Working Paper

Optimal Ramsey Capital Income Taxation —A Reappraisal

Abstract: This paper addresses a long-standing problem in the optimal Ramsey capital taxation literature. The tractability of our model enables us to solve the Ramsey problem analytically along the entire transitional path. We show that the conventional wisdom on Ramsey tax policy and its underlying intuition and rationales do not hold in our model and may thus be misrepresented in the literature. We uncover a critical trade off for the Ramsey planner between aggregate allocative efficiency in terms of the modified golden rule and individual allocative efficiency in terms of self-insurance. Facing the trade-off, the Ramsey planner prefers issuing debt rather than taxing capital if possible. In particular, the planner always intends to supply enough bonds to relax individuals'' borrowing constraints to achieve the modified golden rule by crowding out capital. A capital tax is not the optimal tool to achieve aggregate allocative efficiency, despite possible over-accumulation of capital. Thus, the optimal capital tax can be zero, positive, or even negative, depending on the Ramsey planner's ability to issue debt. The modified golden rule can fail to hold whenever the government encounters a debt limit. Finally, the planner's desire to relax individuals'' borrowing constraints may lead to unlimited debt accumulation, resulting in a dynamic path featuring no steady state.

Keywords: Optimal Capital Taxation; Ramsey Problem; incomplete markets;

JEL Classification: E13; E62; H21; H30;

https://doi.org/10.20955/wp.2017.024

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2017-09-07

Number: 2017-24

Pages: 39 pages