Capital Taxation: Quantitative Explorations of the Inverse Euler Equation

50 Pages Posted: 15 May 2006 Last revised: 3 May 2009

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Iván Werning

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: April 10, 2009

Abstract

This paper studies the efficiency gains from distorting savings in dynamic Mirrleesian private-information economies. We develop a method that pertubs the consumption process optimally, while preserving incentive compatibility. The Inverse Euler equation holds at the new optimized allocation. Starting from an equilibrium where agents can save freely allows us to compute the efficiency gains from savings disortions. We investigate how these gains depend on a limited set of features of the economy. We find an important role for general equilibrium effects. In particular, efficiency gains are greatly reduced when, rather than assuming a fixed interest rate, decreasing returns to capital are incorporated with a neoclassical technology. We compute the efficiency gains for the incomplete market model in Aiyagari [1994] and find them to be relatively modest for the baseline calibration. For higher levels of uncertainty, the efficiency gains can be sizable, but we find that most of the improvements can then attributed to the relaxation of borrowing constraints, rather than the introduction of savings distortions.

Keywords: Capital taxation, inverse Euler equation, constrained efficient, Chamley-Judds

JEL Classification: E6, H2

Suggested Citation

Farhi, Emmanuel and Werning, Ivan, Capital Taxation: Quantitative Explorations of the Inverse Euler Equation (April 10, 2009). MIT Department of Economics Working Paper No. 06-15, Available at SSRN: https://ssrn.com/abstract=902070 or http://dx.doi.org/10.2139/ssrn.902070

Emmanuel Farhi

Harvard University - Department of Economics ( email )

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Ivan Werning (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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