A UNIFIED FRAMEWORK FOR OPTIMAL TAXATION WITH UNDIVERSIFIABLE RISK

Vasia Panousi,Catarina Reis

doi:10.1017/s1365100519000695

Vasia Panousi, Catarina Reis

Open Access

https://doi.org/10.1017/s1365100519000695

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Abstract

This paper considers a model of linear capital taxation for an economy where capital and labor income are subject to idiosyncratic uninsurable risk. To keep the model tractable, we assume that investment decisions are made before uncertainty is realized, so that the realization of the capital and labor income shocks only affects current consumption. In this setting, we are able to jointly analyze capital and labor income risk and derive analytical results regarding the optimal taxation of capital. We find that the optimal capital tax is positive in the long run if there is only capital income risk. The reason for this is that the capital tax provides insurance against capital income risk. Furthermore, for high levels of risk, increasing the capital tax may actually induce capital accumulation. On the other hand, if there is only labor income risk, the optimal capital tax is zero. The sign of the optimal tax can only be negative if the two types of risk are negatively correlated and labor income risk is large enough.

Highlights

This model aims to study individual idiosyncratic risk in a simple framework with both labor income risk and capital income risk
This paper will be able to do so by making the simplifying assumption that investment decisions are made before uncertainty is realized
)kt : The crucial assumption in this paper is that households choose kt+1 before the uncertainty in t and t is realized. This implies that all households will make the same investment decisions over time, which allows us to maintain the representative agent of the model by limiting the e¤ect of the idiosyncratic shock realization to current consumption

Summary

Introduction

This model aims to study individual idiosyncratic risk in a simple framework with both labor income risk and capital income risk. In our model if there are only labor income shocks the optimal capital income tax is zero. This is di¤erent from the Aiyagari (1995) paper, where the optimal capital income tax is positive if there is labor income risk. If there is only capital income risk the optimal tax is always positive in our model.

Results

Conclusion