Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk

49 Pages Posted: 27 Nov 2018 Last revised: 22 Jan 2022

See all articles by Sebastian Dyrda

Sebastian Dyrda

University of Toronto - Department of Economics

Marcelo Pedroni

University of Amsterdam; Tinbergen Institute

Date Written: January 20, 2022

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 labor 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 labor 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 50 percent; (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 labor via wealth effects on labor supply---lower productivity households can afford to work relatively less.

Keywords: Optimal taxation; Heterogeneous agents; Incomplete markets

JEL Classification: E2; E6; H2; H3; D52

Suggested Citation

Dyrda, Sebastian and Pedroni, Marcelo, Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk (January 20, 2022). Available at SSRN: https://ssrn.com/abstract=3289306 or http://dx.doi.org/10.2139/ssrn.3289306

Sebastian Dyrda (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S3G7
Canada

Marcelo Pedroni

University of Amsterdam ( email )

Roetersstraat 11
Amsterdam, North Holland 1018 WB
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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