Capital Market Imperfections and Tax Policy Analysis in the Life Cycle Model

Abstract

One issue often overlooked in dynamic fiscal policy analysis is the importance of assumptions made regarding individuals' abilities to use capital markets to transfer income across time. We focus on the impact of borrowing restrictions on consumption functions within the life cycle framework, and address a set of fiscal policy issues. Our principal concerns are two. First, taking into account the effect of borrowing constraints affects the calculation of the efficiency costs of taxation substantially. Second, we address within the life cycle model the importance of precautionary saving in response to capital market imperfections and consequent implications for effects of social insurance programs.