By YiLi Chien and Yi Wen
This paper addresses a long-standing problem in the optimal Ramsey capital taxation literature. The tractability of our model enables us to solve the Ramsey problem analytically along the entire transitional path. We show that the conventional wisdom on Ramsey tax policy and its underlying intuition and rationales do not hold in our model and may thus be misrepresented in the literature. We uncover a critical trade off for the Ramsey planner between aggregate allocative efficiency in terms of the modified golden rule and individual allocative efficiency in terms of self-insurance. Facing the trade off, the Ramsey planner prefers issuing debt rather than taxing capital if possible. In particular, the planner always intends to supply enough bonds to relax individuals’ borrowing constraints and through which to achieve the modified golden rule by crowding out capital. Capital tax is not the vital tool to achieve aggregate allocative efficiency despite possible over-accumulation of capital. Thus the optimal capital tax can be zero, positive, or even negative, depending on the Ramsey planner’s ability to issue debt. The modified golden rule can fail to hold whenever the government encounters a debt limit. Finally, the desire to relax individuals’ borrowing constraints by the planner may lead to unlimited debt accumulation, resulting in a dynamic path featuring no steady state.
This is an important contribution in the seemingly endless debate about capital income taxation. Here, the paper refocuses the issue on the ability of the government to issue debt. In particular, it shows that you cannot simultaneously impose debt limits on a government while hoping to achieve aggregate allocative efficiency. Whether you want to tax or even subsidize capital income would then depend on interest burden and labor income tax.