Journal Article

Optimal Taxation in a Limited Commitment Economy

Yena Park

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 81, issue 2, pages 884-918
Published in print April 2014 | ISSN: 0034-6527
Published online October 2013 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1093/restud/rdt038
Optimal Taxation in a Limited Commitment Economy

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  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • General Equilibrium and Disequilibrium
  • Taxation, Subsidies, and Revenue

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This article studies optimal Ramsey taxation when risk sharing in private insurance markets is imperfect due to limited enforcement. In a limited commitment economy, there are externalities associated with capital and labour because individuals do not take into account that their labour and saving decisions affect aggregate labour and capital supply and wages, and thus the value of autarky. Therefore, a Ramsey government has an additional goal, which is to internalize these externalities of labour and capital to improve risk sharing, in addition to its usual goal—minimizing distortions in financing government expenditures. These two goals drive capital and labour taxes in opposite directions. It is shown that the steady-state optimal capital income taxes are levied only to remove the negative externality of the capital, whereas optimal labour income taxes are set to meet the budgetary needs of the government in the long run, despite the presence of positive externalities of labour.

Keywords: Ramsey Taxation; Limited Enforcement; D52; E62; H21; H23

Journal Article.  14114 words.  Illustrated.

Subjects: Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook ; General Equilibrium and Disequilibrium ; Taxation, Subsidies, and Revenue

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