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

81 Pages Posted: 18 Apr 2018

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: 2018

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 feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent 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 generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and 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 (2018). ZEW - Centre for European Economic Research Discussion Paper No. 18-014. Available at SSRN: https://ssrn.com/abstract=3164218 or http://dx.doi.org/10.2139/ssrn.3164218

Dirk Krueger (Contact Author)

University of Pennsylvania - Department of Economics ( email )

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

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Alexander Ludwig

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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