Working Paper: CEPR ID: DP2172
Authors: Andrew Scott
Abstract: Using a stochastic growth model we derive analytic expressions for optimal labour and capital tax rates under both complete and incomplete markets. We find taxes are driven by two factors reflecting : (a) Ramsey efficiency considerations and (b) the financing needs of the government which vary with the excess burden of taxation.In the case of complete markets the government insures against variations in the excess burden of taxation and taxes change purely for efficiency reasons. The serial correlation and volatility of labour taxes are determined by those of employment and do not necessarily imply smooth taxrates. Under incomplete markets both Ramsey considerations and variations in the excess burden of taxation lead to changes in taxes with the latter providing a unit root component to optimal labour taxes.Using US data we find that the majority of fluctuations in marginal tax rates are due to fluctuations in the excess burden of taxation rather than exploitation of Ramsey considerations.
Keywords: Fiscal Policy; Incomplete Markets; Optimal Taxation; Tax Smoothing
JEL Codes: E60; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| completeness of markets (D52) | smoother tax rates (H29) |
| incomplete markets (D52) | increased volatility in labor tax rates (H31) |
| government financing needs (H59) | tax rate variability (H29) |
| employment levels (J23) | labor tax rates (J89) |
| negative fiscal shocks (H69) | capital tax rates (H24) |