We evaluate the optimal fiscal policy in a standard incomplete-markets model with uninsurable idiosyncratic shocks, 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 expands the US social welfare system significantly, increasing overall transfers 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.
We show that the equilibrium policy rule in beauty contest models is equivalent to that of a single agent’s forecast of the economic fundamental. This forecast is conditional on a modified information process, which simply discounts the precision of idiosyncratic shocks by the degree of strategic complementarity. The result holds for any linear Gaussian signal process (static or persistent, stationary or nonstationary, exogenous or endogenous), and also extends to network games. Theoretically, this result provides a sharp characterization of the equilibrium and its properties under dynamic information. Practically, it provides a straightforward method to solve models with complicated information structures. (JEL C72, D82, D83, D84)
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.
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