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A unified framework for optimal taxation with undiversifiable risk

Author

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  • Catarina Reis

    (Universidade Católica Portuguesa)

  • Vasia Panousi

    (Board of Governors of the Federal Reserv)

Abstract

This paper considers a model of linear capital taxation for an economy where capital and labor income are subject to idiosyncratic uninsurable risk. To keep the model tractable, we assume that investment decisions are made before uncertainty is realized, so that the realization of the capital income shock only affects current consumption. In this setting, we find that the optimal capital tax is positive in the long run if there is only capital income risk. The reason for this is that the capital tax provides insurance against capital income risk. On the other hand, if there is only labor income risk the optimal capital tax is zero. The sign of the optimal tax is ambiguous if both types of risk are present and depends on the correlation between the two shocks.

Suggested Citation

  • Catarina Reis & Vasia Panousi, 2016. "A unified framework for optimal taxation with undiversifiable risk," 2016 Meeting Papers 951, Society for Economic Dynamics.
    • Handle: RePEc:red:sed016:951
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    References listed on IDEAS

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    1. Vasia Panousi & George-Marios Angeletos, 2007. "Revisiting the Supply-Side Effects of Government Spending Under Incomplete Markets," 2007 Meeting Papers 545, Society for Economic Dynamics.
    2. Andrew Atkeson & V. V. Chari & Patrick J. Kehoe, 1999. "Taxing capital income: a bad idea," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 23(Sum), pages 3-17.
    3. 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.
    4. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-622, May.
    5. 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.
    6. Aiyagari, S Rao, 1995. "Optimal Capital Income Taxation with Incomplete Markets, Borrowing Constraints, and Constant Discounting," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1158-1175, December.
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    Cited by:

    1. Tom Phelan, 2019. "On the Optimality of Differential Asset Taxation," Working Papers 19-17R, Federal Reserve Bank of Cleveland, revised 01 Sep 2022.
    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. Corina Boar & Matthew Knowles, 2020. "Entrepreneurship, Agency Frictions and Redistributive Capital Taxation," Discussion Paper Series, School of Economics and Finance 202004, School of Economics and Finance, University of St Andrews.
    4. Thomas Phelan, 2019. "Efficient wealth inequality and differential asset taxation with dynamic agency," 2019 Meeting Papers 1350, Society for Economic Dynamics.

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