Optimal Capital Taxation with Idiosyncratic Investment Risk

Abstract

We examine the optimal taxation of capital in a general-equilibrium heterogeneousagent economy with uninsurable idiosyncratic investment or capital-income risk. Our framework combines elements from the Ramsey and the Mirrlees traditions, as we consider a linear tax but also introduce lump-sum transfers. The tractability of our model allows for an analytic characterization of the long run, as well as along the transition to the steady state. Specifically, the ex ante optimal tax, evaluated in the long run, maximizes human wealth, namely the present discounted value of agents’ income from riskless sources. The sign of the optimal tax depends on the strength of distortion versus redistribution considerations. When idiosyncratic risk in the economy is below a minimum lower bound, the optimal tax is negative, brings capital to its first-best level, and does not maximize aggregate consumption. When risk is above this lower bound, the optimal tax can be either positive or negative, brings the capital stock to its maximum feasible level, and maximizes aggregate consumption. In both cases, the tax encourages risk taking and increases capital accumulation. We also show that the transition to the long-run optimal tax occurs monotonically from above, so that the short run entails higher capital taxes than the long run.