Time-Consistent Taxation with Heterogeneous Agents

Abstract

I study optimal taxes and transfers along transition paths in an incomplete markets model with uninsurable risk, wherein individuals play a dynamic game with successive governments that lack the ability to commit to future policies. I characterize and solve for Markov-perfect equilibria in this dynamic game. I find that the government balances two types of externalities: income redistribution externalities through transfers and pecuniary externalities caused by changes in the factor composition of income. Commitment affects how the government balances the two types of externalities along the transition path. Quantitative analysis with a calibrated economy shows that the government with commitment substantially increases taxes and transfers early in the transition and maintains them thereafter. By doing so, the government attains front-loaded positive externalities from reduced income inequality and favorable factor price changes for low-income individuals while placing negative externalities from stagnant income redistribution and unfavorable factor price changes for low-income individuals in the long run. Without commitment, this equilibrium is not credible because the government disregards the upfront welfare gains and balances the two types of externalities in a forward-looking manner in each period.

Keywords: Markov-Perfect Policy, Income Taxation, Incomplete Markets, Heterogeneous Agents

JEL Classification: E61, H21