Events at CERGE-EI

Prof. Alex Ludwig

Goethe University Frankfurt, Germany

Authors: Dirk Krueger and Alexander Ludwig

Abstract: In this paper we characterize the optimal linear tax on capital in the standard Overlapping Generations model with neoclassical productionand capital accumulation as well as idiosyncratic labor income riskand incomplete markets. For logarithmic utility we provide a completeanalytical solution of the optimal Ramsey tax policy problem for arbitrarysocial welfare weights across generations. The Ramsey allocationis characterized by a constant (over time) aggregate saving rate that isindependent of the extent of idiosyncratic income risk. The Ramsey governmentinternalizes that an increase in the household saving rate impactswages and interest rate in general equilibrium; we show that with logarithmicthis pecuniary externality general equilibrium effect exactly cancelsout the standard precautionary savings effect in partial equilibrium. Theconstant tax on capital implementing this saving rate is increasing in theextent of income risk, but might be positive or negative, depending on howthe Ramsey government values current and future generations. We alsoshow that if it is positive, then a government implementing this tax rategenerates a Pareto-improving, policy induced transition from the unregulatedsteady equilibrium even if this equilibrium is dynamically efficient.We then generalize our results to arbitrary Epstein-Zin-Weil utility andshow that the optimal steady state saving rate is increasing in the amountof income risk if and only if the intertemporal elasticity of substitution issmaller than 1. The associated tax rate is increasing in income risk unlessboth the IES and risk aversion are large.

The seminar is co-financed by the European Union.

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