Optimal Taxation in a Limited Commitment Economy

By Yena Park

http://d.repec.org/n?u=RePEc:pen:papers:12-033&r=dge

This paper studies optimal Ramsey taxation when risk sharing in private insurance markets is imperfect due to limited enforcement. In a limited commitment economy, there are externalities associated with capital and labor because individuals do not take into account that their labor and saving decisions affect aggregate supply, wages and thus the value of autarky. Due to these externalities, the Ramsey government has an additional goal, which is to internalize the externalities of labor and capital to improve risk sharing, in addition to its usual goal – minimizing distortions when financing government expenditures. These two goals drive capital and labor taxes in opposite directions. By balancing these conflicting goals, the steady-state optimal capital income taxes are levied only to remove the negative externality of the capital, and optimal labor income taxes are set to meet the budgetary needs of the government in the long run, despite positive externalities of labor.

This paper studies an interesting aspect of capital under limited commitment and thus imperfect insurance: this leads to higher accumulation of capital. But having more aggregate capital also improves autarky wages and thus uncentives to leave the insurance contract. Thus, you want to tax capital to bring it back to the efficient level. Yet, there is also the standard Ramsey result that capital should not be taxed.

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