Constrained Inefficiency and Optimal Taxation with Uninsurable Risks

• Main Authors: GOTTARDI, Piero, KAJII, Atsushi, NAKAJIMA, Tomoyuki
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2016
• Subjects: optimal linear taxes; incomplete markets; constrained efficiency; Economic Theory; Finance
• Online Access: https://ink.library.smu.edu.sg/soe_research/1800; https://ink.library.smu.edu.sg/context/soe_research/article/2799/viewcontent/p_wp064.pdf
• Institution: Singapore Management University

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 and 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.