Insurance and Taxation over the Life Cycle

Iván Werning and Emmanuel Farhi

No 909, 2010 Meeting Papers from Society for Economic Dynamics

Abstract: We consider a dynamic Mirrlees economy in a life cycle context and study the optimal insurance arrangement. Individual productivity evolves as a Markov process and is private information. We use a first order approach in discrete and continuous time and obtain novel theoretical and numerical results. Our main contribution is a formula describing the dynamics for the labor-income tax rate. When productivity is an AR(1) our formula resembles an AR(1) with a trend where: (i) the auto-regressive coefficient equals that of productivity; (ii) the trend term equals the covariance productivity with consumption growth divided by the Frisch elasticity of labor; and (iii) the innovations in the tax rate are the negative of consumption growth. The last property implies a form of short-run regressivity. Our simulations illustrate these results and deliver some novel insights. The average labor tax rises from 0% to 40% over 40 years, while the average tax on savings falls from 20% to 0% at retirement. We compare the second best solution to simple history independent tax systems, calibrated to mimic these average tax rates. We find that age dependent taxes capture a sizable fraction of the welfare gains. In this way, our theoretical results provide insights into simple tax systems.

Date: 2010
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Related works:
Journal Article: Insurance and Taxation over the Life Cycle (2013)
Working Paper: Insurance and Taxation over the Life Cycle (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed010:909

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