Working Paper: CEPR ID: DP12717
Authors: Dirk Krueger; Alexander Ludwig
Abstract: We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium feedback of private precautionary saving. For logarithmic utility our full analytical solution of the Ramsey problem shows that the optimal aggregate saving rate is independent of income risk. The optimal time-invariant tax on capital is increasing in income risk. Its sign depends on the extent of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently generates a Pareto-improving transition even if the initial equilibrium is dynamically efficient. We generalize our results to Epstein-Zin-Weil utility and show that the optimal steady state saving rate is increasing in income risk if and only if the intertemporal elasticity of substitution is smaller than 1.
Keywords: idiosyncratic risk; taxation of capital; overlapping generations; precautionary saving
JEL Codes: H21; H31; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal aggregate saving rate (E21) | idiosyncratic income risk (D14) |
| income risk (G52) | optimal time-invariant tax on capital (H21) |
| optimal time-invariant tax on capital (H21) | Pareto-improving transition (D61) |
| intertemporal elasticity of substitution < 1 (D15) | optimal steady state saving rate (D15) |
| precautionary savings effect + general equilibrium effects (E21) | optimal aggregate saving rate (E21) |
| Ramsey government's internalization of negative externalities (H00) | future generations' welfare (I39) |