Working Paper 508

Optimal Capital Income Taxation With Incomplete Markets, Borrowing Constraints, and Constant Discounting

S. Rao Aiyagari

Revised March 1, 1994

For a wide class of dynamic models, Chamley (1986) has shown that the optimal capital income tax rate is zero in the long run. Lucas (1990) has argued that for the U.S. economy there is a significant welfare gain from switching to this policy. We show that for the Bewley (1986) class of models with heterogeneous agents and incomplete markets (due to uninsured idiosyncratic shocks), and borrowing constraints the optimal tax rate on capital income is positive even in the long run. Quantitative analysis of a parametric version of such a model suggests that one cannot dismiss the possibility that the observed tax rates on capital and labor income for the U.S. economy are fairly close to being (long run) optimal. We also provide an existence proof for the dynamic Ramsey optimal tax problem in this environment.

Published In: Journal of Political Economy (Vol. 103, No. 6, December 1995, pp. 1158-1175)

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