Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

  • Dyrda S
  • Pedroni M
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Abstract

This paper studies optimal taxation in an enviroment where heterogeneous households face uninusrable 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 U.S. 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 imposted 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 captial incomes in total income, increasing welfare by providing insurance and redistribution. We are able to quantify these welfare effects. We also show that calculating the entire transition path (as opposed to considering steady states only) is quantitiatively important. Implementing the policy that maximizes welare in steady state leads to a welfare loss of 6.4 percent once transitory effects are accounted for

Author-supplied keywords

  • heterogenous agents
  • incomplete markets
  • optimal taxation

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Authors

  • Sebastian Dyrda

  • Marcelo Pedroni

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