Optimal Taxation and Constrained Inefficiency in an Infinite-Horizon Economy with Incomplete Markets
46 Pages Posted: 5 Sep 2011
Date Written: August 31, 2011
We study the dynamic Ramsey problem of finding optimal public debt and linear taxes on capital and labor income within a tractable infinite horizon model with incomplete markets. With zero public expenditure and debt, it is optimal to tax the risky labor income and subsidize capital, while a positive amount of public debt is welfare improving. A steady state optimality condition is derived which implies that the tax on capital is positive, when savings are sufficiently inelastic to returns. A calibration of our model to the US economy indicates positive optimal taxes and a small but positive optimal debt level.
Keywords: incomplete markets, Ramsey equilibrium, optimal taxation, optimal public debt, constrained inefficiency
JEL Classification: D520, D600, D900, E200, E620, H210, O400
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