Optimal Capital Tax and Debt Policy Under Incomplete Asset Markets

Two results characterize previous studies of optimal capital income taxation: (i) In order to avoid distorting capital accumulation incentives the ex ante capital tax rate should be set to zero in the long run and ii) by varying the ex post capital tax rate governments may be able to insulate labor taxes from shocks to public finances. This paper explores to what extent these results survive depending on whether the government can issue state-contingent debt and whether state-contingent capital income taxation is possible. We show that although incomplete asset markets with state-contingent capital income taxes can implement the same allocation as complete asset markets, they imply a range and volatility of the capital taxes which is far from similar from what we can observe in the data. The results also confirm the main findings of Marcet and Scott (2003) regarding the counterfactual response of debt to public finance shocks under (effectively) complete markets. Then, we experiment with two more realistic assumptions on tax-setting: uniform income taxation and capital taxes fixed one period ahead. These features together with incomplete asset markets (a one period risk-free bond) lead to more realistic behavior of both government debt and capital income taxes. We also show how the incomplete market problem can be reformulated with the use of the recursive contracts approach and discuss the numerical implementation in detail