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Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

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  • Sebastian Dyrda
  • Marcelo Pedroni

Abstract

This paper studies optimal taxation in an environment where heterogeneous households face uninsurable idiosyncratic risk. To do this, we formulate a Ramsey problem in a standard infinite horizon incomplete markets model. We solve numerically for the optimal path 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 -17 percent in the long-run. Relative to keeping fiscal instruments at their initial levels, this leads to an average welfare gain equivalent to a permanent 4.9 percent increase in consumption. Even though non-distortive lump-sum taxes are available, the optimal plan has positive capital and labor taxes. Such taxes reduce the proportions of uncertain and unequal labor and capital incomes in total income, increasing welfare by providing insurance and redistribution. We quantify these welfare effects. We also show that calculating the entire transition path (as opposed to considering steady states only) is quantitatively important. Implementing the policy that maximizes welfare in steady state leads to a welfare loss of 6.4 percent once transitory effects are accounted for.

Suggested Citation

  • Sebastian Dyrda & Marcelo Pedroni, 2015. "Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks," Working Papers tecipa-550, University of Toronto, Department of Economics.
  • Handle: RePEc:tor:tecipa:tecipa-550
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    More about this item

    Keywords

    Optimal Taxation; Heterogenous Agents; Incomplete markets;
    All these keywords.

    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

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