Optimal Asset Taxes in Financial Markets with Aggregate Uncertainty

This paper studies Pareto-optimal risk-sharing arrangements in a private information economy with aggregate uncertainty and ex ante heterogeneous agents. I show how to implement Pareto-optima as equilibria when agents can trade claims to consumption contingent on aggregate shocks in financial markets. The first result is that if aggregate and idiosyncratic shocks are independent, the implementation of optimal allocations does not require any interventions in financial markets. This result can be extended to dynamic settings in the sense that, in this case, only savings need to be distorted, but not trades in financial markets. Second, I characterize optimal trading distortions in financial markets when aggregate and idiosyncratic shocks are not independent. In this case, optimal asset taxes must be higher for those securities that pay out in aggregate states in which consumption is more volatile. For instance, this can provide an efficiency justification for the frequently observed differential tax treatment of different asset classes, such as debt and equity claims.

Competitive Screening in Insurance Markets with Endogenous Wealth Heterogeneity

We examine equilibria in competitive insurance markets with adverse selection when wealth differences arise endogenously from unobservable savings or labor supply decisions. The endogeneity of wealth implies that high risk individuals may ceteris paribus exhibit the lower marginal willingness to pay for insurance than low risks, a phenomenon that we refer to as irregular-crossing preferences. In our model, both risk and patience (or productivity) are privately observable. In contrast to the models in the existing literature, where wealth heterogeneity is exogenously assumed, equilibria in our model no longer exhibit a monotone relation between risk and coverage. Individuals who purchase larger coverage are no longer higher risks, a phenomenon frequently observed in empirical studies.Insurance Markets, Adverse Selection, Multidimensional Screening

Competitive Markets without Commitment

In the presence of a time-inconsistency problem with optimal agency contracts, we show that competitive markets implement allocations that Pareto dominate those achieved by a benevolent planner, they induce strictly more effort, and they sometimes make the commitment problem disappear entirely. In particular, we analyze a model with moral hazard and two-sided lack of commitment. After agents have chosen a hidden effort and the need to provide incentives has vanished, firms can modify their contracts and agents can switch firms. As long as the ex-post market outcome satisfies a weak notion of competitiveness and sufficiently separates individuals who choose different effort levels, the market allocation is Pareto superior to a social planner’s allocation. We construct a specific market game that naturally generates robust equilibria with these properties. In addition, we show that equilibrium contracts without commitment are identical to those with full commitment if the latter involve no cross-subsidization between individuals who choose different effort levels.Time-Inconsistency, Moral Hazard, Competitive Markets, Adverse Selection

Competitive Screening in Insurance Markets with Endogenous Labor Supply

We examine equilibria in competitive insurance markets when individuals take unobservable labor supply decisions. Precautionary labor motives intro-duce countervailing incentives in the insurance market, and equilibria with positive profits can occur even in the standard case in which individuals exogenously differ in risk only. We then extend the model to allow for both privately known risks and labor productivities. This endogenously introduces two-dimensional heterogeneity in the insurance market since precautionary labor effects lead to differences in income and hence risk aversion. Under these circumstances, separating and pooling equilibria exist, which generally differ from those with exogenous two-dimensional heterogeneity considered by the existing literature. Notably, in contrast to standard screening models, profits may be increasing with insurance coverage, and the correlation between risk and coverage can be zero or negative in equilibrium, a phenomenon frequently observed in empirical studies.Insurance markets, adverse selection, precautionary labor

A Grexit may be plausible from an economic perspective, but politically it would be a disaster

Should the rest of Europe be concerned by the consequences of Greece leaving the Eurozone? Florian Schui writes that while from an economic perspective a Grexit is entirely manageable, from a political perspective it would be a disaster for the EU. He argues that Greece leaving the euro would send the message that European leaders are more willing to allow the Eurozone to break up than they are to abandon austerity policies

Signaling to experts

We study competitive equilibria in a signaling economy with heterogeneously informed buyers. In terms of the classic Spence (1973) model of job market signaling, firms have access to direct but imperfect information about worker types, in addition to observing their education. Firms can be ranked according to the quality of their information, i.e. their expertise. In equilibrium, some high-type workers forgo signaling and are hired by better informed firms, which make positive profits. Workers’ education decisions and firms’ use of their expertise are strategic complements, allowing for multiple equilibria that can be Pareto ranked. We characterize wage dispersion and the extent of signaling as a function of the distribution of expertise among firms. Our model can also be applied to a variety of other signaling problems, including securitization, corporate financial structure, insurance markets, or dividend policy

Optimal taxation with rent-seeking

We develop a framework for optimal taxation when agents can earn their income both in traditional activities, where private and social products coincide, and in rent-seeking activities, where private returns exceed social returns either because they involve the capture of pre-existing rents or because they reduce the returns to traditional work. We characterize Pareto optimal income taxes that do not condition on how much of an individual's income is earned in each of the two activities. These optimal taxes feature an externality-corrective term, the magnitude of which depends both on the Pigouvian correction that would obtain if rent-seeking incomes could be perfectly targeted and on the relative impact of rent-seeking externalities on the private returns to traditional and to rent-seeking activities. If rent-seeking externalities primarily affect other rent-seekers, for example, the optimal correction lies strictly below the Pigouvian correction. A calibrated model indicates that the gap between the Pigouvian and optimal correction can be quantitatively important. Our results thus point to a hefty informational requirement for correcting rent-seeking externalities through the income tax code

Optimal Taxation with Rent-Seeking

Recent policy proposals have suggested taxing top incomes at very high rates on the grounds that some or all of the highest wage earners are engaged in socially unproductive or counterproductive activities, such as externality imposing speculation in the financial sector. To address this, we provide a model in which agents can choose between working in a traditional sector, where private and social products coincide, and a crowdable rent-seeking sector, where some or all of earned income reflects the capture of pre-existing output rather than increased production. We characterize Pareto optimal linear and non-linear income tax systems under the assumption that the social planner cannot or does not observe whether any given individual is a traditional worker or a rent-seeker. We find that optimal marginal taxes on the highest wage earners can remain remarkably modest even if all high earners are socially unproductive rent-seekers and the government has a strong intrinsic desire for progressive redistribution. Intuitively, taxing their effort at a lower rate stimulates their rent-seeking efforts, thereby keeping private returns for other potential rent-seekers low and discouraging further entry.

Insurance and taxation

Thesis (Ph. D.)--Massachusetts Institute of Technology, Dept. of Economics, 2010.Cataloged from PDF version of thesis.Includes bibliographical references (p. 135-144).Chapter 1 analyzes Pareto optimal non-linear taxation of profits and labor income in a private information economy with endogenous firm formation. Individuals differ in both their skill and their cost of setting up a firm, and choose between becoming workers and entrepreneurs. I show that a tax system in which entrepreneurial profits and labor income must be subject to the same non-linear tax schedule makes use of general equilibrium effects through wages to indirectly achieve redistribution between entrepreneurs and workers. As a result, constrained Pareto optimal policies can involve negative marginal tax rates at the top and, if available, input taxes that distort the firms' input choices. However, these properties disappear when a differential tax treatment of profits and labor income is possible, as for instance implemented by a corporate income tax. In this case, redistribution is achieved directly through the tax system rather than "trickle down" effects, and production efficiency is always optimal. When I extend the model to incorporate entrepreneurial borrowing in credit markets, I find that endogenous cross-subsidization in the credit market equilibrium results in excessive (insufficient) entry of low-skilled (high-skilled) agents into entrepreneurship. Even without redistributive objectives, this gives rise to an additional, corrective role for differential taxation of entrepreneurial profits and labor income. In particular, a regressive profit tax may restore the efficient occupational choice. In chapter 2, which is joint work with Nick Netzer, we show that, in the presence of a time-inconsistency problem with optimal agency contracts, competitive markets can implement allocations that Pareto dominate those achieved by a benevolent planner, and they induce more effort. In particular, we analyze a model with moral hazard and two-sided lack of commitment. After agents have chosen a hidden effort and the need to provide incentives has vanished, firms can modify their contracts and agents can switch firms, resulting in an adverse selection problem at the ex-post stage. As long as the ex-post market outcome satisfies a weak notion of competitiveness and sufficiently separates individuals who choose different effort levels, the market allocation is Pareto superior to a social planner's allocation with a complete breakdown of incentives. In addition, even when a planner without commitment is able to sustain effort incentives, competitive markets without commitment implement more effort in equilibrium under general conditions. We illustrate our findings with standard market equilibrium concepts. Chapter 3 studies Pareto-optimal risk-sharing arrangements in a private information economy with aggregate uncertainty and ex ante heterogeneous agents. I show that any such arrangement has to be such that ratios of expected inverse marginal utilities across different agents are independent of aggregate shocks. I use this condition to show how to implement Pareto-optima as equilibria when agents can trade claims to consumption contingent on aggregate shocks in financial markets. If aggregate shocks affect individual outputs only, the implementation of optimal allocations does not require interventions in financial markets. If they also affect probability distributions over idiosyncratic risk, however, transaction taxes need to be introduced that are higher for claims to consumption in states with a more volatile distribution of likelihood ratios in the sense of second-order stochastic dominance. Two implementation results are provided. If transaction taxes are constrained to be linear, they need to condition on individual outputs in addition to aggregate shocks. To prevent double-deviations, they induce additional risk for agents who buy financial claims and provide additional insurance to those who sell them. Finally, an implementation with non-linear transaction taxes that do not depend on idiosyncratic shocks is constructed..by Florian Scheuer.Ph.D

Optimal Taxation with Rent-Seeking

Recent policy proposals have suggested taxing top incomes at very high rates on the grounds that some or all of the highest wage earners are engaged in socially unpro- ductive or counterproductive activities, such as externality imposing speculation in the financial sector. To address this, we provide a model in which agents can choose between working in a traditional sector, where private and social products coincide, and a crowdable rent-seeking sector, where some or all of earned income reflects the capture of pre-existing output rather than increased production. We character- ize Pareto optimal linear and non-linear income tax systems under the assumption that the social planner cannot or does not observe whether any given individual is a traditional worker or a rent-seeker. We find that optimal marginal taxes on the high- est wage earners can remain modest even if all high earners are socially unproductive rent-seekers and the government has a strong intrinsic desire for progressive redis- tribution. Intuitively, taxing their effort at a lower rate stimulates their rent-seeking efforts, thereby keeping private returns for other potential rent-seekers low and dis- couraging further entry