Run Capital Taxation: Chamley-Judd Revisited," American Economic Review, American Economic Association, vol. 110(1), pages 86-119, January.
    32. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-417, June.
    33. Röhrs, Sigrid & Winter, Christoph, 2017. "Reducing government debt in the presence of inequality," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 1-20.
    34. Trabandt, Mathias & Uhlig, Harald, 2011. "The Laffer curve revisited," Journal of Monetary Economics, Elsevier, vol. 58(4), pages 305-327.
    35. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Sebastian Dyrda & Marcelo Pedroni, 2015. "Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks," Working Papers tecipa-549, University of Toronto, Department of Economics.
    2. Krueger, Dirk & Ludwig, Alexander & Villalvazo, Sergio, 2021. "Optimal taxes on capital in the OLG model with uninsurable idiosyncratic income risk," Journal of Public Economics, Elsevier, vol. 201(C).
    3. Dirk Krueger, 2006. "Public Insurance against Idiosyncratic and Aggregate Risk: The Case of Social Security and Progressive Income Taxation," CESifo Economic Studies, CESifo Group, vol. 52(4), pages 587-620, December.
    4. Ozan Bakis & Baris Kaymak & Markus Poschke, 2015. "Transitional Dynamics and the Optimal Progressivity of Income Redistribution," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(3), pages 679-693, July.
    5. François Le Grand & Xavier Ragot, 2017. "Optimal Fiscal Policy with Heterogeneous Agents and Aggregate Shocks," Working Papers hal-03458683, HAL.
    6. Conesa, Juan Carlos & Krueger, Dirk, 2006. "On the optimal progressivity of the income tax code," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1425-1450, October.
    7. William B. Peterman & Erick Sager, 2022. "Optimal Public Debt with Life Cycle Motives," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(4), pages 404-437, October.
    8. Alexander Ludwig & Dirk Krueger, 2010. "Optimal Progressive Taxation and Education Subsidies in a Model of Endogenous Human Capital Formation," 2010 Meeting Papers 388, Society for Economic Dynamics.
    9. Krueger, Dirk & Ludwig, Alexander, 2016. "On the optimal provision of social insurance: Progressive taxation versus education subsidies in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 77(C), pages 72-98.
    10. Kabukçuoğlu, Ayşe, 2017. "The winners and losers of tax reform: An assessment under financial integration," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 90-122.
    11. Acikgoz, Omer, 2015. "Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets," MPRA Paper 73380, University Library of Munich, Germany.
    12. Piero Gottardi & Atsushi Kajii & Tomoyuki Nakajima, 2015. "Optimal Taxation and Debt with Uninsurable Risks to Human Capital Accumulation," American Economic Review, American Economic Association, vol. 105(11), pages 3443-3470, November.
    13. Marco Cozzi, 2018. "Optimal Capital Taxation with Incomplete Markets and Schumpeterian Growth," Department Discussion Papers 1803, Department of Economics, University of Victoria.
    14. repec:hal:spmain:info:hdl:2441/6bl2553ksc9vlq1fltjs9h1cht is not listed on IDEAS
    15. Frédéric Dufourt & Lisa Kerdelhué & Océane Piétri, 2022. "Budget-Neutral Capital Tax Cuts," Annals of Economics and Statistics, GENES, issue 146, pages 93-121.
    16. Özlem Kina & Ctirad Slavik & Hakki Yazici, 2020. "Redistributive Capital Taxation Revisited," CESifo Working Paper Series 8627, CESifo.
    17. Acikgoz, Omer, 2013. "Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets," MPRA Paper 50160, University Library of Munich, Germany.
    18. repec:hal:wpspec:info:hdl:2441/6bl2553ksc9vlq1fltjs9h1cht is not listed on IDEAS
    19. Fabian Kindermann & Dirk Krueger, 2014. "High Marginal Tax Rates on the Top 1%? Lessons from a Life Cycle Model with Idiosyncratic Income Risk," NBER Working Papers 20601, National Bureau of Economic Research, Inc.
    20. Fabian Kindermann & Dirk Krueger, 2022. "High Marginal Tax Rates on the Top 1 Percent? Lessons from a Life-Cycle Model with Idiosyncratic Income Risk," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(2), pages 319-366, April.
    21. Krueger, Dirk & Ludwig, Alexander, 2013. "On the Optimal Provision of Social Insurance," MEA discussion paper series 201302, Munich Center for the Economics of Aging (MEA) at the Max Planck Institute for Social Law and Social Policy.
    22. Sergio Ocampo & Gueorgui Kambourov & Daphne Chen & Burhanettin Kuruscu & Fatih Guvenen, 2017. "Use It or Lose It: Efficiency Gains from Wealth Taxation," 2017 Meeting Papers 913, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed016:1245. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Zimmermann (email available below). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.