Optimal Ramsey Capital Income Taxation —A Reappraisal

September 21, 2017

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.


Are consistent expectations better than rational expectations?

September 21, 2017

By Elliot Aurissergues


In this paper, I argue that agents may prefer learning a misspecified model instead of learning the rational expectation model. I consider an economy with two types of agent. Fundamentalists learn a model where endogenous variables depend on relevant exogenous variables whereas followers learn a model where endogenous variables are function of their lagged values. A Fundamentalist is like a DSGE econometrician and a follower is like a VAR econometrician. If followers (resp. fundamentalists) give more accurate forecasts, a fraction of fundamentalists (resp. followers) switch to the follower model. I apply this algorithm in a linear model. Results are mixed for rational expectations. Followers may dominate in the long run when there are strategic complementarities and high persistence of exogenous variables. When additional issues are introduced, like structural breaks or unobservable exogenous variable, followers can have a significant edge on fundamentalists. I apply the algorithm in three economic models a cobweb model, an asset price model and a simple macroeconomic model.

This horse race is a bit different from the ones focusing on the forecasting ability of statistical and micro-founded models. Here it is about how well agents following each strategy do in a fictitious world. It turns out “fundamentalists” do not do too well when the model changes on them. The critical aspect here is whether they are really blind to what is happening here. Says for example that suddenly a government loses the ability to borrow. A real-world fundamentalist would be able to reevaluate with this information. In this paper, though, he continues with a model that is obviously misspecified and only over time realizes that there is a new constraint. What is the more likely scenario?

Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective

September 13, 2017

By Patrick Fève and Olivier Pierrard


In this paper, we revisit the role of regulation in a small-scale dynamic stochastic general equilibrium (DSGE) model with interacting traditional and shadow banks. We estimate the model on US data and we show that shadow banking interferes with macro-prudential policies. More precisely, asymmetric regulation causes a leak towards shadow banking which weakens the expected stabilizing effect. A counterfactual experiment shows that a regulation of the whole banking sector would have reduced investment fluctuations by 10% between 2005 and 2015. Our results therefore suggest to base regulation on the economic functions of financial institutions rather than on their legal forms.

Regulators and banks play a cat and mouse game, and I wonder whether to adopt a rule like “if it looks like a bank, regulate as a bank” would work. But this is a good attempt at tackling the shadow banking sector, which is difficult to track properly both in real life and as a modeler.

Goods and Factor Market Integration: A Quantitative Assessment of the EU Enlargement

September 7, 2017

By Lorenzo Caliendo, Luca David Opromolla, Fernando Parro and Alessandro Sforza


The economic effects from labor market integration are crucially affected by the extent to which countries are open to trade. In this paper we build a multi-country dynamic general equilibrium model with trade in goods and labor mobility across countries to study and quantify the economic effects of trade and labor market integration. In our model trade is costly and features households of different skills and nationalities facing costly forward-looking relocation decisions. We use the EU Labour Force Survey to construct migration flows by skill and nationality across 17 countries for the period 2002-2007. We then exploit the timing variation of the 2004 EU enlargement to estimate the elasticity of migration flows to labor mobility costs, and to identify the change in labor mobility costs associated to the actual change in policy. We apply our model and use these estimates, as well as the observed changes in tariffs, to quantify the effects from the EU enlargement. We find that new member state countries are the largest winners from the EU enlargement, and in particular unskilled labor. We find smaller welfare gains for EU-15 countries. However, in the absence of changes to trade policy, the EU-15 would have been worse off after the enlargement. We study even further the interaction effects between trade and migration policies and the role of different mechanisms in shaping our results. Our results highlight the importance of trade for the quantification of the welfare and migration effects from labor market integration.

Trade in goods and movement of labor are substitutes. Opening trade and labor may thus introduce complex interactions. This paper tries to sort that out in general equilibrium, and it turns out everyone wins, although not necessarily a lot.

Banking Panics and Output Dynamics

September 1, 2017

By Daniel Sanches


This paper develops a dynamic general equilibrium model with an essential role for an illiquid banking system to investigate output dynamics in the event of a banking crisis. In particular, it considers the ex-post efficient policy response to a banking crisis as part of the dynamic equilibrium analysis. It is shown that the trajectory of real output following a panic episode crucially depends on the cost of converting long-term assets into liquid funds. For small values of the liquidation cost, the recession associated with a banking panic is protracted as a result of the premature liquidation of a large fraction of productive banking assets to respond to a panic. For intermediate values, the recession is more severe but short-lived. For relatively large values, the contemporaneous decline in real output in the event of a panic is substantial but followed by a vigorous rebound in real activity above the long-run level.

Hmm, Daniel Sanches is onto something here. Could the high level of financial development be the reason it took so long for the United States to get out of the last banking crisis? Eyeballing the graphs, it looks like the total cost of a banking crisis recession is higher if liquidation is less costly. That seems to be a surprising and counter-intuitive result, as large financial frictions seem to be better. And I wonder whether the steady-state effect of liquidation costs is stronger than the cyclical effect. So many questions…

Dynastic Precautionary Savings

August 29, 2017

By Corina Boar


This paper demonstrates that parents accumulate savings to insure their children against income risk. I refer to these as dynastic precautionary savings. Using a sample of matched parent-child pairs from the Panel Study of Income Dynamics, I test for dynastic precautionary savings by examining the response of parental consumption to the child’s permanent income uncertainty. I exploit variation in permanent income risk across age and industry-occupation groups to confirm that higher uncertainty in the child’s permanent income depresses parental consumption. In particular, I find that the elasticity of parental consumption to child’s permanent income risk ranges between -0.08 and -0.06, and is of similar magnitude to the elasticity of parental consumption to own income risk. Motivated by the empirical evidence, I analyze the implications of dynastic precautionary saving in a quantitative model of altruistically linked overlapping generations. I use the model to (i) examine the size and timing of inter-vivos transfers and bequest, (ii) perform counterfactual experiments to isolate the contribution of dynastic precautionary savings to wealth accumulation and intergenerational transfers, and (iii) assess the effect of two policy proposals that can affect parents’ incentives to engage in dynastic precautionary savings: universal basic income and guaranteed minimum income. Lastly, I explore the implications of strategic interactions between parents and children for parents’ precautionary and dynastic precautionary behavior.

This is a seriously cool paper. I can even relate to it on a personal level… With all the talk about increased uncertainty for the new generation, this is important work. It is also important to see what the implications are for mobility, because if only wealthy parents can give such a security blanket to their kids, a lot of untapped talent will remain unused. This is something we already worry about for access to education, and this paper shows that this is also important for the first years on the job market as well.

Quantifying the Welfare Gains from History Dependent Income Taxation

August 4, 2017

By Marek Kapicka


I quantify the welfare gains from introducing history dependent income tax in an incomplete markets framework where individuals face uninsurable random walk idiosyncratic shocks. I assume that the income tax paid is a function of a geometrical weighted average of past incomes, and solve for the optimal weights. I find that the optimal weights on past incomes decline geometrically at a rate equal to the discount rate. The welfare gains from history dependence are large, about 1.77 percent of consumption. I decompose the total effect into an efficiency effect that increases labor supply, and an insurance effect that reduces volatility of consumption and find that, quantitatively, the insurance effect dominates the efficiency effect. The optimal tax increases consumption insurance by trading higher tax progressivity with repect to past incomes for a reduced tax progressivity with respect to the current income.

Interesting result. It clearly makes sense that taxes should not only depend on income in the current snapshot in time. The paper shows that even a rigid formula on past taxes easily enhances welfare. Imagine if the formula were more flexible than a weighted average.