This paper investigates the optimal tax structure in an overlapping generations model in which individuals face idiosyncratic income risk, borrowing constraints and lifetime uncertainty. The calibrated model economy produces some quantitative results that differ significantly from the findings of the previous research. The main finding in this imperfect insurance setup is that moving away from capital income taxation toward higher labor income taxation yields a (steady-state) welfare benefit of 1% of aggregate consumption compared with the 6% figure Lucas (1990) finds in an infinite-horizon, complete markets model. This is because replacing the tax on capital income with a higher tax on labor income redistributes resources away from the young working years during which borrowing constraints are more likely to bind. Furthermore, when the individuals have access to a private annuity market to insure against uncertain lifetimes, it becomes optimal to tax capital. When a consumption tax is made available, it is optimal to switch to consumption taxation. The welfare benefit from implementing this optimal plan is on the order of 1.5-3.2% of GNP.
- Federal Reserve Bank of Minneapolis. Research Department.
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