Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk

97 Pages Posted: 20 Feb 2018 Last revised: 26 Aug 2019

See all articles by Dirk Krueger

Dirk Krueger

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Alexander Ludwig

Leibniz Institute for Financial Research SAFE; University of Cologne - Faculty of Management, Economics and Social Sciences

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Date Written: August 16, 2019

Abstract

We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium effects of private precautionary saving on factor prices. For logarithmic utility a complete analytical solution of the Ramsey problem exhibits an optimal aggregate saving rate that is independent of income risk, whereas the optimal time-invariant tax on capital implementing this saving rate is increasing in income risk. The optimal saving rate is constant along the transition and its sign depends on the magnitude of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently induces a Pareto-improving transition even if the initial equilibrium is dynamically efficient. For general Epstein-Zin-Weil utility we show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1.

Keywords: Idiosyncratic Risk, Taxation of Capital, Overlapping Generations, Precautionary Saving, Pecuniary Externality

JEL Classification: H21, H31, E21

Suggested Citation

Krueger, Dirk and Ludwig, Alexander, Optimal Taxes on Capital in the OLG Model with Uninsurable Idiosyncratic Income Risk (August 16, 2019). SAFE Working Paper No. 201. Available at SSRN: https://ssrn.com/abstract=3124792 or http://dx.doi.org/10.2139/ssrn.3124792

Dirk Krueger

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
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Philadelphia, PA 19104-6297
United States
215-898-6691 (Phone)
215-573-2057 (Fax)

HOME PAGE: http://www.econ.upenn.edu/~dkrueger/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
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Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alexander Ludwig (Contact Author)

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

University of Cologne - Faculty of Management, Economics and Social Sciences ( email )

Albertus-Magnus-Platz
Cologne, D-50923
Germany

HOME PAGE: http://www.wiso.uni-koeln.de/cmr/alexludwig

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