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  • Optimal Taxation and Debt with Uninsurable Risks to Human Capital Accumulation

    Abstract

    We consider an economy where individuals face uninsurable risks to their human capital accumulation, and analyze the optimal level of linear taxes on capital and labor income together with the optimal path of government debt. We show that in the presence of such risks it is beneficial to tax both labor and capital and to issue public debt. We also assess the quantitative importance of these findings, and show that the benefits of government debt and capital taxes both increase with the magnitude of idiosyncratic risks and the degree of relative risk aversion.

    Introduction

    Human capital is an important component of wealth both at the individual and aggregate level, and its role has been investigated in various fields in economics. In public finance, Jones, Manuelli and Rossi (1997) show that the zero-capital-tax result of Chamley (1986) and Judd (1985)1 can be strengthened if human capital accumulation is explicitly taken into account. Specifically, they demonstrate that, in a deterministic economy with human capital accumulation, in the long run not only capital but also labor income taxes should be zero, hence the government must accumulate wealth - that is, public debt be negative - to finance its expenditure.

  • Constrained Inefficiency and Optimal Taxation with Uninsurable Risks

    Abstract

    When individuals’ labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two period general equilibrium model with production, we derive a decomposition formula of the welfare effects of these taxes into insurance and distribution effects. This allows us to determine how the sign of the optimal taxes on capital and labor depend on the nature of the shocks, the degree of heterogeneity among consumers’ income as well as on the way in which the tax revenue is used to provide lump sum transfers to consumers. When shocks affect primarily labor income and heterogeneity is small, the optimal tax on capital is positive. However in other cases a negative tax on capital is welfare improving. (JEL codes: D52, H21. Keywords: optimal linear taxes, incomplete markets, constrained efficiency)

    Introduction

    The main objective of this paper is to investigate the welfare effects of investment and labor income taxes in a two period production economy with uninsurable background risk. More precisely, we examine whether the introduction of linear, distortionary taxes or subsidies on labor income and/or on the returns from savings are welfare improving and what is then the optimal sign of such taxes. This amounts to studying the Ramsey problem in a general equilibrium set-up. We depart however from most of the literature on the subject for the fact that we consider an environment with no public expenditure, where there is no need to raise tax revenue. Nonetheless, optimal taxes are typically nonzero; even distortionary taxes can improve the allocation of risk in the face of incomplete markets. Then the question is which production factor should be taxed: we want to identify the economic properties which determine the signs of the optimal taxes on production factors.

  • Constrained Inefficiency and Optimal Taxation with Uninsurable Risks

    Abstract

    When individuals’ labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two period general equilibrium model with production, we derive a decomposition formula of the welfare effects of these taxes into insurance and distribution effects. This allows us to determine how the sign of the optimal taxes on capital and labor depend on the nature of the shocks, the degree of heterogeneity among consumers’ income as well as on the way in which the tax revenue is used to provide lump sum transfers to consumers. When shocks affect primarily labor income and heterogeneity is small, the optimal tax on capital is positive. However in other cases a negative tax on capital is welfare improving. (JEL codes: D52, H21. Keywords: optimal linear taxes, incomplete markets, constrained efficiency)

    Introduction

    The main objective of this paper is to investigate the effects and the optimal taxation of investment and labor income in a two period production economy with uninsurable background risk. More precisely, we examine whether the introduction of linear, distortionary taxes or subsidies on labor income and/or on the returns from savings are welfare improving and what is then the optimal sign of such taxes. This amounts to studying the Ramsey problem in a general equilibrium set-up. We depart however from most of the literature on the subject for the fact that we consider an environment with no public expenditure, where there is no need to raise tax revenue. Nonetheless, optimal taxes are typically nonzero; even distortionary taxes can improve the allocation of risk in the face of incomplete markets. Then the question is which production factor should be taxed: we want to identify the economic properties which determine the signs of the optimal taxes on production factors.

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