Time-Consistent Taxation with Heterogeneous Agents

Jang, Youngsoo (2023): Time-Consistent Taxation with Heterogeneous Agents.

Abstract

I study optimal taxes and transfers along transition paths in an incomplete markets model with uninsurable risk, wherein individuals play a dynamic game with successive governments that lack the ability to commit to future policies. I characterize and solve for Markov-perfect equilibria in this dynamic game. I find that the government balances two types of externalities: income redistribution externalities through transfers and pecuniary externalities caused by changes in the factor composition of income. Commitment affects how the government balances the two types of externalities along the transition path. Quantitative analysis with a calibrated economy shows that the government with commitment substantially increases taxes and transfers early in the transition and maintains them thereafter. By doing so, the government attains front-loaded positive externalities from reduced income inequality and favorable factor price changes for low-income individuals while placing negative externalities from stagnant income redistribution and unfavorable factor price changes for low-income individuals in the long run. Without commitment, this equilibrium is not credible because the government disregards the upfront welfare gains and balances the two types of externalities in a forward-looking manner in each period.

• Item Type: MPRA Paper
• Language: English
• Keywords: Markov-Perfect Policy, Income Taxation, Incomplete Markets, Heterogeneous Agents
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination; H - Public Economics > H1 - Structure and Scope of Government > H11 - Structure, Scope, and Performance of Government

References

Aiyagari, S Rao, “Uninsured idiosyncratic risk and aggregate saving,” The Quarterly Journal of Economics, 1994, 109 (3), 659–684.

and Dan Peled, “Social insurance and taxation under sequential majority voting and utilitarian regimes,” Journal of Economic Dynamics and Control, 1995, 19 (8), 1511–1528.

Barro, Robert J and David B Gordon, “Rules, discretion and reputation in a model of monetary policy,” Journal of monetary economics, 1983, 12 (1), 101–121.

Calvo, Guillermo A, “On the Time Consistency of Optimal Policy in a Monetary Economy,” Econometrica, 1978, 46 (6), 1411–1428.

Carroll, Christopher D, “The method of endogenous gridpoints for solving dynamic stochastic optimization problems,” Economics letters, 2006, 91 (3), 312–320.

Corbae, Dean, Pablo D’Erasmo, and Burhanettin Kuruscu, “Politico-economic consequences of rising wage inequality,” Journal of Monetary Economics, 2009, 56 (1), 43–61.

Davila, Julio, Jay H Hong, Per Krusell, and Jose´-V´ıctor R´ıos-Rull, “Constrained efficiency in the neoclassical growth model with uninsurable idiosyncratic shocks,” Econometrica, 2012, 80 (6), 2431–2467.

Dyrda, Sebastian and Marcelo Pedroni, “Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk,” Review of Economic Studies, Forthcoming, 2022.

Farhi, Emmanuel, Christopher Sleet, Ivan Werning, and Sevin Yeltekin, “Non-linear capital taxation without commitment,” Review of Economic Studies, 2012, 79 (4), 1469–1493.

Greenwood, Jeremy, Zvi Hercowitz, and Gregory W Huffman, “Investment, capacity utiliza- tion, and the real business cycle,” The American Economic Review, 1988, pp. 402–417.

Haan, Wouter J Den, “Assessing the accuracy of the aggregate law of motion in models with heterogeneous agents,” Journal of Economic Dynamics and Control, 2010, 34 (1), 79–99.

Jang, Youngsoo, Takeki Sunakawa, and Minchul Yum, “Heterogeneity, Transfer Progressivity and Business Cycles,” 2021.

Kim, Heejeong, “Inequality, disaster risk, and the great recession,” Review of Economic Dynamics, 2021.

Klein, Paul and Jose´-V´ıctor R´ıos-Rull, “Time-consistent optimal fiscal policy,” International Economic Review, 2003, 44 (4), 1217–1245.

, Per Krusell, and Jose´-V´ıctor R´ıos-Rull, “Time-consistent public policy,” The Review of Eco- nomic Studies, 2008, 75 (3), 789–808.

Krusell, Per and Anthony A Smith Jr, “Income and wealth heterogeneity in the macroeconomy,” Journal of political Economy, 1998, 106 (5), 867–896.

and Jose´-V´ıctor R´ıos-Rull, “On the size of US government: political economy in the neoclas- sical growth model,” American Economic Review, 1999, 89 (5), 1156–1181.

, Vincenzo Quadrini, and Jose´-V´ıctor R´ıos-Rull, “Are consumption taxes really better than income taxes?,” Journal of monetary Economics, 1996, 37 (3), 475–503.

Kydland, Finn E and Edward C Prescott, “Rules rather than discretion: The inconsistency of optimal plans,” Journal of political economy, 1977, 85 (3), 473–491.

Lucas, Robert and Nancy Stokey, “Optimal fiscal and monetary policy in an economy without capital,” Journal of Monetary Economics, 1983, 12 (1), 55–93.

Reiter, Michael, “Recursive computation of heterogeneous agent models,” manuscript, Universi- tat Pompeu Fabra, 2002, pp. 28–35.

, “Solving the incomplete markets model with aggregate uncertainty by backward induction,” Journal of Economic Dynamics and Control, 2010, 34 (1), 28–35.

Rouwenhorst, K Geert, “Asset Pricing Implications of Equilibrium Business Cycle Models. In: Cooley, T.F. (Ed.),” in “Frontiers of business cycle research,” Princeton University Press, 1995, pp. 294–330.

Song, Zheng, Kjetil Storesletten, and Fabrizio Zilibotti, “Rotten parents and disciplined children: A politico-economic theory of public expenditure and debt,” Econometrica, 2012, 80 (6), 2785–2803.

Straub, Ludwig and Iva´n Werning, “Positive long-run capital taxation: Chamley-Judd revisited,” American Economic Review, 2020, 110 (1), 86–119.