Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk

Sebastian Dyrda and Marcelo Pedroni

The Review of Economic Studies, 2023, vol. 90, issue 2, 744-780

Abstract: We study optimal fiscal policy in a standard incomplete-markets model with uninsurable idiosyncratic income risk, where a Ramsey planner chooses time-varying paths of proportional capital and labour income taxes, lump-sum transfers (or taxes), and government debt. We find that (1) short-run capital income taxes are effective in providing redistribution since the tax base is relatively unequal and inelastic; (2) an increasing pattern of labour income taxes over time mitigates intertemporal distortions from capital income taxes; (3) the optimal policy increases overall transfers, calibrated initially to the US welfare system, by roughly ; (4) two-thirds of the welfare gains come from redistribution and the remaining third come mostly from insurance; and (5) redistribution also leads to a more efficient allocation of labour via wealth effects on labour supply—lower productivity households can afford to work relatively less.

Keywords: Optimal taxation; Heterogeneous agents; Incomplete markets; E2; E6; H2; H3; D52 (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:oup:restud:v:90:y:2023:i:2:p:744-780.

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