Finance and Economics Discussion Series

Optimal Capital Taxation with Idiosyncratic Investment Risk

Vasia Panousi and Catarina Reis
2012-70

Abstract: We examine the optimal taxation of capital in a Ramsey setting of a general-equilibrium heterogeneous-agent economy with uninsurable idiosyncratic investment or capital-income risk. We prove that the ex ante optimal tax, evaluated at steady state, maximizes human wealth, namely the present discounted value of agents' income from sources that are not subject to capital risk. Furthermore, when the amount of idiosyncratic risk in the economy is higher than a minimum lower bound, the optimal tax is positive and it is precisely the tax that maximizes the economy-wide aggregates, such as the capital stock and output. By contrast, when the amount of risk is exogenously very low, the social planner finds it optimal to increase social risk taking by subsidizing investment in capital.

Keywords: Optimal capital taxation, idiosyncratic investment risk, general equilibrium, heterogeneous agents