Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets

Piero Gottardi, Atsushi Kajii and Tomoyuki Nakajima

No 745, KIER Working Papers from Kyoto University, Institute of Economic Research

Abstract: How should capital and labor be taxed when individuals' labor income is subject to unin- surable idiosyncratic risks? To address this question, we develop a tractable infinite horizon model with incomplete markets and consider a dynamic optimal taxation problem with linear taxes on the wage and interest income. We derive two general principles for public policy in such an environment: (i) providing an insurance for the idiosyncratic income risks; and (ii) allocating tax burdens efficiently over time. The first principle calls for taxing the labor income. The second principle clarifies when accumulating government debt is welfare improving, and also when the tax rate on physical capital needs to be strictly positive in the long run. We also calibrate our model to the U.S. economy and find that the presence of idiosyncratic income risks significantly affects the optimal tax rates and the optimal amount of the government debt.

Keywords: incomplete markets; constrained inefficiency; optimal taxation; Ramsey equilibrium. (search for similar items in EconPapers)
JEL-codes: D52 D60 D90 E20 E62 H21 O40 (search for similar items in EconPapers)
Pages: 36pages
Date: 2010-12
New Economics Papers: this item is included in nep-acc, nep-dge and nep-pub
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Citations: View citations in EconPapers (4)

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Related works:
Working Paper: Optimal Taxation and Constrained Inefficiency in an Infinite-Horizon Economy with Incomplete Markets (2011)
Working Paper: Optimal taxation and constrained inefficiency in an infinite-horizon economy with incomplete markets (2011)
Working Paper: Optimal taxation and constrained inefficiency in an in finite-horizon economy with incomplete markets (2011)
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