Working Paper: NBER ID: w24335
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: capital taxation; overlapping generations; idiosyncratic income risk; optimal tax policy
JEL Codes: E21; H21; H31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| income risk (G52) | optimal capital tax rate (H21) |
| optimal aggregate saving rate (E21) | income risk (G52) |
| optimal capital tax rate (H21) | Pareto-improving transition (D61) |
| income risk (G52) | optimal steady-state saving rate (D15) |
| intertemporal elasticity of substitution < 1 (D15) | optimal steady-state saving rate (D15) |